COVANCE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) 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 September 30, 2012.

Overview Covance is a leading drug development services company providing a wide range of early-stage and late-stage 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 reportable segments for financial reporting purposes: early development services, which includes preclinical and clinical pharmacology service offerings; and late-stage development services, which includes central laboratory, Phase II-IV clinical development and market access services. Although each segment has separate services within it, they can be and increasingly are, combined in integrated service offerings. Covance believes it is one of the largest drug development services companies, based on 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 provide data to clients as rapidly as possible and reduce product development time. We believe 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.

Critical Accounting Policies Covance's consolidated financial statements are prepared in accordance with U.S.

generally accepted accounting principles ("GAAP"), which require management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from these estimates. The following discussion highlights what we believe to be the critical accounting policies and judgments made in the preparation of these consolidated financial statements.

Revenue Recognition. Covance recognizes revenue either as services are performed or products are delivered, depending on the nature of the work contracted. Historically, a majority of Covance's net revenues have been earned under contracts which range in duration from a few months to two years, but can extend in duration up to five years or longer. Covance also has committed minimum volume arrangements with certain clients with initial terms that generally range in duration from three to ten years. Underlying these arrangements are individual project contracts for the specific services to be provided. These arrangements enable our clients to secure our services in exchange for which they commit to purchase an annual minimum dollar value ("volume") of services. Under these types of arrangements, if the annual minimum volume commitment is not reached, the client is required to pay Covance for the shortfall. Progress towards the achievement of annual minimum volume commitments is monitored throughout the year. Annual minimum commitment shortfalls are not included in net revenues until the amount has been determined and agreed to by the client.

Covance does not have any individual significant contracts as pertains to revenue recognition. By way of background, at any point in time Covance is working on thousands of active client projects, which are governed by individual contracts. In addition, the Company has not had a single customer who accounted for more than ten percent of aggregate net revenues during any one of the last three years. Covance serves in excess of 1,000 biopharmaceutical companies and has over 23,000 active client projects. Most projects are customized based on the needs of the client, the type of services being provided, therapeutic indication of the drug, geographic locations and other variables. Project specific terms related to pricing, billing milestones and the scope and type of services to be provided are generally negotiated and contracted on a project-by-project basis.

Service contracts generally take the form of fee-for-service or fixed-price arrangements. In cases where performance spans multiple accounting periods, revenue is recognized as services are performed, measured on a proportional-performance basis, generally using output measures that are specific to the service provided. Examples of output measures in our early development segment include the number of slides read, dosings performed, or specimens prepared for preclinical laboratory services, or number of dosings or number of volunteers enrolled for clinical pharmacology. Examples of output measures in our late-stage development segment's Phase II-IV clinical development service offering include among others, number of investigators enrolled, number of sites initiated, number of patients enrolled and number of monitoring visits completed. Revenue is determined by dividing the actual units of work completed by the total units of work required under the contract and multiplying that percentage by the total contract value. The total contract value, or total contractual payments, represents the 20 -------------------------------------------------------------------------------- Table of Contents aggregate contracted price for each of the agreed upon services to be provided.

Covance does not have any contractual arrangements spanning multiple accounting periods where revenue is recognized on a proportional-performance basis under which the Company has earned more than an immaterial amount of performance-based revenue (i.e. potential additional revenue tied to specific deliverables or performance). Changes in the scope of work are common, especially under long-term contracts, and generally result in a change in contract value. Once the client has agreed to the changes in scope and renegotiated pricing terms, the contract value is amended and revenue is recognized, as described above.

Estimates of costs to complete are made to provide, where appropriate, for losses expected on contracts. Costs are not deferred in anticipation of contracts being awarded, but instead are expensed as incurred. For the nine months ended September 30, 2012, Covance did not experience a change in the estimates used to determine the amounts recognized as revenue (i.e. output measures or costs to complete) for any project resulting in a material impact on our financial position, results of operations or cash flows.

Billing schedules and payment terms are generally negotiated on a contract-by-contract basis. In some cases, Covance bills the client for the total contract value in progress-based installments as certain non-contingent billing milestones are reached over the contract duration, such as, but not limited to, contract signing, initial dosing, investigator site initiation, patient enrollment or database lock. The term "billing milestone" relates only to a billing trigger in a contract whereby amounts become billable and payable in accordance with a negotiated predetermined billing schedule throughout the term of a project. These billing milestones are not performance-based (i.e., potential additional arrangement consideration tied to specific deliverables or performance). In other cases, billing and payment terms are tied to the passage of time (e.g., monthly billings). In either case, the total contract value and aggregate amounts billed to the client would be the same at the end of the project. While Covance attempts to negotiate terms that provide for billing and payment of services prior or within close proximity to the provision of services, this is not always the case, as evidenced by fluctuations in the levels of unbilled receivables and unearned revenue from period to period. While a project is ongoing, cash payments are not necessarily representative of aggregate revenue earned at any particular point in time, as revenues are recognized when services are provided, while amounts billed and paid are in accordance with the negotiated billing and payment terms.

In some cases, payments received are in excess of revenue recognized. For example, a contract invoicing schedule may provide for an upfront payment of 10% of the full contract value upon contract signing, but at the time of signing, performance of services has not yet begun, and therefore, no revenue has yet been recognized. Payments received in advance of services being provided, such as in this example, are deferred as unearned revenue on the balance sheet. As the contracted services are subsequently performed and the associated revenue is recognized, the unearned revenue balance is reduced by the amount of revenue recognized during the period.

In other cases, services may be provided and revenue is recognized before the client is invoiced. In these cases, revenue recognized will exceed amounts billed, and the difference, representing an unbilled receivable, is recorded for this amount which is currently unbillable to the customer pursuant to contractual terms. Once the client is invoiced, the unbilled receivable is reduced for the amount billed, and a corresponding account receivable is recorded. All unbilled receivables are billable to customers within one year from the respective balance sheet date.

Most contracts are terminable by the client, either immediately or upon notice.

These contracts often require payment to Covance of expenses to wind down the study, fees earned to date and, in some cases, a termination fee or a payment to Covance of some portion of the fees or profits that could have been earned by Covance under the contract if it had not been terminated early. Termination fees are included in net revenues when realization is assured.

Bad Debts. Covance endeavors to assess and monitor the creditworthiness of its customers to which it grants credit terms in the ordinary course of business.

Covance maintains a provision for doubtful accounts relating to amounts due that may not be collected. This bad debt provision is monitored on a monthly basis and adjusted as circumstances warrant. Since the recorded bad debt provision is based upon management's judgment, actual bad debt write-offs may be greater or less than the amount recorded. Historically, bad debt write-offs have not been material.

Taxes. Since Covance conducts operations on a global basis, its 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 which Covance operates. In addition, Covance maintains a reserve for unrecognized tax benefits, changes to which could impact Covance's effective tax rate in the period such changes are made.

The Company recognizes a tax benefit from an uncertain tax position only if the Company believes it is more likely than not to be sustained upon examination based on the technical merits of the position. The amount of the accrual for which an exposure exists is measured as the largest amount of benefit determined on a cumulative probability basis that the Company believes is more likely than not to be realized upon ultimate settlement of the position. Components of the reserve are classified 21 -------------------------------------------------------------------------------- Table of Contents as either a current or long-term liability in the consolidated balance sheet based on when the Company expects each of the items to be settled. Covance accrues interest and penalties in relation to unrecognized tax benefits as a component of income tax expense.

As of September 30, 2012, the balance of the reserve for unrecognized tax benefits is $7.6 million, including accrued interest of $0.6 million, which is recorded as a long-term liability in other liabilities on the consolidated balance sheet. This reserve relates to exposures for income tax matters such as transfer pricing, nexus, and deemed income. The decrease in the reserve primarily relates to the settlement of various income tax audits across multiple jurisdictions.

The Company also maintains a tax reserve related to exposures for non-income tax matters including value-added tax, state sales and use and other taxes. The balance of this reserve at September 30, 2012 is $1.1 million and is recorded as a current liability in accrued expenses and other current liabilities on the consolidated balance sheet.

While Covance believes it has identified all reasonably identifiable exposures and the reserve it has established for identifiable exposures is appropriate under the circumstances, it is possible that additional exposures exist and that exposures will be settled at amounts different than the amounts reserved. It is also possible that changes in facts and circumstances could cause Covance to either materially increase or reduce the carrying amount of its tax reserve.

Covance's policy is to provide income taxes on earnings of foreign subsidiaries only to the extent those earnings are taxable or are expected to be remitted.

Covance's historical policy has been to leave its unremitted foreign earnings invested indefinitely outside the United States. Covance intends to continue to leave its unremitted foreign earnings invested indefinitely outside the United States. As a result, taxes have not been provided on any of the remaining accumulated foreign unremitted earnings as of September 30, 2012.

Stock-Based Compensation. The Company sponsors several stock-based compensation plans pursuant to which non-qualified stock options and restricted stock awards are granted to eligible employees. These plans are described more fully in Note 10 to our audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011 and Note 7 to our consolidated financial statements in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2012 included elsewhere herein.

The grant-date fair value of awards expected to vest is expensed on a straight-line basis over the vesting period of the related awards. The grant-date fair value of stock awards is based upon the underlying price of the stock on the date of grant. The grant-date fair value of stock option awards must be determined using an option pricing model. Option pricing models require the use of estimates and assumptions as to (a) the expected term of the option, (b) the expected volatility of the price of the underlying stock, (c) the risk-free interest rate for the expected term of the option and (d) pre-vesting forfeiture rates. The Company uses the Lattice-Binomial option pricing formula for determining the grant-date fair value of stock option awards.

The expected term of the option is based upon the contractual term and expected employee exercise and expected post-vesting employment termination behavior.

The expected volatility of the price of the underlying stock is based upon the volatility of the Company's stock computed over a period of time equal to the expected term of the option. The risk free interest rate is based upon the implied yields currently available from the U.S. Treasury zero-coupon yield curve for issues with a remaining duration equal to the expected term of the option. Pre-vesting forfeiture rates are estimated based upon past voluntary termination behavior and past option forfeitures.

The following table sets forth the weighted-average assumptions used to calculate the fair value of options granted for the three and nine month periods ended September 30, 2012 and 2011: Three Months Ended September 30 Nine Months Ended September 30 2012 2011 2012 2011 Expected stock price volatility 38% 37% 38% 37% Range of risk free interest rates 0.03% - 2.01% 0.10% - 3.62% 0.03% - 2.01% 0.10% - 3.62% Expected life of options (years) 5.2 4.8 5.2 4.8 Changes in any of these assumptions could impact, potentially materially, the amount of expense recorded in future periods related to stock-based awards.

22 -------------------------------------------------------------------------------- Table of Contents Impairment of Assets. Covance reviews its long-lived assets other than goodwill and other indefinite lived intangible assets, for impairment when events or changes in circumstances occur that indicate that the carrying value of the asset may not be recoverable. The assessment of possible impairment is based upon Covance's judgment of its ability to recover the value of the asset from the expected future undiscounted cash flows of the related operations. Actual future cash flows may be greater or less than estimated. During the second quarter of 2012, Covance determined that the carrying value of its equity method investment in a supplier of research products was no longer recoverable based upon changes in the research product market. The impairment was determined to be other-than-temporary and Covance recorded a charge of $7.4 million to write off the remaining carrying value of the equity investment as of June 30, 2012.

Covance performs an annual test for impairment of goodwill and other indefinite lived intangible assets during the fourth quarter. Covance tests goodwill for impairment at the reporting unit level only when, after completing a qualitative analysis, it is determined that it is more likely than not that the fair value of a reporting unit is below its carrying value. This test is performed by comparing the carrying value of the reporting unit to its fair value. Covance assesses fair value based upon its estimate of the present value of the future cash flows that it expects to be generated by the reporting unit. The most recent test for impairment performed for 2011 indicated that no reporting units were at significant risk for impairment. However, in the second quarter of 2012, Covance commenced actions to close its clinical pharmacology operations located in Basel, Switzerland and as a result determined the goodwill associated with the acquisition of the Basel clinic in March 2009 was impaired and recorded a charge of $18.0 million to write off the carrying value of the goodwill as of June 30, 2012. The Basel clinic is part of Covance's Early Development segment and clinical pharmacology reporting unit, however, because the clinic was operated on a standalone basis and was not integrated into the reporting unit after its acquisition, the related goodwill was evaluated for impairment at the site level and not the reporting unit level. In light of the impairment recognized for the Basel clinic, the Company conducted an impairment analysis of the remaining goodwill in the clinical pharmacology reporting unit and determined there was no additional impairment resulting from this action. There were no other events or changes in circumstances through September 30, 2012 that warranted a reconsideration of our impairment test results. However, changes in expectations as to the present value of a reporting unit's future cash flows might impact subsequent years' assessments of impairment.

Defined Benefit Pension Plans. Covance sponsors defined benefit pension plans for the benefit of its employees at several foreign subsidiaries, as well as a non-qualified supplemental executive retirement plan and a post-employment retiree health and welfare plan for the benefit of eligible employees at certain U.S. subsidiaries. The measurement of the related benefit obligation and net periodic benefit cost recorded each year is based upon actuarial computations which require the use of judgment as to certain assumptions. The more significant of these assumptions are: (a) the appropriate discount rate to use in computing the present value of the benefit obligation; (b) the expected return on plan assets (for funded plans); and (c) the expected future rate of salary increases (for pay-related plans). Actual results (such as the return on plan assets, future rate of salary increases and plan participation rates) will likely differ from the assumptions used. Those differences, along with changes that may be made in the assumptions used from period to period, will impact the amounts reported in the financial statements and footnote disclosures.

Set forth below is a discussion of the impact that (a) differences between assumed results and actual results and (b) assumption changes have had on our results of operations for the years ended December 31, 2011, 2010 and 2009 and on the financial position of the plans as of December 31, 2011 and 2010 for our United Kingdom defined benefit pension plans (the largest of our defined benefit-type pension plans).

United Kingdom Plans (dollars in millions) 2011 2010 2009 2008 Net periodic pension cost $ 1.6 $ 1.6 $ 2.0 $ 3.4 Assumptions used to determine net periodic pension cost: Discount rate 5.20 % 5.75 % 6.25 % 5.50 % Expected rate of return on assets 6.50 % 6.75 % 6.75 % 6.75 % Salary increases 4.50 % 4.50 % 4.25 % 4.25 % 23 -------------------------------------------------------------------------------- Table of Contents The movement in the net periodic benefit cost from period to period is attributable to the following: United Kingdom Plans (dollars in millions) 2010 to 2011 2009 to 2010 2008 to 2009 Change in discount rate $ 2.1 $ 1.3 $ (2.2 ) Change in rate of salary increases - (0.1 ) - Other, including differences between actual experience and assumptions used (2.1 ) (1.6 ) 1.4 Foreign currency exchange rate changes - - (0.6 ) Net change in periodic benefit cost $ - $ (0.4 ) $ (1.4 ) United Kingdom Plans 2011 2010 2009 Assumptions used to determine benefit obligation: Discount rate 4.60 % 5.20 % 5.75 % Salary increases 4.00 % 4.50 % 4.50 % The change in the projected benefit obligation from period to period is attributable to the following: United Kingdom Plans (dollars in millions) 2010 to 2011 2009 to 2010 Projected benefit obligation, beginning of year $ 156.6 $ 139.9 Service/interest cost components of net periodic benefit cost in year 12.7 11.4 Benefits paid (2.3 ) (2.4 ) Actuarial loss: Decrease in discount rate 23.8 20.0Other, including differences between actual experience and assumptions used (25.0 ) (7.8 ) Foreign currency exchange rate changes 1.9 (4.5 ) Projected benefit obligation, end of year $ 167.7 $ 156.6 Foreign Currency Risks Since Covance operates on a global basis, it is exposed to various foreign currency risks. Two specific risks arise from the nature of certain contracts.

The first risk can occur when Covance executes contracts with its customers where the contracts are denominated in a currency different than the local currencies of the Covance subsidiaries performing work under the contracts. As a result, revenue recognized for services rendered may be denominated in a currency different from the currencies in which the subsidiaries' expenses are incurred. Fluctuations in exchange rates (from those in effect at the time the contract is executed and pricing is established to the time services are rendered and revenue is recognized) can affect the subsidiary's net revenues and resultant earnings. This risk is generally applicable only to a portion of the contracts executed by Covance's subsidiaries providing clinical services.

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".

We also have other cross-currency contracts executed by other Covance subsidiaries where the foreign currency amounts billed are determined by converting local currency revenue amounts to the contract billing currency using the exchange rates in effect at the time services are rendered. These contracts do not give rise to foreign currency denominated revenue and local currency denominated expenses, but they do give rise to a second type of risk. This second type of risk results from the passage of time between the invoicing of customers under both of these types of contracts and the ultimate collection of customer payments against such invoices. Because such invoices are 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 24 -------------------------------------------------------------------------------- Table of Contents amount as of the invoice date. Subsequent changes in exchange rates from the time the invoice is prepared to the time 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 was recorded. This difference is recognized by Covance as a foreign currency transaction gain or loss, as applicable, in the 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 balance. At September 30, 2012, accumulated other comprehensive income on the consolidated balance sheet includes the cumulative translation account balance of $42.3 million.

Operating Expenses and Reimbursable Out-of-Pockets Covance segregates its recurring operating expenses among four categories: cost of revenue; reimbursable out-of-pocket expenses; selling, general and administrative expenses; and depreciation and amortization. Cost of revenue includes direct labor and related benefits, other direct costs, shipping and handling fees, and an allocation of facility charges and information technology costs, and excludes depreciation and amortization. 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 thousands 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.

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 for travel, printing, meetings, couriers, etc.), for which it is reimbursed at cost, without mark-up or profit. Investigator fees are not reflected in total revenues or expenses where 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. All other out-of-pocket costs are included in total revenues and expenses.

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, (4) changes in the mix of our services, and (5) 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 Three Months Ended September 30, 2012 Compared with Three Months Ended September 30, 2011. Net revenues totaling $544.8 million for the three months ended September 30, 2012 increased 0.3%, or 4.1% excluding the unfavorable impact of foreign exchange rate variances between both periods, as compared to $543.3 million for the corresponding 2011 period. Net revenues from Covance's early development segment decreased 8.1%, or 7.2% excluding the unfavorable impact of foreign exchange rate variances between both periods. The decline in the early development segment was due primarily to lower volumes in toxicology, resulting in part from the closure of the Company's Arizona and Virginia sites, research products and clinical pharmacology services. Net revenues from Covance's late-stage development segment increased 6.9%, or 13.1% excluding the unfavorable impact of foreign exchange rate variances between both periods.

Growth in the late-stage development segment was led by the strong performance of our Phase II-IV clinical development services and increased volume in our central laboratory services, which was partially offset by decreased volume in our market access services.

25 -------------------------------------------------------------------------------- Table of Contents Cost of revenue increased 1.7% to $389.7 million or 71.5% of net revenues for the three months ended September 30, 2012 as compared to $383.3 million or 70.6% of net revenues for the corresponding 2011 period. Gross margins decreased by 90 basis points to 28.5% for the three months ended September 30, 2012 from 29.4% for the corresponding 2011 period due primarily to a charge for costs associated with the expected settlement of an inventory supply agreement of $4.0 million (or 0.7% of net revenues).

Overall, selling, general and administrative expenses increased 16.1% to $94.4 million for the three months ended September 30, 2012 from $81.3 million for the corresponding 2011 period. As a percentage of net revenues, selling, general and administrative expenses increased by 230 basis points to 17.3% for the three months ended September 30, 2012 from 15.0% for the corresponding 2011 period. Included in selling, general and administrative expenses during the three months ended September 30, 2012 is $13.0 million (or 2.4% of net revenues) in costs associated with the 2012 restructuring actions to better align capacity to preclinical market demand and further improve profitability going forward.

These actions include the closure of the Company's toxicology facility in Chandler, Arizona, its clinical pharmacology facilities in Honolulu, Hawaii and Basel, Switzerland, as well as a capacity and workforce reduction in Muenster, Germany and in its corporate and functional support infrastructure. Included in selling, general and administrative expense during the three months ended September 30, 2011 was $4.2 million (or 0.8% of net revenues) in costs associated with the 2011 restructuring initiatives to rationalize capacity, reduce the cost of overhead and support functions and to streamline processes.

Selling, general and administrative expenses as a percentage of net revenues can and does vary depending on the timing and nature of various professional fees and other discretionary spending.

Depreciation and amortization increased 9.1% to $30.1 million for the three months ended September 30, 2012 from $27.6 million for the corresponding 2011 period. As a percentage of net revenues, depreciation and amortization increased by 40 basis points to 5.5% for the three months ended September 30, 2012, from 5.1% for the corresponding 2011 period. Depreciation and amortization during the three months ended September 30, 2012 includes $1.1 million (or 0.2% of net revenues) in accelerated depreciation associated with the 2012 restructuring actions described above. Depreciation and amortization during the three months ended September 30, 2011 included $1.1 million (or 0.2% of net revenues) in accelerated depreciation associated with the 2011 restructuring initiatives also described above. The balance of the increase results from depreciation on assets placed in service over the last year.

Income from operations decreased 40.0% to $30.6 million (or 5.6% of net revenues) for the three months ended September 30, 2012, from $51.0 million (or 9.4% of net revenue) for the corresponding 2011 period. Income from operations for the three months ended September 30, 2012 included restructuring charges of $14.1 million (or 2.6% of net revenues) and costs associated with the expected settlement of an inventory supply agreement of $4.0 million (or 0.7% of net revenues). Income from operations for the three months ended September 30, 2011 included $5.3 million (or 1.0% of net revenues) in costs associated with the 2011 restructuring initiatives described above.

Income from operations from Covance's early development segment for the three months ended September 30, 2012 decreased 78.6% or $26.1 million to $7.1 million, compared to $33.2 million for the corresponding 2011 period. As a percentage of net revenues, early development results of operations declined from 13.8% of early development net revenues in the three months ended September 30, 2011 to 3.2% in the corresponding 2012 period. The decline in results of operations in Covance's early development segment for the three months ended September 30, 2012 was primarily driven by restructuring and other charges of $17.2 million (or 7.8% of segment net revenues) during the 2012 three month period versus $1.9 million (or 0.8% of segment net revenues) during the 2011 three month period, coupled with the lower revenue in toxicology, research products and clinical pharmacology services described above.

Income from operations from Covance's late-stage development segment for the three months ended September 30, 2012 increased 14.5% or $8.1 million to $64.4 million as compared to $56.3 million for the corresponding 2011 period. As a percentage of net revenues, late-stage development income from operations increased 130 basis points from 18.6% of late-stage development net revenues in the three month period ended September 30, 2011 to 19.9% of net revenues in the corresponding 2012 period, driven by the increase in revenue in both Phase II-IV clinical development and central laboratories, partially offset by the decrease in revenue from market access services. Income from operations for the three months ended September 30, 2012 includes restructuring charges of $0.4 million (or 0.1% of segment net revenues). Income from operations from Covance's late-stage development segment for the three months ended September 30, 2011 included $2.1 million (or 0.7% of segment net revenues) in costs associated with the 2011 restructuring initiatives described above.

Corporate expense increased $2.5 million to $40.9 million or 7.5% of net revenues for the three months ended September 30, 2012 as compared to $38.4 million or 7.1% of net revenues for the corresponding 2011 period.

Corporate expenses for the 26 -------------------------------------------------------------------------------- Table of Contents three months ended September 30, 2012 includes restructuring charges of $0.5 million (or 0.1% of net revenues) while corporate expenses for the three months ended September 30, 2011 included $1.3 million (or 0.3% of net revenues) in restructuring charges. Also included in corporate expense is stock-based compensation expense which totaled $10.4 million or 1.9% of net revenues for each of the three months ended September 30, 2012 and 2011.

Other income, net increased $1.4 million to $0.3 million for the three months ended September 30, 2012 from an expense of $1.1 million for the corresponding 2011 period. The primary driver of the increase is a gain on sale of investment of $1.5 million in the three months ended September 30, 2012. Net interest expense increased $0.6 million to $0.9 million during the 2012 period from $0.3 million in the corresponding 2011 period. Net foreign exchange transaction losses decreased $0.5 million, to $0.3 million during the 2012 period from $0.8 million in the corresponding 2011 period.

Covance's effective tax rate for the three months ended September 30, 2012 was a benefit of 22.6% compared to a provision of 19.6% for the corresponding 2011 period. Covance's effective tax rate for the three months ended September 30, 2012 includes a net tax benefit of $10.7 million primarily associated with the settlement of various income tax audits across multiple jurisdictions, $0.8 million associated with a reduction in the United Kingdom income tax rate, which resulted in a decrease in the Company's United Kingdom net deferred tax liabilities and a $5.7 million benefit related to $18.1 million of 2012 restructuring cost actions and other charges. Covance's effective tax rate for the three months ended September 30, 2011 included a tax benefit of $1.9 million on $5.3 million in restructuring charges and a net tax benefit of $0.7 million associated primarily with a reduction in the future United Kingdom income tax rate, which resulted in a decrease in the Company's United Kingdom net deferred tax liabilities. The remaining year-over-year decrease in Covance's effective tax rate is attributable primarily to a shift in the mix of our pre-tax earnings across various tax jurisdictions and to the impact of tax planning initiatives.

Covance has a 47% minority equity position in Noveprim Limited ("Noveprim"), a supplier of research products. For the three months ended September 30, 2012, Covance did not recognize any share of Noveprim's results, as the Company suspended equity accounting for this investment effective June 30, 2012 as the carrying value of its investment is zero. For the three months ended September 30, 2011, Covance recognized income of $0.5 million, representing its share of Noveprim's earnings, net of the elimination of profit on inventory purchased from Noveprim and still on hand at Covance.

Net income of $37.8 million for the three months ended September 30, 2012 decreased $2.9 million or 7.0% as compared to $40.7 million for the corresponding 2011 period. Net income for the three months ended September 30, 2012 includes $9.6 million, net of tax, of restructuring charges and $2.8 million, net of tax, of costs associated with the expected settlement of an inventory supply agreement, partially offset by a benefit of $11.5 million for favorable tax items and a $1.0 million gain, net of tax on the sale of an investment. The net income in the three months ended September 30, 2011 included restructuring charges totaling $3.4 million, net of tax, and $0.7 million in favorable tax items.

Nine months Ended September 30, 2012 Compared with Nine months Ended September 30, 2011. Net revenues totaling $1.62 billion for the nine months ended September 30, 2012 increased 3.5%, or 5.6% excluding the unfavorable impact of foreign exchange rate variances between both periods, as compared to $1.56 billion for the corresponding 2011 period. Net revenues from Covance's early development segment decreased 6.3%, or 5.6% excluding the unfavorable impact of foreign exchange rate variances between both periods. The decline in the early development segment was due primarily to lower volumes in toxicology, resulting in part from the closure of the Company's Arizona and Virginia sites, and research products. Net revenues from Covance's late-stage development segment increased 11.4%, or 14.6% excluding the unfavorable impact of foreign exchange rate variances between both periods. Growth in the late-stage development segment was led by the strong performance of our Phase II-IV clinical development services and increased volume in our central laboratory services, which was partially offset by decreased volume in our market access services.

Cost of revenue increased 7.2% to $1.2 billion or 72.6% of net revenues for the nine months ended September 30, 2012 as compared to $1.1 billion or 70.0% of net revenues for the corresponding 2011 period. Gross margins decreased by 260 basis points to 27.4% for the nine months ended September 30, 2012 from 30.0% for the corresponding 2011 period due to an inventory impairment charge to write down certain preclinical inventory and costs associated with the expected settlement of an inventory supply agreement of $24.8 million (or 1.5% of net revenues) and the volume decrease in early development, which was only partially offset by strength in late-stage services.

Overall, selling, general and administrative expenses increased 7.6% to $266.0 million for the nine months ended September 30, 2012 from $247.3 million for the corresponding 2011 period. As a percentage of net revenues, selling, general and administrative expenses increased by 60 basis points to 16.4% for the nine months ended September 30, 2012 from 15.8% 27 -------------------------------------------------------------------------------- Table of Contents for the corresponding 2011 period. Included in selling, general and administrative expenses during the nine months ended September 30, 2012 is $21.4 million (or 1.3% of net revenues) in costs associated with the 2012 restructuring actions to better align capacity to preclinical market demand and further improve profitability going forward. These actions include the closure of the Company's toxicology facility in Chandler, Arizona, its clinical pharmacology facilities in Honolulu, Hawaii and Basel, Switzerland, as well as a capacity and workforce reduction in Muenster, Germany and in its corporate and functional support infrastructure. Included in selling, general and administrative expense during the nine months ended September 30, 2011 was $13.8 million (or 0.9% of net revenues) in costs associated with the 2011 restructuring initiatives to rationalize capacity, reduce the cost of overhead and support functions and to streamline processes. Selling, general and administrative expenses as a percentage of net revenues can and does vary depending on the timing and nature of various professional fees and other discretionary spending.

Depreciation and amortization increased 10.1% to $87.3 million for the nine months ended September 30, 2012 from $79.3 million for the corresponding 2011 period. As a percentage of net revenues, depreciation and amortization increased by 30 basis points to 5.4% for the nine months ended September 30, 2012 from 5.1% for the corresponding 2011 period. Depreciation and amortization during the nine months ended September 30, 2012 includes $2.3 million (or 0.1% of net revenues) in accelerated depreciation associated with the 2012 restructuring actions described above. Depreciation and amortization during the nine months ended September, 2011 included $1.9 million (or 0.1% of net revenues) in accelerated depreciation associated with the 2011 restructuring initiatives also described above. The balance of the increase results from depreciation on assets placed in service over the last year.

Income from operations decreased 48.6% to $72.8 million or 4.5% of net revenues for the nine months ended September 30, 2012 from $141.7 million or 9.1% of net revenues for the corresponding 2011 period. Income from operations for the nine months ended September 30, 2012 includes a goodwill impairment charge of $18.0 million (or 1.1% of net revenues) related to the Basel clinic, which is included in our early development segment results, as well as the restructuring charges of $23.7 million (or 1.5% of net revenues) and the inventory impairment charge and costs associated with the expected settlement of an inventory supply agreement totaling $24.8 million (or 1.5% of net revenues) discussed above.

Income from operations for the nine months ended September 30, 2011 included $15.7 million (or 1.0% of net revenues) in costs associated with the 2011 restructuring initiatives described above.

Results of operations from Covance's early development segment for the nine months ended September 30, 2012 decreased $102.3 million to a loss of $14.7 million, compared to income of $87.6 million for the corresponding 2011 period.

As a percentage of net revenues, early development results of operations declined from 12.6% of early development net revenues in the nine months ended September 30, 2011 to (2.3%) in the corresponding 2012 period. The decline in results of operations in Covance's early development segment for the nine months ended September 30, 2012 was primarily driven by restructuring and other charges of $22.4 million (or 3.4% of segment net revenues) during the 2012 nine month period versus $6.7 million (or 1.0% of segment net revenues) during the 2011 nine month period, the goodwill impairment charge of $18.0 million (or 2.8% of segment net revenues) and the inventory impairment charge and costs associated with the expected settlement of an inventory supply agreement totaling $24.8 million (or 3.8% of segment net revenues), coupled with the lower revenue in toxicology and research products described above.

Income from operations from Covance's late-stage development segment for the nine months ended September 30, 2012 increased 21.9% or $36.8 million to $204.9 million as compared to $168.1 million for the corresponding 2011 period.

As a percentage of net revenues, late-stage development income from operations increased 180 basis points from 19.4% of late-stage development net revenues in the nine month period ended September 30, 2011 to 21.2% of net revenues in the corresponding 2012 period, driven by the increase in revenue in both Phase II-IV clinical development and central laboratories, partially offset by the decrease in revenue in market access services. Income from operations for the nine months ended September 30, 2012 includes restructuring charges of $0.6 million (or 0.1% of segment net revenues). In addition, income from operations from Covance's late-stage development segment for the nine months ended September 30, 2011 included $3.7 million (or 0.4% of segment net revenues) in costs associated with the 2011 restructuring initiatives described above.

Corporate expense increased $3.4 million to $117.4 million or 7.3% of net revenues for the nine months ended September 30, 2012 as compared to $114.0 million or 7.3% of net revenues for the corresponding 2011 period.

Corporate expenses for the nine months ended September 30, 2012 includes restructuring charges of $0.8 million (or 0.05% of net revenues) while corporate expenses for the nine months ended September 30, 2011 included $5.2 million (or 0.3% of net revenues) in restructuring charges. Also included in corporate expense is stock-based compensation expense which totaled $29.8 million or 1.8% of net revenues for the nine months ended September 30, 2012, as compared to $29.3 million or 1.9% of net revenues for the corresponding 2011 period.

28 -------------------------------------------------------------------------------- Table of Contents Other expense, net increased $7.2 million to $9.7 million for the nine months ended September 30, 2012 from $2.5 million for the corresponding 2011 period.

The primary driver of the increase is an impairment charge of $7.4 million associated with an equity method investment in a supplier of research products recorded in the 2012 period. Net interest expense increased $0.8 million to $2.4 million during the 2012 period from $1.6 million for the corresponding 2011 period. Net foreign exchange transaction losses increased $0.4 million, to $1.3 million during the 2012 period from $0.9 million in the corresponding 2011 period. Partially offsetting the increase in expense was a gain on the sale of an investment of $1.5 million during the 2012 period.

Covance's effective tax rate for the nine months ended September 30, 2012 was 3.5% compared to 20.4% for the corresponding 2011 period. Covance's effective tax rate for the nine months ended September 30, 2012 includes a net tax benefit of $10.7 million primarily associated with the settlement of various income tax audits across multiple jurisdictions, $0.8 million associated with a reduction in the United Kingdom income tax rate, which resulted in a decrease in the Company's United Kingdom net deferred tax liabilities and a $15.2 million benefit related to $48.5 million of 2012 restructuring cost actions and other charges. There was no tax benefit recorded for either the $18.0 million goodwill impairment or the $7.4 million equity investment impairment. Covance's effective tax rate for the nine months ended September 30, 2011 included a tax benefit of $5.6 million on $15.7 million in restructuring charges and a net tax benefit of $0.7 million associated primarily with a reduction in the future United Kingdom income tax rate, which resulted in a decrease in the Company's United Kingdom net deferred tax liabilities. The remaining year-over-year decrease in Covance's effective tax rate is attributable primarily to a shift in the mix of our pre-tax earnings across various tax jurisdictions and to the impact of tax planning initiatives.

Covance has a 47% minority equity position in Noveprim Limited ("Noveprim"), a supplier of research products. For the nine months ended September 30, 2012, Covance recognized income of $17 thousand versus $0.3 million in the corresponding 2011 period, representing its share of Noveprim's earnings, net of the elimination of profit on inventory purchased from Noveprim and still on hand at Covance. The Company suspended equity accounting for this investment effective June 30, 2012 as the carrying value of its investment is zero.

Net income of $60.8 million for the nine months ended September 30, 2012 decreased $50.2 million or 45.2% as compared to $111.0 million for the corresponding 2011 period. Net income for the nine months ended September 30, 2012 includes $42.5 million, net of tax, of impairment charges for goodwill, inventory and an equity investment, as well as costs associated with the expected settlement of an inventory supply agreement. In addition, the nine months ended September 30, 2012 includes $16.2 million, net of tax, of restructuring charges, partially offset by a tax benefit of $11.5 million of favorable tax items and a $1.0 million gain, net of tax on the sale of an investment. Net income for the nine months ended September 30, 2011 included restructuring charges totaling $10.1 million, net of tax.

Liquidity and Capital Resources Cash and cash equivalents at September 30, 2012 and December 31, 2011 were $441.4 million and $389.1 million, respectively. Amounts held by foreign subsidiaries were approximately $419 million and $367 million at September 30, 2012 and December 31, 2011, respectively, primarily in Swiss Francs, British Pounds and Euros. Foreign cash balances generally result from unremitted foreign earnings, which the Company intends to leave invested indefinitely outside of the United States. If the Company were to remit such earnings to the United States, it would be subject to additional United States income taxes. Amounts are principally invested in short-term money market funds and bank deposits with major financial institutions which carry a Moody's rating of A1 P1 or better.

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, including possible share repurchases. On March 7, 2012, Covance amended its credit facility, which was not due to expire until October 2015, in order to, in part, provide sufficient liquidity to finance purchases under its recently authorized share buyback program, as well as to secure more favorable financing rates. The amended credit agreement (the "Credit Agreement") provides for a revolving credit facility of up to $500 million. At September 30, 2012, there were $340 million of outstanding borrowings and $2.9 million of outstanding letters of credit under the Credit Agreement. At December 31, 2011, there were $30 million of outstanding borrowings and $2.6 million of outstanding letters of credit under the previous credit agreement. Interest on all outstanding borrowings under the Credit Agreement varies in accordance with the terms of the Credit Agreement and is presently based upon the London Interbank Offered Rate plus a margin of 125 basis points. Interest on all outstanding borrowings under the previous credit agreement was based upon the London Interbank Offered Rate plus a margin of 200 basis points. Interest on outstanding borrowings approximated 1.50% per annum and 1.60% per annum during the three and nine months ended September 30, 2012, respectively. Interest on outstanding borrowings approximated 2.22% per annum and 2.33% per annum during the three and nine months ended September 30, 2011, respectively. Costs associated with the Credit Agreement, which expires in March 2017, consisted primarily of bank and legal 29 -------------------------------------------------------------------------------- Table of Contents fees totaling $1.9 million and are being amortized over the five-year term.

The Credit Agreement contains various financial and other covenants and is collateralized by guarantees of certain of Covance's domestic subsidiaries and a pledge of 65 percent of the capital stock of certain of Covance's foreign subsidiaries. At September 30, 2012, Covance was in compliance with the terms of the Credit Agreement. Covance believes cash on hand plus cash from operations and available borrowings under the Credit Agreement will provide sufficient liquidity for the foreseeable future.

During the nine months ended September 30, 2012, Covance's operations provided net cash of $152.9 million, an increase of $11.9 million from the corresponding 2011 period. The change in net operating assets, net of business sold, used $45.3 million in cash during the nine months ended September 30, 2012, primarily due to a net increase in other assets and liabilities, unbilled services and accounts receivable, partially offset by an increase in unearned revenue. The change in net operating assets, net of business acquired, used $69.0 million in cash during the nine months ended September 30, 2011, primarily due to an increase in unbilled services, accounts receivable, and other assets and liabilities, net, as well as a reduction in income taxes payable, partially offset by an increase in accrued liabilities. Covance's ratio of current assets to current liabilities was 1.34 at September 30, 2012 and 2.02 at December 31, 2011.

Investing activities for the nine months ended September 30, 2012 used $99.5 million, compared to $86.5 million for the corresponding 2011 period.

Capital spending for the first nine months of 2012 totaled $105.2 million, and was primarily for ongoing information technology projects, upgrade of existing equipment, and the purchase of new equipment, hardware and software.

Approximately $52.7 million of capital spending in the first nine months of 2012 represents expenditures associated with assets that have not yet been placed in service at September 30, 2012. In addition, the Company received proceeds of approximately $4.7 million upon the sale of its holdings in Caprion in the nine months ended September 30, 2012. Capital spending for the corresponding 2011 period totaled $86.3 million, and was primarily for ongoing information technology projects, upgrade of existing equipment, and the purchase of new equipment, hardware and software.

Financing activities for the nine months ended September 30, 2012 used $6.7 million, compared to $41.8 million in the corresponding 2011 period. Cash received from financing activities during the nine months ended September 30, 2012 included $310 million of net borrowings under the Credit Agreement, $5.3 million in proceeds from the exercise of stock options and $0.5 million in excess tax benefits realized on the exercise of stock options. Partially offsetting these items was $314.8 million used to purchase 6,653,971 shares of common stock into treasury in connection with share buyback programs authorized by Covance's Board of Directors and $7.7 million for the purchase into treasury of 159,799 shares in connection with employee benefit plans, for an aggregate cost of $322.5 million. During the nine months ended September 30, 2011, cash used for financing activities included the repayment and retirement of $97.5 million of outstanding debt on the term loan portion of the prior credit agreement. In addition, $7.7 million was used to purchase into treasury 134,384 shares of common stock in connection with employee benefit plans.

Partially offsetting these items were net borrowings of $55.0 million on the revolver portion of the prior credit agreement, $6.0 million in proceeds from the exercise of stock options, $1.6 million from employee contributions to the Company's employee stock purchase plan and $0.8 million in excess tax benefits realized on the exercise of stock options.

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 adverse effect on its operations or financial condition.

30 -------------------------------------------------------------------------------- Table of Contents 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, levels of industry research and development spending, the Company's ability to continue to attract and retain qualified personnel, the fixed price nature of contracts or the loss or delay of large studies, risks associated with acquisitions and investments, the Company's ability to increase order volume, the pace of translation of orders into revenue in late-stage development services, testing mix and geographic mix of kit receipts in central laboratories, fluctuations in currency exchange rates, the realization of savings from the Company's announced restructuring actions, the cost and pace of completion of our information technology projects and the realization of benefits therefrom, and other factors described in Covance's filings with the Securities and Exchange Commission, including its Annual Report on Form 10-K.

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