One giant step for Covance … and perhaps other CROs

PRINCETON, N.J.—Stepping up to help fulfill Paris-basedsanofi-aventis' desire to transform its research and development model, NewJersey-based contract research organization (CRO) Covance has sealed a dealwith the French pharma for a 10-year, strategic R&D alliance with a totalvalue of up to $2.2 billion.

In a second part of the transaction, sanofi-aventis alsowill sell its sites in Porcheville, France, and Alnwick, U.K., to Covance forapproximately $25 million. Reportedly, Covance will maintain employment onthese sites for at least the next five years.

"A key strategy for sanofi-aventis is to transform itsR&D model and discover new medicines through the use of novel technologiesand innovative partnerships," says Dr. Marc Cluzel, executive vice presidentfor research and development at sanofi-aventis. "This alliance with Covancewill help us preserve hundreds of valuable jobs in Porcheville and Alnwick,while driving our R&D efficiency for the benefit of the patients."

The news is not only big for sanofi and Covance, but for thewider industry, as Joseph Herring, Covance's chairman and CEO, notes. The deal,he says, which is comprised of two major components—a 10-year servicesagreement and an asset purchases agreement—represents the largest and mostcomprehensive drug development alliance in industry history to date.

"We also believe that transformational relationships of thisnature are the catalyst for driving R&D outsourcing from today's 30 percentlevel to 50 to 70 percent in the coming year," Herring says. "These sorts ofrelationships could lower both the time and the cost of drug development andenable continued investment and innovation, which is the lifeblood of thepharmaceutical industry."

Examining the implications of the deal the day after theannouncement, Barclay's said that "Covance delivered much-needed good news forinvestors yesterday with its announcement of a significant R&D relationshipwith sanofi-aventis … Even though the total value might never reach the $2.2billion watermark, it appears likely to reach $1.8 billion."

"We think this deal reinforces our favorable long-term takeon Covance's prospects, as well as our opinion on the direction of the contractresearch industry," added Morningstar analyst Lauren Migliore. "We're keepingour fair value estimate for Covance intact."

Also, looking to the asset purchases portion of theagreement, she notes that sanofi made a take-or-pay commitment to Covance forthe sites, totaling about $350 million over the next five years.

"These sites are expected to be profitable from the onset ofthe contract period, which helps alleviate our concern that Covance will beworsening its current excess supply problem," Migliore says.

Zacks Investment Research, in an analyst note, furtherpoints out that Covance derives its revenues from two company segments: EarlyDevelopment and Late-Stage Development.

"While the Early Development segment deals with preclinicaltoxicology, analytical chemistry, clinical pharmacology services, researchproducts and discovery services, Late-Stage Development caters to centrallaboratory, Phase II-III clinical development and commercialization services,"Zacks explains. "The Late-Stage Development segment suffered during the latestreported quarter due to the delay in three large Phase III studies, asannounced by Covance earlier. Of these, one trial commenced during the reportedquarter, one was reduced in size and launched in July while the third isexpected to begin enrollment next year. Lower clinical developmentprofitability due to this delay brought operating margin to 21.2 percent … Webelieve the deal with sanofi will enable Covance to recoup some of the lossesdue to delay in some clinical trials mentioned above."

Looking to the multibillion-dollar services agreement,Covance's Herring notes that in 2009, his company recognized approximately $35million in revenues from sanofi-aventis, and he says, "We are in a similarrevenue run rate for 2010. Our central laboratories generate most of thoserevenues with the remainder spread across a blend of our early developmentservices."

This new deal with sanofi-aventis means that Covance willbecome the primary R&D partner for sanofi-aventis and the sole-sourceprovider for central laboratory services, which will mean a significant revenueincrease in the years to come. Previously, Covance has conducted less than halfof sanofi's central lab work, and this new deal will not only expand centrallab work, but also expand long-term commitments of work for discovery support,toxicology, chemistry, clinical pharmacology, Phase II-IV and market accessservices for the next decade.

Herring says that in 2011, he expects the services agreementto deliver approximately $55 million in revenue, or $20 million incremental tothe 2010 run rate, "with the revenue base ramping significantly in the firstthree years." These figures do not include income that will be derived from thePorcheville and Alnwick sites acquired from sanofi, he adds.

While the total contract value of the services and assetsdeals is expected to be $2.2 billion over the next 10 years, approximately $1.2billion will be recognized in Covance's third-quarter backlog—includingapproximately $100 million from previously awarded contracts, Herring says.

"The difference between the expected $2.2 billion contractvalue and the Q3 add to backlog represents revenues expected under the centrallabs sole-source and other long-term commitments not subject to contractminimum volumes," he says. "We anticipate recognizing the remaining billiondollars as orders when the underlying individual projects are awarded."

"Despite the size of this contract, Covance's client baseremains well diversified," Herring adds. "Even with the significant revenuecommitment from sanofi-aventis, we do not expect any client to exceed 10percent of total annual revenues. The structure of the agreement provides solidprofitability from day one, year one and throughout the duration of theagreement, with return on assets well above our cost of capital."

As for the asset purchases agreement, Herring says Covancewill provide continued employment to approximately 300 sanofi-aventis employeesat these two sites, with the Porcheville facility bringing more than 400,000square feet of space while Alnwick is approximately 175,000 square feet.

"Regarding toxicology, certainly there is excess capacity inthe industry and at Covance. However, these sites will not cannibalize ourexisting toxicology capability, as they will be positioned to serve the French andsouthern European markets—markets previously underserved by Covance due to ourlack of geographic presence," Herring points out. "It's also worth noting thatthe other toxicology commitments contained in the services agreement [withsanofi-aventis] will make a nice impact on toxicology capacity utilization atour other sites in other regions of the world."

The addition of chemistry, manufacturing and controls (CMC)services from the Porscheville and Alnwick sites—including preformulation, drugformulation, preclinical and early-stage clinical active pharmaceuticalingredient manufacturing, and radiolabeled chemistry—are entirely new forCovance.

"Historically, a leading cause of delays in early drugdevelopment is related to CMC, such as poor formulations, solubility and/orsalt selection. CMC services are also an important component of an IND- andCTA-enabling package of services, which have ideal synergies with ourindustry-leading preclinical program management offering," Herring says. "Wehave over 200 program management clients who could benefit from utilizing theseCMC services. We have long considered adding such capabilities organically butthis agreement allows us to acquire these specialized facilities, equipment andtalent in the most capitally efficient manner."

Covance reports that for the services deal alone, 75 percentof the work is oriented toward late-stage development and 25 percent is earlydevelopment, but when both the services deal and asset purchases are combined,the breakdown is 60 percent late-stage and 40 percent early development.