In January Covance warned that if demand for toxicology services is flat this year it may cut capacity. Covance is yet to report its first quarter results, which are due on May 3, but analysts are already predicting cuts.
In a preview of first quarter CRO (contract research organisation) results, Tim Evans, senior analyst at Wells Fargo, wrote: “Given the softness in the market, we think that Covance is likely to rationalise some capacity. The question is…how big will the cut be?”
As Evans sees it, there are two possible outcomes. Covance could “surgically trim marginal capacity”, such as in Europe where demand is still weak, or make “draconian cuts” by closing one of its newer facilities.
“[A draconian move] would imply preclinical weakness for the foreseeable future. Shutting down a large facility would not only mean idle capacity but also idle capital, a situation similar to the one in which Charles River Laboratories finds itself with its Shrewsbury facility”, Evans wrote.
David Windley, equity analyst at Jefferies & Company, also expects Covance to make cuts, possibly this quarter. Windley called for Covance to cut toxicology capacity in October and said today that a closure would show preclinical CROs still face “uncertain demand”.
Devil and the deep blue sea
Inking a big deal could increase certainty but is likely to come with new burdens for the CRO, some of which may link to cuts. “Reducing existing capacity recognises that strategic deals have required, and may continue to include, an assumption of client capacity and headcount”, Windley wrote.
Excess capacity means CROs also face a battle to secure acceptable pricing. “It is possible that Charles River or Covance could sign a deal to accelerate outsourcing penetration, though we think the barrier to such a deal is pharma’s insistence on unfavourable terms for the CRO”, Evans wrote.