Marcial: Why Pros Covet Covance

Although hardly a household name, Covance (CVD), which provides a wide range of services in the development of medicines, is a sought-after player in the pharmaceutical, biotech, and medical-device industries. And its stock has been mercurial, bolting to 54 on Oct. 27 from a 52-week low of 31 last Nov. 21.

Offering what's known as contract research, Covance provides services for drug discovery and development to more than 300 companies from large drugmakers to startups. Drugs typically must go through four phases of clinical trials to test how safe and effective they are before their makers can seek government approval to sell them to the public. Covance's labs, biomanufacturing, commercialization, and other clinical support services are aimed at proving the clinical efficacy of compounds in treating certain diseases. Its services for early drug development account for 48% of revenues and include preclinical testing essential to Phase 1 clinical trials, such as toxicology measures. The company derives 51% of revenues from its late-development work in Phase II to Phase IV trials.

Covance is among the top stock picks of dedicated growth investor Eddie Brown, president of Brown Capital Management, who says it is one of those superior growth companies that the market continues to underprice.

Brown, who pioneered the "growth at a reasonable price" approach and coined the acronym GARP in 1983, says that by almost every fundamental metric Covance is undervalued. The stock deserves a price-earnings ratio higher than its current 18 because its average yearly earnings growth rate is 18%, he says. And the stock's price-to-sales ratio of 1.8, notes Brown, is well below its average annual ratio of 2.7 over the past five years. At 11.5, its price-to-cash flow ratio is depressed as well, notes Brown. The average annual five-year ratio for that measure is 16.9. The stock has a lot more upside, argues Brown, estimating that it's undervalued by some 50%.

tightly controlled services Covance is an "exceptional investment" and is the "best-positioned research and development outsourcing provider," says analyst Eric W. Coldwell of investment firm Robert W. Baird. He says his recent visit to Covance's central lab and campus in Greenfield, Ind., reinforced his appreciation of how the company dominates the contract research business—a factor in its growth and profitability.

"Covance's quality and capabilities stand out," says Coldwell, with "highly automated, tightly controlled" services that provide the company's clients with speedy clinical trials that cut waste. He rates the shares outperform, with a 12-month target of 61. The stock, he says, is attractive for mid-cap growth portfolios that emphasize "quality and consistency."

Jeffrey Loo, an analyst at Standard & Poor's, recently upgraded his recommendation on Covance to a buy from hold because he expects the company to capture above-average market share. He notes that while demand for early drug development work has softened as small biotechs continue to conserve funds amid a tough financing environment, he believes the drug outsourcing market is stabilizing.

Expecting early drug development among biotechs to rebound in late 2009 and early 2010, Loo forecasts Covance earnings will continue to rise, to $2.78 a share in 2009 and to $3.26 in 2010. He has a 12-month price target of 64.

For as long as there is strong demand for new drugs, Covance should be in the catbird seat as the pharmaceutical and biotech industries grow. And that should provide long-term support to its stock.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

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