UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended June 30, 2002
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ______________ to ______________
Commission File Number: 1-12213
COVANCE INC.
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(Exact name of Registrant as specified in its Charter)
Delaware 22-3265977
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(State of Incorporation) (I.R.S. Employer Identification No.)
210 Carnegie Center, Princeton, New Jersey 08540
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (609) 452-4440
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of July 18, 2002, the Registrant had 60,404,523 shares of Common Stock
outstanding.
Covance Inc.
Form 10-Q For the Quarterly Period Ended June 30, 2002
INDEX
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets--June 30, 2002 and December 31, 2001..... 2
Consolidated Statements of Income--Three and Six Months ended
June 30, 2002 and 2001............................................... 3
Consolidated Statements of Cash Flows--Six Months ended June 30,
2002 and 2001........................................................ 4
Notes to Consolidated Financial Statements........................... 5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 10
Item 3. Quantitative and Qualitative Disclosure About Market Risk........ 20
Part II. Other Information
Item 4. Submission of Matters to a Vote of Security Holders.............. 21
Item 6. Exhibits and Reports on Form 8-K................................. 21
Signature Page............................................................ 22
1
COVANCE INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands) June 30, December 31,
2002 2001
--------- ---------
(UNAUDITED)
Assets
Current Assets:
Cash and cash equivalents ................................... $ 51,695 $ 35,404
Accounts receivable ......................................... 163,382 167,840
Unbilled services ........................................... 47,551 40,895
Inventory ................................................... 36,070 36,131
Deferred income taxes ....................................... 10,689 13,445
Prepaid expenses and other current assets ................... 32,301 30,778
--------- ---------
Total Current Assets .................................... 341,688 324,493
Property and equipment, net ..................................... 229,880 228,092
Goodwill, net ................................................... 54,107 54,038
Other assets .................................................... 5,058 5,405
--------- ---------
Total Assets ............................................ $ 630,733 $ 612,028
========= =========
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable ............................................ $ 21,113 $ 21,134
Accrued payroll and benefits ................................ 46,621 45,902
Accrued expenses and other current liabilities .............. 42,127 40,296
Unearned revenue ............................................ 101,853 116,712
Income taxes payable ........................................ 10,503 2,739
--------- ---------
Total Current Liabilities ............................... 222,217 226,783
Long-term debt .................................................. -- 15,000
Deferred income taxes ........................................... 11,233 11,613
Other liabilities ............................................... 14,638 13,687
--------- ---------
Total Liabilities ....................................... 248,088 267,083
--------- ---------
Commitments and Contingent Liabilities
Stockholders' Equity:
Preferred Stock - Par value $1.00 per share; 10,000,000
shares authorized; no shares issued and outstanding at
June 30, 2002 and December 31, 2001, respectively ....... -- --
Common Stock - Par value $0.01 per share; 140,000,000
shares authorized 62,403,045 and 61,882,084 shares
issued and outstanding, including those held in treasury,
at June 30, 2002 and December 31, 2001, respectively .... 624 619
Paid-in capital ............................................. 130,668 122,217
Retained earnings ........................................... 280,206 255,326
Accumulated other comprehensive income (loss)--
Cumulative translation adjustment ....................... (7,781) (12,310)
Treasury stock at cost (2,080,449 and 2,073,772 shares at
June 30, 2002 and December 31, 2001, respectively) ...... (21,072) (20,907)
--------- ---------
Total Stockholders' Equity .............................. 382,645 344,945
--------- ---------
Total Liabilities and Stockholders' Equity .............. $ 630,733 $ 612,028
========= =========
The accompanying notes are an integral part of these consolidated financial statements.
2
COVANCE INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
Three Months Ended Six Months Ended
June 30 June 30
---------------------------- ----------------------------
(Dollars in thousands, except per share data) 2002 2001 2002 2001
------------ ------------ ------------ ------------
Net revenues .......................................... $ 219,206 $ 226,421 $ 427,788 $ 455,079
Reimbursable out-of-pockets ........................... 10,623 10,279 20,323 20,226
------------ ------------ ------------ ------------
Total revenues ..................................... 229,829 236,700 448,111 475,305
------------ ------------ ------------ ------------
Cost and expenses:
Cost of revenue (including reimbursable expenses) .. 162,920 175,775 320,679 352,238
Selling, general and administrative ................ 34,215 33,171 65,480 65,468
Depreciation and amortization ...................... 10,205 12,577 20,311 26,196
Restructuring charge ............................... -- 8,178 -- 8,178
------------ ------------ ------------ ------------
Total ............................................ 207,340 229,701 406,470 452,080
------------ ------------ ------------ ------------
Income from operations ................................ 22,489 6,999 41,641 23,225
------------ ------------ ------------ ------------
Other (income) expense, net:
Interest expense ................................... 483 2,563 1,068 7,094
Interest income .................................... (316) (279) (583) (595)
Foreign exchange transaction losses, net ........... 1,522 159 1,378 153
Loss (gain) on sale of businesses .................. -- 8,430 -- (30,803)
------------ ------------ ------------ ------------
Other (income) expense, net ...................... 1,689 10,873 1,863 (24,151)
------------ ------------ ------------ ------------
Income (loss) before taxes ............................ 20,800 (3,874) 39,778 47,376
Provision (benefit) for income taxes .................. 7,698 (1,115) 14,898 18,310
------------ ------------ ------------ ------------
Net income (loss) ..................................... $ 13,102 $ (2,759) $ 24,880 $ 29,066
============ ============ ============ ============
Basic earnings (loss) per share ....................... $ 0.22 $ (0.05) $ 0.41 $ 0.50
Weighted average shares outstanding - basic ........... 60,527,636 58,534,186 60,403,936 58,285,392
Diluted earnings (loss) per share ..................... $ 0.21 $ (0.05) $ 0.40 $ 0.49
Weighted average shares outstanding - diluted ......... 61,940,577 60,454,375 61,826,881 59,707,635
The accompanying notes are an integral part of these consolidated financial statements.
3
COVANCE INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2002 AND 2001
(UNAUDITED)
Six Months Ended June 30
------------------------
(Dollars in thousands) 2002 2001
---------- ----------
Cash flows from operating activities:
Net income ............................................. $ 24,880 $ 29,066
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization ....................... 20,311 26,196
Stock issued under employee benefit and stock
compensation plans ............................... 5,074 6,139
Deferred income tax benefit ......................... 2,376 (1,369)
Gain on sale of businesses .......................... -- (30,803)
Restructuring charge, net of cash paid .............. -- 8,178
Other ............................................... 371 993
Changes in operating assets and liabilities,
net of businessses sold:
Accounts receivable .............................. 4,458 (4,619)
Unbilled services ................................ (6,656) 615
Inventory ........................................ 61 (1,816)
Accounts payable ................................. (21) (5,887)
Accrued liabilities .............................. 2,550 (16,959)
Unearned revenue ................................. (14,859) 5,645
Income taxes payable ............................. 7,764 3,644
Other assets and liabilities, net ................ 1,044 (15,273)
---------- ----------
Net cash provided by operating activities .............. 47,353 3,750
---------- ----------
Cash flows from investing activities:
Capital expenditures ................................ (19,273) (27,886)
Proceeds from sale of businesses .................... -- 251,059
Other, net .......................................... (6) 101
---------- ----------
Net cash (used in) provided by investing activities .... (19,279) 223,274
---------- ----------
Cash flows from financing activities:
Net repayments under revolving credit facilities .... (15,000) (199,000)
Repayments of debt .................................. -- (18,723)
Stock issued under employee stock purchase and
option plans ..................................... 3,382 5,870
Purchase of treasury stock .......................... (165) (146)
---------- ----------
Net cash used in financing activities .................. (11,783) (211,999)
---------- ----------
Net change in cash and cash equivalents ................ 16,291 15,025
Cash and cash equivalents, beginning of period ......... 35,404 7,191
---------- ----------
Cash and cash equivalents, end of period ............... $ 51,695 $ 22,216
========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
4
COVANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
June 30, 2002 and 2001
(dollars in thousands, unless otherwise indicated)
1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States ("GAAP") for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by GAAP for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the six months ended June 30, 2002 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2002. The balance sheet at December 31, 2001 has been derived from
the audited financial statements at that date but does not include all of the
information and footnotes required by GAAP for complete financial statements.
You should read these consolidated financial statements together with the
historical consolidated financial statements of Covance Inc. and subsidiaries
("Covance") for the years ended December 31, 2001, 2000, and 1999 included in
our Annual Report on Form 10-K for the year ended December 31, 2001.
2. Summary of Significant Accounting Policies
Use of Estimates
These unaudited consolidated financial statements have been prepared in
conformity with GAAP, which requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from these estimates.
Reclassifications
Certain prior period balances have been reclassified to conform with
current year presentation.
Prepaid Expenses and Other Current Assets
In connection with the management of multi-site clinical trials,
Covance pays on behalf of its customers fees to investigators, volunteers and
other out-of-pocket costs (such as travel, printing, meetings, couriers, etc.),
for which we are reimbursed at cost, without mark-up or profit. Amounts
receivable from customers in connection with billed and unbilled investigator
fees, volunteer payments and other out-of-pocket pass-through costs are included
in prepaid expenses and other current assets in the accompanying Consolidated
Balance Sheets and totaled $15.4 million and $17.2 million at June 30, 2002 and
December 31, 2001, respectively. See Note 2 "Reimbursable Out-of-Pocket
Expenses".
Inventory
Inventories, which consist principally of supplies, are valued at the
lower of cost (first-in, first-out method) or market.
Goodwill
Effective January 1, 2002, in accordance with the adoption of Financial
Accounting Standards Board ("FASB") Statement No. 142, Goodwill and Other
Intangible Assets, Covance ceased amortization of goodwill. Had amortization
expense not been recorded for the three months ended June 30, 2001, the impact
on income from operations, net income and earnings per share would have been an
increase of $0.9 million, $0.7 million, and $0.01 per share, respectively. Had
amortization expense not been recorded for the six months ended June 30, 2001,
the impact on income from operations, net income and earnings per share would
have been an increase of $1.8 million, $1.4 million, and $0.02 per share,
respectively. See Note 7 "2001 Pro Forma Financial Information".
5
COVANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(UNAUDITED)
June 30, 2002 and 2001
(dollars in thousands, unless otherwise indicated)
Comprehensive Income
Comprehensive income has been calculated in accordance with FASB
Statement No. 130, Reporting Comprehensive Income. Covance has determined total
comprehensive income (loss) to be $19.1 million and $(5.4) million for the three
months ended June 30, 2002 and 2001, respectively, and $29.4 million and $26.9
million for the six months ended June 30, 2002 and 2001, respectively. Covance's
total comprehensive income represents net income plus the change in the
cumulative translation adjustment equity account for the periods presented.
Earnings Per Share
Earnings per share has been calculated in accordance with FASB
Statement No. 128, Earnings Per Share. In computing diluted earnings per share
for the three months ended June 30, 2002 and 2001, the denominator was increased
by 1,412,941 shares and 1,920,189 shares, respectively, and for the six months
ended June 30, 2002 and 2001, the denominator was increased by 1,422,945 shares
and 1,422,243 shares, respectively, representing the dilutive effect of stock
options outstanding at June 30, 2002 and 2001 with exercise prices less than the
average market price of Covance's Common Stock during each respective period.
Reimbursable Out-of-Pocket Expenses
As discussed in Note 2 "Prepaid Expenses and Other Current Assets",
Covance pays on behalf of its customers fees to investigators, volunteers and
other out-of-pocket costs for which we are reimbursed at cost, without mark-up
or profit. Effective January 1, 2002, in connection with the required
implementation of Financial Accounting Standards Board Emerging Issues Task
Force Rule No. 01-14 ("EITF 01-14"), Income Statement Characterization of
Reimbursements Received for "Out-of-Pocket" Expenses Incurred, amounts paid to
volunteers and other out-of-pocket costs are now included in cost of revenue,
while the reimbursements received are reported as revenues in the Consolidated
Statements of Income. Covance will continue to exclude from revenue and expense
in the Consolidated Statements of Income fees paid to investigators and the
associated reimbursement since Covance acts as an agent on behalf of the
pharmaceutical company sponsors with regard to investigator payments. See Note 2
"Recently Issued Accounting Standards" for additional information regarding EITF
01-14.
Segment Reporting
Covance reports information about its operating segments and related
disclosures about products, services, geographic areas and major customers in
accordance with FASB Statement No. 131, Disclosures About Segments of an
Enterprise and Related Information. See Note 6 "Segment Information."
Recently Issued Accounting Standards
In November 2001, the FASB issued EITF 01-14, Income Statement
Characterization of Reimbursements Received for "Out-of-Pocket" Expenses
Incurred. This rule requires that in cases where the contractor acts as a
principal, reimbursements received for out-of-pocket expenses incurred be
characterized as revenue and the associated costs be included as operating
expenses in the income statement. Covance implemented this rule beginning with
the quarter ended March 31, 2002 and as required, has also reclassified
comparative financial information for the three and six months ended June 30,
2001. The implementation of this rule resulted only in the gross up of revenues
and expenses and has no impact upon earnings.
In October 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. This statement was effective
beginning with Covance's quarter ended March 31, 2002. These new rules on asset
impairment supersede FASB Statement 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of and portions of
APB Opinion 30, Reporting the Results of Operations. This Standard provides a
single accounting model for long-lived assets to be disposed and significantly
changes the criteria that would have to be met to classify an asset as
held-for-sale. Classification as held-for-sale is an important distinction since
such assets are not depreciated and are stated at the lower of fair value or
carrying amount. This statement also requires expected future operating losses
from
6
COVANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(UNAUDITED)
June 30, 2002 and 2001
(dollars in thousands, unless otherwise indicated)
discontinued operations to be displayed in the period(s) in which the losses are
incurred, rather than as of the measurement date as presently required. The
adoption of this statement did not have a material impact on Covance's results
of operations, financial position or cash flows.
In July 2001, the FASB issued Statement No. 142, Goodwill and Other
Intangible Assets. This statement requires that goodwill no longer be amortized
to earnings, but instead be reviewed for impairment. Covance adopted this
statement on January 1, 2002 and accordingly ceased the amortization of
goodwill. The adoption of this statement did not have a material impact on
Covance's financial position or cash flows, and the impact on diluted earnings
per share was $0.01 and $0.02 per share for the three and six months ended June
30, 2002, respectively.
3. Supplemental Cash Flow Information
Cash paid for interest for the six months ended June 30, 2002 and 2001
totaled $0.8 million and $7.9 million, respectively. Cash paid for income taxes
for the six months ended June 30, 2002 and 2001 totaled $9.2 million and $14.9
million, respectively.
4. Divestitures
On June 15, 2001, Covance sold its biomanufacturing business
("Biomanufacturing") to Akzo Nobel's pharma business unit, Diosynth, for gross
proceeds of $113.6 million, subject to post-closing adjustments, including
finalization of the closing balance sheet and earnout provision, in accordance
with the Stock Purchase Agreement between Covance and Akzo Nobel, which remains
to be resolved between the parties. Covance recognized a loss of $7.5 million
($4.5 million after tax) from this transaction. Covance used the net proceeds
from the sale of approximately $95 million to reduce borrowings under its senior
revolving credit facility.
On February 14, 2001, Covance sold its pharmaceutical packaging
business ("Packaging") to Fisher Scientific International Inc. for gross
proceeds of $137.5 million. Covance recognized a pre-tax gain of $38.4 million
($24.3 million after tax) from this transaction, of which $39.2 million was
recorded during the three months ended March 31, 2001 in connection with the
sale, and $(0.9) million was recorded during the three months ended June 30,
2001 in connection with a final working capital adjustment. Covance used the net
proceeds from the sale to repay the $18.5 million balance outstanding on the
mortgage on its North American packaging facility and the remaining net proceeds
of approximately $95 million were used to reduce borrowings under its senior
revolving credit facility.
5. Restructuring
In June 2001, Covance announced plans to reorganize its Nexigent
subsidiary, integrating Nexigent's newly developed clinical trials service
offerings into Covance's core businesses and reducing Nexigent's infrastructure.
Under the plan, Nexigent's service offerings - site activation, study
feasibility, electronic data capture, and web-based central laboratory data
access - were to continue to be marketed by Covance's core business units.
Covance recorded a pre-tax restructuring charge in the second quarter of 2001,
totaling approximately $8.2 million ($5.0 million net of tax). The charge
consisted of approximately $6.5 million in asset write-offs, which were taken in
June 2001, and approximately $1.6 million in severance and related benefits in
connection with the elimination of approximately 30 redundant Nexigent
positions. Severance payments began in August 2001 and will continue through
2002.
7
COVANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(UNAUDITED)
June 30, 2002 and 2001
(dollars in thousands, unless otherwise indicated)
6. Segment Information
Covance has two reportable segments: early development and late-stage
development. Early development services, which includes Covance's preclinical
and Phase I clinical service capabilities, involve evaluating a new compound for
safety and early effectiveness as well as evaluating the absorption,
distribution, metabolism and excretion of the compound in the human body. It is
at this stage that a pharmaceutical company, based on available data, will
generally decide whether to continue further development of a drug. Late-stage
development services, which include Covance's central laboratory, clinical
development, biomanufacturing (through June 15, 2001), commercialization and
other clinical support capabilities (including our Packaging operations through
February 14, 2001), are geared toward demonstrating the clinical effectiveness
of a compound in treating certain diseases or conditions, obtaining regulatory
approval and maximizing the drug's commercial potential.
The information provided below for 2001 is on an "as reported" basis
and has not been restated to exclude the results of Biomanufacturing and
Packaging, which were divested during 2001. Certain of the information below has
been presented on a pro forma basis in Note 7.
The accounting policies of the reportable segments are the same as
those described in Note 2. Segment net revenues, operating income and total
assets for the three and six months ended June 30, 2002 and 2001 are as follows:
Early Late-Stage Other
Development Development Reconciling Items Total
----------- ----------- ----------------- -----
Three months ended June 30, 2002
Total revenues from external customers ... $ 91,382 $127,824 $ 10,623 (a) $229,829
Operating income ......................... $ 16,919 $ 16,579 $(11,009)(c) $ 22,489
Total assets ............................. $298,429 $320,504 $ 11,800 (d) $630,733
Three months ended June 30, 2001
Total revenues from external customers ... $ 78,727 $147,694 $ 10,279 (a) $236,700
Operating income ......................... $ 11,124 (b) $ 2,899 (b) $ (7,024)(c) $ 6,999 (b)
Total assets ............................. $239,716 $283,815 $ 45,645 (d) $569,176
Six months ended June 30, 2002
Total revenues from external customers ... $176,766 $251,022 $ 20,323 (a) $448,111
Operating income ......................... $ 31,099 $ 30,607 $(20,065)(c) $ 41,641
Total assets ............................. $298,429 $320,504 $ 11,800 (d) $630,733
Six months ended June 30, 2001
Total revenues from external customers ... $152,772 $302,307 $ 20,226 (a) $475,305
Operating income ......................... $ 22,460 (b) $ 13,558 (b) $(12,793)(c) $ 23,225 (b)
Total assets ............................. $239,716 $283,815 $ 45,645 (d) $569,176
--------------------
(a) Represents revenues associated with reimbursable out-of-pocket expenses.
(b) Includes restructuring charge incurred in the second quarter of 2001
totaling $8,178 ($4,985 after tax).
(c) Represents corporate administrative expenses (primarily information
technology, marketing, communications, human resources, finance and
legal).
(d) Represents corporate assets.
8
COVANCE INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(UNAUDITED)
June 30, 2002 and 2001
(dollars in thousands, unless otherwise indicated)
7. 2001 Pro Forma Financial Information
The following is a reconciliation between amounts on an "as reported"
basis and amounts on a pro forma basis for the three and six months ended June
30, 2001. The pro forma results reflect (1) the exclusion of the results of
Packaging and Biomanufacturing, (2) reduced interest expense from the
application of the net proceeds from the sales of these businesses to
outstanding debt, (3) the exclusion of the gain (loss) recognized on the sale of
businesses during the period, (4) the exclusion of restructuring charges during
the period and (5) the exclusion of goodwill amortization in accordance with the
adoption of FASB Statement No. 142.
Pro Forma Adjustments to Remove
----------------------------------------------------------------------------------------
As Biomanu- Net Loss Goodwill Pro Forma
Reported Packaging facturing on Sale Restructuring Amortization Results
--------- --------- --------- --------- ------------- ------------ ---------
Three Months Ended June 30, 2001
--------------------------------
Net revenues ................ $ 226,421 n/a $ (22,563) $ -- $ -- $ -- $ 203,858
Income from operations ...... $ 6,999 n/a $ (228) $ -- $ 8,178 $ 897 $ 15,846
Income (loss) before taxes .. $ (3,874) n/a $ 1,268 $ 8,430 $ 8,178 $ 897 $ 14,899
Taxes on income ............. $ (1,115) n/a $ 473 $ 3,020 $ 3,193 $ 175 $ 5,746
Net income .................. $ (2,759) n/a $ 795 $ 5,410 $ 4,985 $ 722 $ 9,153
Diluted earnings per share .. $ (0.05) n/a $ 0.01 $ 0.09 $ 0.08 $ 0.01 $ 0.15
Pro Forma Adjustments to Remove
----------------------------------------------------------------------------------------
As Biomanu- Net Gain Goodwill Pro Forma
Reported Packaging facturing on Sale Restructuring Amortization Results
--------- --------- --------- --------- ------------- ------------ ---------
Six Months Ended June 30, 2001
------------------------------
Net revenues................. $ 455,079 $ (11,439) $ (44,173) $ -- $ -- $ -- $ 399,467
Income from operations....... $ 23,225 $ (3,806) $ 1,489 $ -- $ 8,178 $ 1,778 $ 30,864
Income (loss) before taxes... $ 47,376 $ (2,579) $ 4,970 $ (30,803) $ 8,178 $ 1,778 $ 28,920
Taxes on income.............. $ 18,310 $ (762) $ 1,954 $ (11,888) $ 3,193 $ 347 $ 11,154
Net income................... $ 29,066 $ (1,817) $ 3,016 $ (18,915) $ 4,985 $ 1,431 $ 17,766
Diluted earnings per share... $ 0.49 $ (0.03) $ 0.05 $ (0.32) $ 0.08 $ 0.02 $ 0.30
9
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
You should read the following discussion together with the unaudited
Covance consolidated financial statements and the accompanying notes included in
this Quarterly Report on Form 10-Q for the quarter ended June 30, 2002.
Overview
Covance is a leading contract research organization providing a wide
range of product development services on a worldwide basis primarily to the
pharmaceutical, biotechnology and medical device industries. Covance also
provides services such as laboratory testing to the chemical, agrochemical and
food industries. The foregoing services comprise two segments for financial
reporting purposes: early development services, which includes preclinical and
Phase I clinical; and late-stage development services, which includes central
laboratory, clinical development, biomanufacturing (through June 15, 2001),
commercialization and other clinical support services (including our packaging
operations through February 14, 2001). Covance believes it is one of the largest
biopharmaceutical contract research organizations, based on 2001 annual net
revenues, and one of a few that is capable of providing comprehensive global
product development services. Covance offers its clients high quality services
designed to reduce product development time. This enables Covance's customers to
introduce their products into the marketplace faster and as a result, maximize
the period of market exclusivity and monetary return on their research and
development investments. Additionally, Covance's comprehensive services and
broad experience provide its customers with a variable cost alternative to fixed
cost internal development capabilities.
On June 15, 2001, Covance sold its biomanufacturing business
("Biomanufacturing") to Akzo Nobel's pharma business unit, Diosynth, for gross
proceeds of $113.6 million, subject to post-closing adjustments, including
finalization of the closing balance sheet and earnout provision, in accordance
with the Stock Purchase Agreement between Covance and Akzo Nobel, which remains
to be resolved between the parties. Covance recognized a loss of $7.5 million
($4.5 million after tax) from this transaction. On February 14, 2001, Covance
sold its pharmaceutical packaging business ("Packaging") to Fisher Scientific
International Inc. for gross proceeds of $137.5 million. Covance recognized a
pre-tax gain of $38.4 million ($24.3 million after tax) from this transaction,
of which $39.2 million was recorded during the three months ended March 31, 2001
in connection with the sale, and $(0.9) million was recorded during the three
months ended June 30, 2001 in connection with a final working capital
adjustment.
Historically, a majority of Covance's net revenues have been earned
under contracts. These contracts generally range in duration from a few months
to two years, but can extend in duration up to five years. Revenue from these
contracts is generally recognized under either the percentage of completion
method of accounting or as services are rendered or products are delivered,
depending upon the nature of the work contracted. Where the percentage of
completion method is used, Covance generally measures progress toward completion
in terms of units-of-work performed as compared to the total units-of-work
contracted. The contracts may contain provisions for renegotiation for cost
overruns arising from changes in the scope of work. Renegotiated amounts are
included in net revenues when earned and realization is assured. In some cases,
for multi-year contracts a portion of the contract fee is paid at the time the
trial is initiated. These amounts are deferred and recognized as revenue as
services are performed. Additional payments are made based upon the achievement
of performance-based milestones over the contract duration. In connection with
the management of multi-site clinical trials, Covance pays on behalf of its
customers fees to investigators, volunteers and other out-of-pocket costs (such
as travel, printing, meetings, couriers, etc.), for which we are reimbursed at
cost, without mark-up or profit. Investigator fees are not reflected in total
revenues or expenses since Covance acts in the capacity of an agent on behalf of
the pharmaceutical company sponsor, passing through these costs without risk or
reward to Covance. Most contracts are terminable either immediately or upon
notice by the client. These contracts typically require payment to Covance of
expenses to wind down a study, payment to Covance of fees earned to date, and,
in some cases, a termination fee or a payment to Covance of some portion of the
fees or profit that could have been earned by Covance under the contract if it
had not been terminated early.
Effective January 1, 2002, in connection with the required
implementation of Financial Accounting Standards Board Emerging Issues Task
Force Rule No. 01-14 ("EITF 01-14"), Income Statement Characterization of
Reimbursements Received for "Out-of-Pocket" Expenses Incurred, amounts paid to
volunteers and other out-of-pocket costs are now included in cost of revenue,
while the reimbursements received are reported as reimbursable out-of-pocket
revenues in the Consolidated Statements of Income. Covance will continue to
exclude from revenue and expense in the Consolidated Statements of Income fees
paid to investigators and the associated reimbursement since Covance acts as an
agent on behalf of the pharmaceutical company sponsors with regard to
investigator payments. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations - New Accounting Pronouncements" for
additional information regarding EITF 01-14.
10
Covance segregates its recurring operating expenses among three
categories: cost of revenue; selling, general and administrative expenses; and
depreciation and amortization. Cost of revenue consists of appropriate amounts
necessary to complete the revenue and earnings process, and includes direct
labor and related benefit charges, other direct costs and an allocation of
facility charges and information technology costs and excludes depreciation and
amortization. Also, as mentioned above, cost of revenue now includes
reimbursable out-of-pocket costs. Cost of revenue, as a percentage of net
revenues, tends and is expected to fluctuate from one period to another, as a
result of changes in labor utilization and the mix of service offerings
involving hundreds of studies conducted during any period of time. Selling,
general and administrative expenses consist primarily of administrative payroll
and related benefit charges, advertising and promotional expenses,
administrative travel and an allocation of facility charges and information
technology costs, and excludes depreciation and amortization.
Quarterly Results
Covance's quarterly operating results are subject to variation, and are
expected to continue to be subject to variation, as a result of factors such as
(1) delays in initiating or completing significant drug development trials, (2)
termination or reduction in size of drug development trials, (3) acquisitions
and divestitures, and (4) exchange rate fluctuations. Delays and terminations of
trials are often the result of actions taken by Covance's customers or
regulatory authorities and are not typically controllable by Covance. Since a
large amount of Covance's operating costs are relatively fixed while revenue is
subject to fluctuation, moderate variations in the commencement, progress or
completion of drug development trials may cause significant variations in
quarterly results.
Results of Operations
Variances explained below are on an "as reported" basis, but also
include certain pro forma variances (where so noted) - that is, variances
between the three months ended June 30, 2002 and 2001 and between the six months
ended June 30, 2002 and 2001, after giving effect to 1) the divestiture of
Packaging and Biomanufacturing as if these transactions had occurred on January
1, 2001, 2) the exclusion of the impact of restructuring charges totaling $8,178
($4,985 net of tax) recorded during the three and six month periods ended June
30, 2001, and 3) the exclusion of goodwill amortization in accordance with the
adoption of FASB Statement No. 142 (see "Management's Discussion and Analysis of
Financial Condition and Results of Operations - New Accounting Pronouncements"
for additional information regarding Statement No. 142).
Three Months Ended June 30, 2002 Compared with Three Months Ended June 30, 2001.
Net revenues decreased 3.2% to $219.2 million for the three months ended June
30, 2002 from $226.4 million for the corresponding 2001 period, as the 2001
period includes revenues from Covance's biomanufacturing operations through June
15, 2001. On a proforma basis, net revenues increased 7.5% to $219.2 million for
the three months ended June 30, 2002 from $203.9 million for the corresponding
2001 period. Excluding the impact of foreign exchange rate variances between
both periods, on a pro forma basis, net revenues increased 6.0% as compared to
the corresponding 2001 period. Net revenues from Covance's early development
segment grew 16.1%, or 15.1% excluding the impact of foreign exchange rate
variances between both periods, driven primarily by growth in our toxicology
service offering. On a pro forma basis, net revenues from Covance's late-stage
development segment increased 2.2%, or 0.2% excluding the impact of foreign
exchange rate variances between both periods. The modest late-stage development
revenue growth was impacted by our strategy to first improve our operating
margins by an increased focus on contract selectivity, particularly in our Phase
II/III services, and the slower conversion of our backlog to revenue,
particularly in our central laboratory business. Our Phase IV and other
late-stage service offerings continue to experience solid revenue growth.
Cost of revenue, excluding reimbursable out-of-pocket expenses totaling
$10.6 million, decreased 8.0% to $152.3 million or 69.5% of net revenues for the
three months ended June 30, 2002 as compared to $165.5 million (excluding
reimbursable out-of-pocket expenses totaling $10.3 million) or 73.1% of net
revenues for the corresponding 2001 period. Excluding reimbursable out-of-pocket
expenses, gross margins were 30.5% for the three months ended June 30, 2002 and
26.9% for the corresponding 2001 period as the 2001 period includes Covance's
biomanufacturing operations through June 15, 2001, higher investment spending on
internet initiatives and lower margins on bioanalytical services. On a pro forma
basis, as a percentage of net revenues, cost of revenue, excluding reimbursable
out-of-pocket expenses was 71.9% for the 2001 period.
Overall, selling, general and administrative expenses increased 3.1% to
$34.2 million for the three months ended June 30, 2002 from $33.2 million for
the corresponding 2001 period. As a percentage of net revenues, selling, general
and administrative expenses increased to 15.6% for the three months ended June
30, 2002 from 14.7% for the corresponding 2001 period. On a proforma basis, as a
percentage of net revenues, selling, general and administrative expenses were
15.6% for the 2001 period.
11
Depreciation and amortization decreased 18.9% to $10.2 million or 4.7%
of net revenues for the three months ended June 30, 2002 as compared to $12.6
million or 5.6% of net revenues for the corresponding 2001 period, due primarily
to the divestiture of our capital intensive biomanufacturing and packaging
businesses in the first half of 2001 and the implementation of FASB Statement
No. 142 in the first quarter of 2002, which has eliminated the amortization of
goodwill. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - New Accounting Pronouncements."
Income from operations increased 221.3% to $22.5 million for the three
months ended June 30, 2002 from $7.0 million for the corresponding 2001 period.
Income from operations from Covance's early development segment increased $5.8
million or 52.1% to $16.9 million or 18.5% of net revenues for the three months
ended June 30 2002 from $11.1 million or 14.1% of net revenues for the
corresponding 2001 period, primarily driven by growth in our toxicology services
offering. Income from operations from Covance's late-stage development segment
increased $13.7 million or 471.9% to $16.6 million or 13.0% of net revenues for
the three months ended June 30, 2002 from $2.9 million or 2.0% of net revenues
for the corresponding 2001 period.
On a pro forma basis, income from operations increased 41.9% to $22.5
million for the three months ended June 30, 2002 from $15.8 million for the
corresponding 2001 period. As a percentage of net revenues on a pro forma basis,
income from operations increased to 10.3% for the three months ended June 30,
2002 from 7.8% for the corresponding 2001 period. On a pro forma basis, income
from operations from Covance's early development segment increased $5.1 million
or 42.8% to $16.9 million as compared to $11.9 million for the three months
ended June 30, 2001. On a pro forma basis, income from operations from Covance's
late-stage development segment increased $5.6 million or 50.5% to $16.6 million
as compared to $11.0 million for the three months ended June 30, 2001. The
increase in late-stage development operating income on a pro forma basis was due
to Covance's continued focus on margin improvement in our Phase II/III services
mentioned above, margin growth in Phase IV services and reduced spending on
internet initiatives.
Other expense, net for the 2001 period includes an $8.4 million pre-tax
loss on the sale of businesses. Excluding this loss, other expense, net
decreased $0.8 million to $1.7 million for the three months ended June 30, 2002
from $2.4 million for the corresponding 2001 period. This reduction was due to a
decrease in interest expense of $2.1 million, resulting from lower weighted
average borrowings under our long-term credit facility, partially offset by
higher foreign exchange transaction losses reported during the 2002 period, as a
result of the weakening U.S. dollar.
Covance's effective tax rate for the three months ended June 30, 2002
increased to 37.0% from 28.8% for the corresponding 2001 period, and decreased
from 38.6% for the corresponding 2001 period on a pro forma basis.
Net income was $13.1 million for the three months ended June 30, 2002
versus a loss of $2.8 million for the corresponding 2001 period. On a pro forma
basis, net income increased 43.1% or $3.9 million for the three months ended
June 30, 2002 as compared to $9.2 million for the corresponding 2001 period.
Six Months Ended June 30, 2002 Compared with Six Months Ended June 30, 2001. Net
revenues decreased 6.0% to $427.8 million for the six months ended June 30, 2002
from $455.1 million for the corresponding 2001 period, as the 2001 period
includes revenues from Covance's biomanufacturing operations through June 15,
2001 and includes revenues from Covance's packaging operations through February
14, 2001. On a pro forma basis, net revenues increased 7.1% to $427.8 million
for the six months ended June 30, 2002 from $399.5 million for the corresponding
2001 period. Excluding the impact of foreign exchange rate variances between
both periods, on a pro forma basis, net revenues increased 6.7% as compared to
the corresponding 2001 period. Net revenues from Covance's early development
services grew 15.7%, or 15.8% excluding the impact of foreign exchange rate
variances between both periods, driven primarily by growth in our toxicology
service offering. On a pro forma basis, net revenues from Covance's late-stage
development segment increased 1.8%, or 1.1% excluding the impact of foreign
exchange rate variances between both periods. The modest late-stage development
revenue growth was impacted by our strategy to first improve our operating
margins by an increased focus on contract selectivity, particularly in our Phase
II/III services, and the slower conversion of our backlog to revenue,
particularly in our central laboratory business. Our Phase IV and other
late-stage service offerings continue to experience solid revenue growth.
Cost of revenue, excluding reimbursable out-of-pocket expenses totaling
$20.3 million, decreased 9.5% to $300.4 million or 70.2% of net revenues for the
six months ended June 30, 2002 as compared to $332.0 million (excluding
reimbursable out-of-pocket expenses totaling $20.2 million) or 73.0% of net
revenues for the corresponding 2001 period. Excluding reimbursable out-of-pocket
expenses, gross margins were 29.8% for the six months ended June 30, 2002 and
27.0% for the
12
corresponding 2001 period, as the 2001 period includes Covance's
biomanufacturing operations through June 15, 2001 and Covance's packaging
operations through February 14, 2001. Also, the 2001 period included higher
investment spending on internet initiatives and lower margins on bioanalytical
services. On a pro forma basis, as a percentage of net revenues, cost of
revenue, excluding reimbursable out-of-pocket expenses was 72.1% for the 2001
period.
Overall, selling, general and administrative expenses were $65.5
million for both the six months ended June 30, 2002 and 2001. As a percentage of
net revenues, selling, general and administrative expenses increased to 15.3%
for the six months ended June 30, 2002 from 14.4% for the corresponding 2001
period, as the 2001 period includes Covance's biomanufacturing operations
through June 15, 2001 and Covance's packaging operations through February 14,
2001. On a pro forma basis, as a percentage of net revenues, selling, general
and administrative expenses were 15.3% for the 2001 period.
Depreciation and amortization decreased 22.5% to $20.3 million or 4.7%
of net revenues for the six months ended June 30, 2002 from $26.2 million or
5.8% of net revenues for the corresponding 2001 period, due primarily to the
divestiture of our capital intensive biomanufacturing and packaging businesses
in the first half of 2001, and the implementation of FASB Statement No. 142 in
the first quarter of 2002, which has eliminated the amortization of goodwill.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations - New Accounting Pronouncements."
Income from operations increased 79.3% to $41.6 million for the six
months ended June 30, 2002 from $23.2 million for the corresponding 2001 period.
Income from operations from Covance's early development segment increased $8.6
million or 38.5% to $31.1 million or 17.6% of net revenues for the six months
ended June 30, 2002 from $22.5 million or 14.7% of net revenues for the
corresponding 2001 period, primarily driven by growth in our toxicology services
offering. Income from operations from Covance's late-stage development segment
increased $17.0 million or 125.7% to $30.6 million or 12.2% of net revenues for
the six months ended June 30, 2002 from $13.6 million or 4.5% of net revenues
for the corresponding 2001 period.
On a pro forma basis, income from operations increased 34.9% to $41.6
million for the six months ended June 30, 2002 from $30.9 million for the
corresponding 2001 period. As a percentage of net revenues on a pro forma basis,
income from operations increased to 9.7% for the six months ended June 30, 2002
from 7.7% for the corresponding 2001 period. On a pro forma basis, income from
operations from Covance's early development segment increased $7.8 million or
33.4% to $31.1 million as compared to $23.3 million for the six months ended
June 30, 2001. On a pro forma basis, income from operations from Covance's
late-stage development segment increased $10.3 million or 50.5% to $30.6 million
as compared to $20.3 million for the six months ended June 30, 2001. The
increase in late-stage development operating income on a pro forma basis was due
to Covance's continued focus on margin improvements in our Phase II/III
services, and margin growth in Phase IV services.
Other expense, net for the 2001 period includes a $30.8 million net
pre-tax gain on the sale of Packaging and Biomanufacturing in the first half of
2001. Excluding this gain, other expense, net decreased $4.8 million to $1.9
million for the six months ended June 30, 2002 from $6.7 million for the
corresponding 2001 period, due primarily to a $6.0 million reduction in interest
expense resulting from lower weighted average borrowings under our long-term
credit facility, partially offset by higher foreign exchange transaction losses
reported during the 2002 period, as a result of the weakening U.S. dollar.
Covance's effective tax rate for the six months ended June 30, 2002 and
2001 was 37.5% and 38.6%, respectively. The corresponding pro forma effective
tax rate for the 2001 period was 38.6%.
Net income was $24.9 million for the six months ended June 30, 2002
versus $29.1 million for the corresponding 2001 period. On a pro forma basis,
net income increased 40.0% or $7.1 million for the six months ended June 30,
2002 as compared to $17.8 million for the corresponding 2001 period.
Liquidity and Capital Resources
Covance's expected primary cash needs on both a short and long-term
basis are for capital expenditures, expansion of services, possible future
acquisitions, geographic expansion, working capital and other general corporate
purposes. On June 28, 2001, Covance replaced its credit facility with a new $150
million senior revolving credit facility ("the Credit Facility"). Covance
believes cash from operations and available borrowings under the Credit Facility
will provide sufficient liquidity for the foreseeable future. At June 30, 2002
there were no outstanding borrowings and $1.6 million of outstanding letters of
credit under the Credit Facility. At December 31, 2001, there was $15.0 million
of outstanding borrowings and $0.9 million of outstanding letters of credit
under the Credit Facility. Interest on all outstanding borrowings under the
Credit Facility is based
13
upon the London Interbank Offered Rate ("LIBOR") plus a margin and approximated
3.22% per annum for the six month period ended June 30, 2002. Interest on the
previous credit facility approximated 7.51% for the same period in 2001. Costs
associated with replacing the previous credit facility in June 2001, consisting
primarily of bank fees totaling $1.7 million, are being amortized over the three
year facility term.
During the six months ended June 30, 2002, Covance's operations
provided net cash of $47.4 million, an increase of $43.6 million from the
corresponding 2001 period. Cash flows from net earnings adjusted for non-cash
activity provided $53.0 million for the six months ended June 30, 2002, up $14.6
million or 38.1% from $38.4 million for the corresponding 2001 period. The
change in net operating assets used $5.7 million in cash during the six months
ended June 30, 2002 primarily due to a reduction in unearned revenue partially
offset by an increase in income taxes payable, while this net change used $34.7
million in cash during the six months ended June 30, 2001, primarily due to a
decrease in accrued liabilities and an increase in other current assets.
Covance's ratio of current assets to current liabilities was 1.54 at June 30,
2002 and 1.43 at December 31, 2001.
Net days sales outstanding ("DSOs") at June 30, 2002 were 46 days, up
from 41 days at December 31, 2001. DSOs have historically followed a seasonal
pattern whereby they are generally at their lowest levels at year end and
increase during the first six to nine months of the year, before returning to
their seasonally lower levels at year end. The impact upon liquidity from a one
day change in DSOs is approximately $2 million in cash flow.
Investing activities for the six months ended June 30, 2002 used $19.3
million, compared to using $27.8 million for the corresponding 2001 period,
excluding the $251.1 million in proceeds from the sales of Packaging and
Biomanufacturing in the first half of 2001. Capital spending for the first six
months of 2002 totaled $19.3 million, and was primarily for the expansion of
Covance's toxicology capacity, outfitting of new facilities, purchase of new
equipment, upgrade of existing equipment and computer equipment and software for
newly hired employees. Capital spending for the corresponding 2001 period was
primarily for the outfitting of new facilities, purchase of new equipment,
upgrade of existing equipment and computer equipment and software for newly
hired employees. Planned capital expenditures in 2002 include spending
associated with the $27 million expansion of Covance's toxicology capacity in
Madison, Wisconsin and the $13 million expansion and enhancement of our
Harrogate, England facility.
Foreign Currency
Since Covance operates on a global basis, it is exposed to various
foreign currency risks. Two specific risks arise from the nature of the
contracts Covance executes with its customers since from time to time contracts
are denominated in a currency different than the particular Covance subsidiary's
local currency. These risks are generally applicable only to a portion of the
contracts executed by Covance's foreign subsidiaries providing clinical
services. The first risk occurs as revenue recognized for services rendered is
denominated in a currency different from the currency in which the subsidiary's
expenses are incurred. As a result, the subsidiary's net revenues and resultant
earnings can be affected by fluctuations in exchange rates. Historically,
fluctuations in exchange rates from those in effect at the time contracts were
executed have not had a material effect upon Covance's consolidated financial
results. See "Risk Factors."
The second risk results from the passage of time between the invoicing
of customers under these contracts and the ultimate collection of customer
payments against such invoices. Because the contract is denominated in a
currency other than the subsidiary's local currency, Covance recognizes a
receivable at the time of invoicing for the local currency equivalent of the
foreign currency invoice amount. Changes in exchange rates from the time the
invoice is prepared and payment from the customer is received will result in
Covance receiving either more or less in local currency than the local currency
equivalent of the invoice amount at the time the invoice was prepared and the
receivable established. This difference is recognized by Covance as a foreign
currency transaction gain or loss, as applicable, and is reported in other
expense (income) in Covance's Consolidated Statements of Income.
Finally, Covance's consolidated financial statements are denominated in
U.S. dollars. Accordingly, changes in exchange rates between the applicable
foreign currency and the U.S. dollar will affect the translation of each foreign
subsidiary's financial results into U.S. dollars for purposes of reporting
Covance's consolidated financial results. The process by which each foreign
subsidiary's financial results are translated into U.S. dollars is as follows:
income statement accounts are translated at average exchange rates for the
period; balance sheet asset and liability accounts are translated at end of
period exchange rates; and equity accounts are translated at historical exchange
rates. Translation of the balance sheet in this manner affects the stockholders'
equity account, referred to as the cumulative translation adjustment account.
This account exists only in the foreign subsidiary's U.S. dollar balance sheet
and is necessary to keep the foreign balance sheet stated in U.S. dollars in
14
balance. To date such cumulative translation adjustments have not been material
to Covance's consolidated financial position.
Taxes
Since Covance conducts operations on a global basis, Covance's
effective tax rate has and will continue to depend upon the geographic
distribution of its pre-tax earnings among locations with varying tax rates.
Covance's profits are further impacted by changes in the tax rates of the
various jurisdictions. In particular, as the geographic mix of Covance's pre-tax
earnings among various tax jurisdictions changes, Covance's effective tax rate
may vary from period to period.
Inflation
While most of Covance's net revenues are earned under contracts, the
long-term contracts (those in excess of one year) generally include an inflation
or cost of living adjustment for the portion of the services to be performed
beyond one year from the contract date. As a result, Covance believes that the
effects of inflation generally do not have a material effect on its operations
or financial condition.
New Accounting Pronouncements
In November 2001, the FASB issued EITF 01-14, Income Statement
Characterization of Reimbursements Received for "Out-of-Pocket" Expenses
Incurred. This rule requires that in cases where the contractor acts as a
principal, reimbursements received for out-of-pocket expenses incurred be
characterized as revenue and the associated costs be included as operating
expenses in the income statement. Covance implemented this rule beginning with
the quarter ended March 31, 2002 and as required, has also reclassified
comparative financial information for the three and six months ended June 30,
2001. The implementation of this rule results only in the gross up of revenues
and expense and has no impact upon earnings.
In October 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. This statement was effective for
Covance's quarter ended March 31, 2002. These new rules on asset impairment
supersede FASB Statement 121, Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed Of and portions of APB Opinion 30,
Reporting the Results of Operations. This Standard provides a single accounting
model for long-lived assets to be disposed and significantly changes the
criteria that would have to be met to classify an asset as held-for-sale.
Classification as held-for-sale is an important distinction since such assets
are not depreciated and are stated at the lower of fair value or carrying
amount. This statement also requires expected future operating losses from
discontinued operations to be displayed in the period(s) in which the losses are
incurred, rather than as of the measurement date as presently required. The
adoption of this statement did not have a material impact on Covance's results
of operations, financial position or cash flows.
In July 2001, the FASB issued Statement No. 142, Goodwill and Other
Intangible Assets. This statement requires that goodwill no longer be amortized
to earnings, but instead be reviewed for impairment. Covance adopted this
statement on January 1, 2002 and accordingly ceased the amortization of
goodwill. The adoption of this statement did not have a material impact on
Covance's financial position or cash flows, and the impact on diluted earnings
per share was $0.01 and $0.02 per share for the three and six months ended June
30, 2002, respectively.
Forward Looking Statements. Statements in this Management's Discussion
and Analysis of Financial Condition and Results of Operations, as well as in
certain other parts of this Quarterly Report on Form 10-Q that look forward in
time, are forward looking statements made pursuant to the safe harbor provisions
of the Private Securities Litigation Reform Act of 1995. Forward looking
statements include statements concerning plans, objectives, goals, strategies,
future events or performance, expectations, predictions, and assumptions and
other statements which are other than statements of historical facts. All such
forward looking statements are based on the current expectations of management
and are subject to, and are qualified by, risks and uncertainties that could
cause actual results to differ materially from those expressed or implied by
those statements. These risks and uncertainties include, without limitation,
competitive factors, outsourcing trends in the pharmaceutical industry, the
Company's ability to continue to attract and retain qualified personnel, the
fixed price nature of contracts or the loss of large contracts, the Company's
ability to increase profitability of its clinical development services and to
increase order volume in central laboratory services, and continued growth in
demand for bioanalytical services and Covance's ability to provide these
services on a large scale basis, and other factors described in Covance's
filings with the Securities and Exchange Commission including its Annual Report
on Form 10-K.
15
Risk Factors
This section discusses various risk factors that are attendant with our
business and the provision of our services. If the events outlined below were to
occur individually or in the aggregate, our business, results of operations and
financial condition could be materially adversely affected.
Changes in government regulation could decrease the need for the services we
provide.
Governmental agencies throughout the world, but particularly in the
United States, strictly regulate the drug development process. Our business
involves helping pharmaceutical and biotechnology companies navigate the
regulatory drug approval process. Changes in regulation, such as a relaxation in
regulatory requirements or the introduction of simplified drug approval
procedures or an increase in regulatory requirements that we have difficulty
satisfying, could eliminate or substantially reduce the need for our services.
Also, if government efforts to contain drug costs and pharmaceutical and
biotechnology company profits from new drugs, our customers may spend less, or
reduce their growth in spending, on research and development.
Failure to comply with existing regulations could result in a loss of revenue or
earnings.
Any failure on our part to comply with applicable regulations could
result in the termination of on-going research or sales and marketing projects
or the disqualification of data for submission to regulatory authorities. For
example, if we were to fail to verify that patient participants were fully
informed and have fully consented to a particular clinical trial, the data
collected from that trial could be disqualified. If this were to happen, we
could be contractually required to repeat the trial at no further cost to our
customer, but at substantial cost to us.
We may bear financial losses because most of our contracts are of a fixed price
nature and may be delayed or terminated or reduced in scope for reasons beyond
our control.
As described in our discussion of contractual arrangements in the
description of our business, most of our contracts provide for services on a
fixed price or fee-for-service with a cap basis and they may be terminated or
reduced in scope either immediately or upon notice. Since our contracts are
predominantly structured as fixed price or fee-for-service with a cap, we bear
the risk of a financial loss if we initially under price our contracts or
otherwise overrun our cost estimates. Such under pricing or significant cost
overruns could have a material adverse effect on our business, results of
operations or financial condition. Cancellations may occur for a variety of
reasons, including:
o the failure of products to satisfy safety requirements;
o unexpected or undesired results of the products;
o insufficient patient enrollment;
o insufficient investigator recruitment;
o the client's decision to terminate the development of a product or
to end a particular study; and
o our failure to perform properly our duties under the contract.
The loss, reduction in scope or delay of a large contract or the loss or delay
of multiple contracts could materially adversely affect our business, although
our contracts frequently entitle us to receive the costs of winding down the
terminated projects, as well as all fees earned by us up to the time of
termination. Some contracts also entitle us to a termination fee, usually in the
form of a pre-set penalty or a percentage of the revenue expected to be earned
for completion of the project.
We may not be able to successfully develop and market new services.
An important element of our strategy is the successful development and
marketing of new services that complement or expand our existing business. If we
are unable to (1) develop new services and (2) create demand for those newly
developed services, we will not be able to implement this element of our
strategy, and our future business, results of operations and financial condition
could be adversely affected. For example, we have recently introduced our
bioanalytical service offerings. If
16
demand for these services does not develop as anticipated, our business,
financial condition, or results of operations may be materially adversely
affected. We cannot assure you that we will be able to develop or market this
type of service successfully.
Our quarterly operating results may vary.
Our operating results may vary significantly from quarter to quarter
and are influenced by such factors as:
o the commencement, completion or cancellation of large contracts;
o the progress of ongoing contracts;
o the timing of and charges associated with completed acquisitions or
other events;
o changes in the mix of our services; and
o exchange rate fluctuations.
We believe that operating results for any particular quarter are not
necessarily a meaningful indication of future results. While fluctuations in our
quarterly operating results could negatively affect the market price of our
common stock, these fluctuations may not be related to our future overall
operating performance.
We depend on the pharmaceutical and biotechnology industries.
Our revenues depend greatly on the expenditures made by the
pharmaceutical and biotechnology industries in research and development.
Accordingly, economic factors and industry trends that affect our clients in
these industries also affect our business. For example, the practice of many
companies in these industries has been to hire outside organizations such as
ourselves to conduct large clinical research and development projects. This
practice has grown significantly in the last decade, and we have benefited from
this trend. However, if this trend were to change and companies in these
industries were to reduce the number of research and development projects they
outsource, our business could be materially adversely affected.
We operate in a highly competitive industry.
Competitors in the contract research organization industry range from
small, limited-service providers to full service global contract research
organizations. Our main competition consists of in-house departments of
pharmaceutical companies, full-service contract research organizations, and
universities and teaching hospitals, although to a lesser degree. We compete on
a variety of factors, including:
o reputation for on-time quality performance;
o expertise and experience in specific areas;
o scope of service offerings;
o strengths in various geographic markets;
o price;
o technological expertise and efficient drug development processes;
o ability to acquire, process, analyze and report data in a
time-saving and accurate manner;
o ability to manage large-scale clinical trials both domestically and
internationally;
o expertise and experience in health economics and outcomes services;
and
o size.
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For instance, our clinical development services have from time to time
experienced periods of increased price competition which had a material adverse
effect on Covance's late-stage development profitability and consolidated net
revenues and net income. Covance took actions in 2000 to mitigate the effects of
this price competition; however, if market conditions were to deteriorate,
additional actions might be required in the future.
There is competition among the larger contract research organizations
for both clients and potential acquisition candidates. Additionally, small,
limited-service entities considering entering the contract research organization
industry will find few barriers to entry, thus further increasing possible
competition.
Finally, an increase in investment community interest in our industry
could result in an increased availability of financial resources for contract
research organizations. Such availability of resources could lead to increased
competition. We cannot assure you that competing pressures we face will not have
a material effect on us.
We may expand our business through acquisitions.
We review many acquisition candidates and, in addition to acquisitions
which we have already made, we are continually evaluating new acquisition
opportunities. Factors which may affect our ability to grow successfully through
acquisitions include:
o difficulties and expenses in connection with integrating the
acquired company and achieving the expected benefits;
o diversion of management's attention from current operations;
o the possibility that we may be adversely affected by risk factors
facing the acquired companies;
o acquisitions could be dilutive to earnings, or in the event of
acquisitions made through the issuance of our common stock to the
shareholders of the acquired company, dilutive to the percentage of
ownership of our existing stockholders;
o potential losses resulting from undiscovered liabilities of
acquired companies not covered by the indemnification we may obtain
from the seller;
o risks of not being able to overcome differences in foreign business
practices, language and other cultural barriers in connection with
the acquisition of foreign companies; and
o loss of key employees of the acquired company.
We may be affected by potential health care reform.
In recent years the United States Congress and state legislatures have
considered various types of health care reform in order to control growing
health care costs. Health care reform may again be addressed by the United
States Congress and state legislatures. We are unable to predict what
legislative proposals will be adopted in the future, if any. Similar reform
movements have occurred in Europe and Asia.
Implementation of health care reform legislation that contain costs
could limit the profits that can be made from the development of new drugs. This
could adversely affect research and development expenditures by pharmaceutical
and biotechnology companies which could in turn decrease the business
opportunities available to us both in the United States and abroad. In addition,
new laws or regulations may create a risk of liability, increase our costs or
limit our service offerings. We cannot predict the likelihood of any of these
events.
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Our revenues and earnings are exposed to exchange rate fluctuations.
We derive a large portion of our net revenues from international
operations. For the six month period ended June 30, 2002, we derived
approximately 33% of our net revenues from outside the United States. Our
financial statements are denominated in U.S. dollars. As a result, factors
associated with international operations, including changes in foreign currency
exchange rates, could significantly affect our results of operations and
financial condition.
The loss of our key personnel could adversely affect our business.
Our success depends to a significant extent upon the efforts of our
senior management team and other key personnel. We do not maintain insurance on
the life of any of our employees. The loss of the services of such personnel
could adversely affect our business. Because of the nature of our business, our
success is dependent upon our ability to attract and retain technologically
qualified personnel. There is substantial competition for qualified personnel,
and we cannot assure you that we will be successful in recruiting or retaining
qualified personnel to enable us to conduct our business and compete effectively
in our industry.
Our contract research services create a risk of liability.
In connection with many clinical trials, we contract with physicians,
also referred to as investigators, to conduct the clinical trials to test new
drugs on human volunteers. These tests can create a risk of liability for
personal injury or death to volunteers, resulting from negative reactions to the
drugs administered or from professional malpractice by third party
investigators, particularly to volunteers with life-threatening illnesses. We do
not believe we are legally accountable for the medical care rendered by
third-party investigators and we seek to limit our liability with trial
sponsors, third party investigators and others. However, it is possible that we
could be exposed to liability. For example, we could be held liable for the
following:
o our errors or omissions that create harm during a trial to study
volunteers or after a trial to consumers of the drug after
regulatory approval of the drug;
o general risks associated with our Phase I facilities, including
negative consequences from the administration of drugs to clinical
trial participants or the professional malpractice of Phase I
medical care providers;
o errors or omissions by our preclinical or central laboratories that
cause harm to study volunteers or consumers of an approved drug;
o errors or omissions by our preclinical laboratories arising from
our tests conducted for the agrochemical and food industries; and
o risks that animals in our breeding facilities may be infected with
diseases that may be harmful and even lethal to themselves and
humans despite preventive measures contained in our company
policies for the quarantine and handling of imported animals.
We believe that our risks are generally reduced by the following:
o contracts with our clients and, where applicable, investigators
containing provisions entitling us to be indemnified by them;
o insurance maintained by our clients, investigators, where
applicable, and by us; and
o various regulatory requirements we must follow in connection with
our business.
Contractual indemnifications generally do not protect us against
liability arising from certain of our own actions, such as negligence. We could
be materially and adversely affected if we were required to pay damages or bear
the costs of defending any claim (1) which is not covered by a contractual
indemnification provision, (2) in the event that a party who must indemnify us
does not fulfill its indemnification obligations or (3) which is beyond the
level of our insurance coverage. There can be no assurance that we will be able
to maintain such insurance coverage on terms acceptable to us.
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Reliance on air transportation.
Our central laboratories and, to a lesser extent, our other businesses,
are heavily reliant on air travel for transport of clinical trial kits and other
material and people, and disruption to the air travel system could have a
material adverse effect on our business. While we have developed contingency
plans for a variety of events that could disrupt or limit available air
transportation, there are no assurances that such plans will be effective or
sufficient to avert such a material adverse effect.
Actions of animal rights extremists may affect our business.
Our early development services utilize animals (predominantly rodents)
in preclinical testing of the safety and efficacy of drugs and also breeds and
sell animals for biomedical research. Acts of vandalism and other acts by animal
rights extremists who object to the use of animals in drug development could
have a material adverse effect on our business.
Item 3. Quantitative and Qualitative Disclosure About Market Risk
Our $150.0 million credit facility is U.S. Dollar denominated and is
not subject to transaction or translation exposure. Interest on all outstanding
borrowings under this credit facility is based upon LIBOR plus a margin and
approximated 3.22% per annum for the six months ended June 30, 2002. At June 30,
2002 we did not have any outstanding borrowings under our credit facility.
For the six months ended June 30, 2002, approximately 33% of our net
revenues were from outside the United States. We do not engage in derivative or
hedging activities related to our potential foreign exchange exposures. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Foreign Currency" for a more detailed discussion of our foreign
currency risks and exposures.
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Part II. Other Information
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Stockholders of Covance was held on May 7, 2002,
pursuant to notice.
The following table sets forth the number of votes cast for, against or
withheld, as well as the number of abstentions and broker non-votes, as to each
matter voted on at the meeting:
Number of Number of
Proposal Votes For Votes Withheld
-------- --------- --------------
To elect three members to the Covance
Class II Board of Directors:
J. Randall MacDonald 54,306,977 1,088,474
Kathleen G. Murray 54,352,502 1,042,949
William C. Ughetta 54,368,952 1,026,499
Number of Number of Number of Number
Proposal Votes For Votes Against Abstentions Broker Non-Votes
-------- --------- -------------- ----------- ----------------
To approve the 2002 Employee Equity
Participation Plan 39,307,628 8,771,968 1,362,244 5,953,611
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Not Applicable
(b) Reports on Form 8-K
During the three month period ended June 30, 2002, no reports on Form
8-K were filed.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
COVANCE INC.
Dated: July 26, 2002 By: /s/ CHRISTOPHER A. KUEBLER
-------------------------------
Christopher A. Kuebler
Chairman of the Board
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
Signature Title Date
/s/ CHRISTOPHER A. KUEBLER Chairman of the Board July 26, 2002
------------------------------ and Chief Executive Officer
Christopher A. Kuebler (Principal Executive Officer)
/s/ WILLIAM E. KLITGAARD Corporate Senior Vice President July 26, 2002
------------------------------ and Chief Financial Officer
William E. Klitgaard (Principal Financial Officer)
/s/ MICHAEL GIANNETTO Corporate Vice President and Controller July 26, 2002
------------------------------ (Principal Accounting Officer)
Michael Giannetto
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