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One giant step for Covance … and perhaps other CROs
November 2010
by Jeffrey Bouley  |  Email the author
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PRINCETON, N.J.—Stepping up to help fulfill Paris-based sanofi-aventis' desire to transform its research and development model, New Jersey-based contract research organization (CRO) Covance has sealed a deal with the French pharma for a 10-year, strategic R&D alliance with a total value of up to $2.2 billion.  
 
In a second part of the transaction, sanofi-aventis also will sell its sites in Porcheville, France, and Alnwick, U.K., to Covance for approximately $25 million. Reportedly, Covance will maintain employment on these sites for at least the next five years.
 
"A key strategy for sanofi-aventis is to transform its R&D model and discover new medicines through the use of novel technologies and innovative partnerships," says Dr. Marc Cluzel, executive vice president for research and development at sanofi-aventis. "This alliance with Covance will 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 the wider industry, as Joseph Herring, Covance's chairman and CEO, notes. The deal, he says, which is comprised of two major components—a 10-year services agreement and an asset purchases agreement—represents the largest and most comprehensive drug development alliance in industry history to date.
 
"We also believe that transformational relationships of this nature are the catalyst for driving R&D outsourcing from today's 30 percent level to 50 to 70 percent in the coming year," Herring says. "These sorts of relationships could lower both the time and the cost of drug development and enable continued investment and innovation, which is the lifeblood of the pharmaceutical industry."  
 
Examining the implications of the deal the day after the announcement, Barclay's said that "Covance delivered much-needed good news for investors yesterday with its announcement of a significant R&D relationship with sanofi-aventis … Even though the total value might never reach the $2.2 billion watermark, it appears likely to reach $1.8 billion."  
 
"We think this deal reinforces our favorable long-term take on Covance's prospects, as well as our opinion on the direction of the contract research industry," added Morningstar analyst Lauren Migliore. "We're keeping our fair value estimate for Covance intact." Also, looking to the asset purchases portion of the agreement, she notes that sanofi made a take-or-pay commitment to Covance for the sites, totaling about $350 million over the next five years.
 
"These sites are expected to be profitable from the onset of the contract period, which helps alleviate our concern that Covance will be worsening its current excess supply problem," Migliore says.  
 
Zacks Investment Research, in an analyst note, further points out that Covance derives its revenues from two company segments: Early Development and Late-Stage Development.  
 
"While the Early Development segment deals with preclinical toxicology, analytical chemistry, clinical pharmacology services, research products and discovery services, Late-Stage Development caters to central laboratory, Phase II-III clinical development and commercialization services," Zacks explains. "The Late-Stage Development segment suffered during the latest reported quarter due to the delay in three large Phase III studies, as announced by Covance earlier. Of these, one trial commenced during the reported quarter, one was reduced in size and launched in July while the third is expected to begin enrollment next year. Lower clinical development profitability due to this delay brought operating margin to 21.2 percent … We believe the deal with sanofi will enable Covance to recoup some of the losses due 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 $35 million in revenues from sanofi-aventis, and he says, "We are in a similar revenue run rate for 2010. Our central laboratories generate most of those revenues with the remainder spread across a blend of our early development services."  
 
This new deal with sanofi-aventis means that Covance will become the primary R&D partner for sanofi-aventis and the sole-source provider for central laboratory services, which will mean a significant revenue increase in the years to come. Previously, Covance has conducted less than half of sanofi's central lab work, and this new deal will not only expand central lab work, but also expand long-term commitments of work for discovery support, toxicology, chemistry, clinical pharmacology, Phase II-IV and market access services for the next decade.
 
 
Herring says that in 2011, he expects the services agreement to deliver approximately $55 million in revenue, or $20 million incremental to the 2010 run rate, "with the revenue base ramping significantly in the first three years." These figures do not include income that will be derived from the Porcheville and Alnwick sites acquired from sanofi, he adds. While the total contract value of the services and assets deals is expected to be $2.2 billion over the next 10 years, approximately $1.2 billion will be recognized in Covance's third-quarter backlog—including approximately $100 million from previously awarded contracts, Herring says.  
 
"The difference between the expected $2.2 billion contract value and the Q3 add to backlog represents revenues expected under the central labs sole-source and other long-term commitments not subject to contract minimum volumes," he says. "We anticipate recognizing the remaining billion dollars as orders when the underlying individual projects are awarded."  
 
"Despite the size of this contract, Covance's client base remains well diversified," Herring adds. "Even with the significant revenue commitment from sanofi-aventis, we do not expect any client to exceed 10 percent of total annual revenues. The structure of the agreement provides solid profitability from day one, year one and throughout the duration of the agreement, with return on assets well above our cost of capital."
 
 
As for the asset purchases agreement, Herring says Covance will provide continued employment to approximately 300 sanofi-aventis employees at these two sites, with the Porcheville facility bringing more than 400,000 square feet of space while Alnwick is approximately 175,000 square feet.  
 
"Regarding toxicology, certainly there is excess capacity in the industry and at Covance. However, these sites will not cannibalize our existing toxicology capability, as they will be positioned to serve the French and southern European markets—markets previously underserved by Covance due to our lack of geographic presence," Herring points out. "It's also worth noting that the other toxicology commitments contained in the services agreement [with sanofi-aventis] will make a nice impact on toxicology capacity utilization at our 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, drug formulation, preclinical and early-stage clinical active pharmaceutical ingredient manufacturing, and radiolabeled chemistry—are entirely new for Covance.  
 
"Historically, a leading cause of delays in early drug development is related to CMC, such as poor formulations, solubility and/or salt selection. CMC services are also an important component of an IND- and CTA-enabling package of services, which have ideal synergies with our industry-leading preclinical program management offering," Herring says. "We have over 200 program management clients who could benefit from utilizing these CMC services. We have long considered adding such capabilities organically but this agreement allows us to acquire these specialized facilities, equipment and talent in the most capitally efficient manner."
 
Covance reports that for the services deal alone, 75 percent of the work is oriented toward late-stage development and 25 percent is early development, but when both the services deal and asset purchases are combined, the breakdown is 60 percent late-stage and 40 percent early development.
 
 
Code: E111002

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