Analyst says Covance execs are smart to back Lab Corp deal

04-Nov-2014 - Last updated on 04-Nov-2014 at 14:42 GMT

Lab Corp to buy Covance

Lab Corp will buy Covance for $6.1bn in a surprise deal that follows another quarter in which early phase gains were offset by underperformance in central labs.

The deal – which was announced on Monday – is intended to help Lab Corp expand its research business according to CEO David King who said it provides “immediate scale” and a platform in the $141bn biopharmaceutical R&D market.

Lab Corp also expects to “achieve annual cost synergies in excess of $100m million to be fully realized within three years of closing,” which is scheduled for 2015.

Results

News of the takeover coincided with Covance’s announcement of its third quarter results.

The contract research organisation (CRO) reprted that revenue for the three months ended September 30 was $671m, up from $647m, largely driven by in its early-phase business.

CEO Joe Herring said: "In early development, revenue of $234.8m grew 6.6% year-on-year and pro forma operating margin increased 120 basis points year-on-year and 100 basis points sequentially to 14.3%,” citing strong demand for pharmacology and toxicology as key.

This contrasted with Covance’s late phase business, which continued to struggle as a result of the underperformance in central labs business as Herring acknowledged in his commentary.

“Late-Stage Development third quarter revenue grew 1.5% year-on-year to $392.3m and pro forma operating margins were 22.3%, versus 22.6% in the third quarter of 2013.

“Central laboratories revenue grew approximately 3% year-on-year versus an exceptional third quarter of 2013 and was offset by an unexpected decline in clinical development revenue due to the combined impact of cancellations and continued slow backlog conversion.”

Analyst

Covance’s performance in Q3 was a factor in analysts’ response to the Lab Corp news.

ISI Group's Ross Muken pointed out that, although revenue from Covance’s central labs business grew 2% in Q3, the rate of growth was much lower than in previous periods which he said is indicative of a longer term negative trend.

“The last time this business [central labs] grew at an elevated rate for several years, it corrected hard with two straight years at zero growth. Given the incremental margins of this business we believe this trend merits intense scrutiny. Furthermore, the performance in the remainder of late phase remains choppy, evident of elevated cancellations and poor backlog conversion.

With this in mind Muken was positive about the Lab Corp deal, saying that: “CVD management was smart to monetize a large portion of the equity given peak valuation levels, deteriorating underlying fundamentals in a high margin segment.

Muken also said the deal was a shrewd move given Covance’s relationship with French drugmaker Sanofi – with which it signed a strategic deal in 2010 – which he said is going through a period of “uncertainty.”