**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C.  20549**

**FORM 10-Q**

x  **Quarterly Report Pursuant to Section 13 or 15(d) of the SecuritiesExchange Act of 1934**

**For thequarterly period ended September 30, 2006**

**or**

o  **Transition Report Pursuant to Section 13 or 15(d) of the SecuritiesExchange Act of 1934**

**For thetransition period from                                     to**

**CommissionFile Number:  1-12213**

**COVANCEINC**.(Exact name of Registrant as specified in its Charter)

| **Delaware**                                    | ** ** | **22-3265977**                        |
|-------------------------------------------------|------------|---------------------------------------|
| (State of  Incorporation)                       |       | (I.R.S. Employer  Identification No.) |
|                                            |       |                                  |
| **210  Carnegie Center, Princeton, New Jersey** | ** ** | **08540**                             |
| (Address of  Principal Executive Offices)       |       | (Zip Code)                            |

 

Registrant’stelephone number, including area code:  **(609) 452-4440**

Indicate by checkmark whether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act (the “Exchange Act”) of 1934during the preceding 12 months (or for such shorter period that the Registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.YES x    NO o

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer (as described in Rule 12b-2 of the Exchange Act).

| Large Accelerated  Filer  x |   | Accelerated  Filer o |   | Non-Accelerated  Filer o |
|----------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicateby check mark whether the Registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).YES o    NO x

APPLICABLE ONLY TOCORPORATE ISSUERS:

As of October 20,2006, the Registrant had 63,985,593 shares of Common Stock outstanding.

 

----

**CovanceInc.Form 10-Q For the Quarterly Period Ended September 30, 2006**

**INDEX**
|                                                                                                 | ** **                                                                                  | ** ** | **Page** |
|-------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|------------|----------|
|                                                                                            |                                                                                        |       |     |
| **Part I. Financial Information**                                                               |                                                                                        |       |
| ** **                                                                                      |                                                                                        |       |
| Item 1. Financial Statements (Unaudited)                                                        |                                                                                        |       |
|                                                                                            |                                                                                        |       |     |
| Consolidated Balance Sheets—September 30, 2006 and  December 31, 2005                      |                                                                                        | 2          |
|                                                                                            |                                                                                        |       |     |
| Consolidated Statements of Income—Three and Nine  Months ended September 30, 2006 and 2005 |                                                                                        | 3          |
|                                                                                            |                                                                                        |       |     |
| Consolidated Statements of Cash Flows—Nine Months  ended September 30, 2006 and 2005       |                                                                                        | 4          |
|                                                                                            |                                                                                        |       |     |
| Notes to Consolidated Financial Statements                                                      |                                                                                        | 5          |
|                                                                                            |                                                                                        |       |     |
| Item 2.                                                                                         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       | 19       |
|                                                                                            |                                                                                        |       |     |
| Item 3.                                                                                         | Quantitative  and Qualitative Disclosure About Market Risk                                  |       | 30       |
|                                                                                            |                                                                                        |       |     |
| Item 4.                                                                                         | Controls and  Procedures                                                                    |       | 30       |
|                                                                                            |                                                                                        |       |     |
| **Part  II. Other Information**                                                                 |                                                                                        |       |
| ** **                                                                                      |                                                                                        |       |     |
| Item  1a.                                                                                       | Risk  Factors                                                                               |       | 31       |
|                                                                                            |                                                                                        |       |     |
| Item 6.                                                                                         | Exhibits                                                                                    |       | 35       |
|                                                                                            |                                                                                        |       |     |
| **Signatures**                                                                                  |                                                                                        | 36         |

** **

1

----

**COVANCEINC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSSEPTEMBER 30, 2006 AND DECEMBER 31, 2005**
| **(Dollars in thousands)**                                                                                                                                                                                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                       | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                                       | ** ** | **(UNAUDITED)**        | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Current Assets:                                                                                                                                                                                                                  |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                       |       | $                      | 210,080    |                  | $          | 160,717 |   |
| Accounts  receivable                                                                                                                                                                                                             |       | 212,802                |       | 206,098               |       |
| Unbilled  services                                                                                                                                                                                                               |       | 95,661                 |       | 88,297                |       |
| Inventory                                                                                                                                                                                                                        |       | 44,794                 |       | 40,293                |       |
| Deferred income  taxes                                                                                                                                                                                                           |       | 5,468                  |       | 2,062                 |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                       |       | 62,278                 |       | 49,243                |       |
| Total Current  Assets                                                                                                                                                                                                            |       | 631,083                |       | 546,710               |       |
| Property and equipment,  net                                                                                                                                                                                                     |       | 455,753                |       | 410,665               |       |
| Goodwill, net                                                                                                                                                                                                                    |       | 119,730                |       | 61,262                |       |
| Other assets                                                                                                                                                                                                                     |       | 47,463                 |       | 37,966                |       |
| Total  Assets                                                                                                                                                                                                                    |       | $                      | 1,254,029  |                  | $          | 1,056,603 |   |
| ** **                                                                                                                                                                                                                       |       |                   |       |                  |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                    |       |                   |       |                  |       |
| Current Liabilities:                                                                                                                                                                                                             |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                                                 |       | $                      | 27,824     |                  | $          | 26,975 |   |
| Accrued payroll  and benefits                                                                                                                                                                                                    |       | 75,270                 |       | 64,226                |       |
| Accrued expenses  and other current liabilities                                                                                                                                                                                  |       | 50,693                 |       | 48,298                |       |
| Unearned revenue                                                                                                                                                                                                                 |       | 100,991                |       | 96,987                |       |
| Income taxes  payable                                                                                                                                                                                                            |       | 19,573                 |       | 16,242                |       |
| Total Current  Liabilities                                                                                                                                                                                                       |       | 274,351                |       | 252,728               |       |
| Deferred income taxes                                                                                                                                                                                                            |       | 41,696                 |       | 45,545                |       |
| Other liabilities                                                                                                                                                                                                                |       | 31,145                 |       | 26,559                |       |
| Total  Liabilities                                                                                                                                                                                                               |       | 347,192                |       | 324,832               |       |
| Commitments and  Contingent Liabilities                                                                                                                                                                                          |       |                   |       |                  |       |
| Stockholders’ Equity:                                                                                                                                                                                                       |       |                   |       |                  |       |
| Preferred Stock  — Par value $1.00 per share; 10,000,000 shares authorized; no shares issued  and outstanding at September 30, 2006 and December 31, 2005                                                                   |       | 3⁄4                 |       | 3⁄4                |       |
| Common Stock -  Par value $0.01 per share; 140,000,000 shares authorized; 73,099,123 and  71,813,112 shares issued and outstanding, including those held in treasury,  at September 30, 2006 and December 31, 2005, respectively |       | 731                    |       | 718                   |       |
| Paid-in capital                                                                                                                                                                                                                  |       | 412,499                |       | 350,678               |       |
| Retained  earnings                                                                                                                                                                                                               |       | 719,496                |       | 612,811               |       |
| Accumulated  other comprehensive income —  Cumulative translation adjustment                                                                                                                                                |       | 28,619                 |       | 13,367                |       |
| Treasury stock  at cost (9,152,637 and 9,002,620 shares at September 30, 2006 and  December 31, 2005, respectively)                                                                                                         |       | (254,508               | )          | (245,803              | )          |
| Total  Stockholders’ Equity                                                                                                                                                                                                 |       | 906,837                |       | 731,771               |       |
| Total Liabilities and  Stockholders’ Equity                                                                                                                                                                                 |       | $                      | 1,254,029  |                  | $          | 1,056,603 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

2

----

**COVANCEINC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOMEFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005(UNAUDITED)**
| ** **                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | **September 30**            | ** ** | **September 30**           | ** ** |
| ** **                                                                      | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net revenues                                                                    |       | $                                | 341,478    |                            | $          | 295,368 |   | $ | 997,227 |   | $ | 870,596 |   |
| Reimbursable  out-of-pockets                                                    |       | 14,681                           |       | 11,759                          |       | 49,744 |   | 36,726 |   |
| Total revenues                                                                  |       | 356,159                          |       | 307,127                         |       | 1,046,971 |   | 907,322 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Cost and  expenses:                                                             |       |                             |       |                            |       |   |   |   |   |
| Cost of revenue (excluding depreciation and  amortization)                      |       | 223,662                          |       | 194,823                         |       | 660,045 |   | 577,309 |   |
| Reimbursed out-of-pocket expenses                                               |       | 14,681                           |       | 11,759                          |       | 49,744 |   | 36,726 |   |
| Selling, general and administrative                                             |       | 54,196                           |       | 44,673                          |       | 153,794 |   | 131,299 |   |
| Depreciation and amortization                                                   |       | 14,584                           |       | 11,758                          |       | 41,468 |   | 35,092 |   |
| Total costs and expenses                                                        |       | 307,123                          |       | 263,013                         |       | 905,051 |   | 780,426 |   |
| Income from  operations                                                         |       | 49,036                           |       | 44,114                          |       | 141,920 |   | 126,896 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Other (income)  expense, net:                                                   |       |                             |       |                            |       |   |   |   |   |
| Interest income                                                                 |       | (1,749                           | )          | (809                            | )          | (5,371 | ) | (2,975 | ) |
| Interest expense                                                                |       | 56                               |       | 86                              |       | 183 |   | 265 |   |
| Foreign exchange transaction (gain) loss, net                                   |       | (95                              | )          | (2                              | )          | (28 | ) | 949 |   |
| Other income, net                                                               |       | (1,788                           | )          | (725                            | )          | (5,216 | ) | (1,761 | ) |
| Income before  taxes and equity investee earnings                               |       | 50,824                           |       | 44,839                          |       | 147,136 |   | 128,657 |   |
| Taxes on income                                                                 |       | 12,726                           |       | 13,685                          |       | 41,389 |   | 39,444 |   |
| Equity investee  earnings                                                       |       | 178                              |       | 78                              |       | 938 |   | 433 |   |
| Net income                                                                      |       | $                                | 38,276     |                            | $          | 31,232 |   | $ | 106,685 |   | $ | 89,646 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Basic earnings  per share                                                       |       | $                                | 0.60       |                            | $          | 0.50 |   | $ | 1.68 |   | $ | 1.43 |   |
| Weighted average  shares outstanding - basic                                    |       | 63,827,555                       |       | 62,498,313                      |       | 63,542,002 |   | 62,586,651 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Diluted earnings  per share                                                     |       | $                                | 0.59       |                            | $          | 0.49 |   | $ | 1.65 |   | $ | 1.41 |   |
| Weighted average shares  outstanding — diluted                             |       | 64,965,380                       |       | 63,696,805                      |       | 64,758,456 |   | 63,757,590 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

3

----

**COVANCEINC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005(UNAUDITED)**
| **(Dollars in thousands)**                                                         | ** ** | **Nine Months Ended September 30** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                               | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                                       |       |                                                   |       |   |   |
| Net income                                                                                   |       | $                                                      | 106,685    |   | $ | 89,646 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:           |       |                                                   |       |   |   |
| Depreciation and amortization                                                                |       | 41,468                                                 |       | 35,092 |   |
| Non-cash compensation expense associated with  employee benefit and stock compensation plans |       | 21,990                                                 |       | 10,257 |   |
| Deferred income tax provision (benefit)                                                      |       | (658                                                   | )          | (2,349 | ) |
| Equity investee earnings                                                                     |       | (938                                                   | )          | (433 | ) |
| Other                                                                                        |       | (187                                                   | )          | 549 |   |
| Changes in operating assets and liabilities, net of  businesses acquired:                    |       |                                                   |       |   |   |
| Accounts receivable                                                                          |       | (998                                                   | )          | (24,042 | ) |
| Unbilled services                                                                            |       | (7,364                                                 | )          | (17,210 | ) |
| Inventory                                                                                    |       | (4,087                                                 | )          | (964 | ) |
| Accounts payable                                                                             |       | 725                                                    |       | (1,937 | ) |
| Accrued liabilities                                                                          |       | 10,003                                                 |       | (1,855 | ) |
| Unearned revenue                                                                             |       | 1,978                                                  |       | (5,956 | ) |
| Income taxes payable                                                                         |       | 8,274                                                  |       | 23,234 |   |
| Other assets and liabilities, net                                                            |       | (11,558                                                | )          | (4,495 | ) |
| Net cash  provided by operating activities                                                   |       | 165,333                                                |       | 99,537 |   |
|                                                                                         |       |                                                   |       |   |   |
| Cash flows from  investing activities:                                                       |       |                                                   |       |   |   |
| Capital expenditures                                                                         |       | (71,755                                                | )          | (94,338 | ) |
| Acquisition of businesses                                                                    |       | (74,561                                                | )          | (6,627 | ) |
| Other, net                                                                                   |       | 699                                                    |       | 115 |   |
| Net cash used in  investing activities                                                       |       | (145,617                                               | )          | (100,850 | ) |
|                                                                                         |       |                                                   |       |   |   |
| Cash flows from  financing activities:                                                       |       |                                                   |       |   |   |
| Stock issued under employee stock purchase and  option plans                                 |       | 34,901                                                 |       | 29,675 |   |
| Purchase of treasury stock                                                                   |       | (8,705                                                 | )          | (55,213 | ) |
| Net cash  provided by (used in) financing activities                                         |       | 26,196                                                 |       | (25,538 | ) |
|                                                                                         |       |                                                   |       |   |   |
| Effect of exchange  rate changes on cash                                                     |       | 3,451                                                  |       | (10,461 | ) |
| Net change in  cash and cash equivalents                                                     |       | 49,363                                                 |       | (37,312 | ) |
| Cash and cash  equivalents, beginning of period                                              |       | 160,717                                                |       | 177,712 |   |
| Cash and cash  equivalents, end of period                                                    |       | $                                                      | 210,080    |   | $ | 140,400 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

4

----

**COVANCE INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

**1.  Basis ofPresentation**

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith U.S. generally accepted accounting principles (“GAAP”) for interimfinancial information and with the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by GAAP for completefinancial statements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been included.  Operating results for the three and ninemonths ended September 30, 2006 are not necessarily indicative of the resultsthat may be expected for the year ending December 31, 2006.  The balance sheet at December 31, 2005 hasbeen derived from the audited financial statements at that date but does notinclude all of the information and footnotes required by GAAP for completefinancial statements.  You should readthese consolidated financial statements together with the historicalconsolidated financial statements of Covance Inc. and subsidiaries (“Covance”)for the years ended December 31, 2005, 2004, and 2003 included in our AnnualReport on Form 10-K for the year ended December 31, 2005.

**2.  Summary of Significant Accounting Policies**

**Principles ofConsolidation**

These unauditedconsolidated financial statements include the accounts of all entitiescontrolled by Covance.  All significantintercompany accounts and transactions are eliminated.  The equity method of accounting is used forinvestments in affiliates in which Covance owns between 20 and 50 percent anddoes not have the ability to exercise control. See Note 4.

**Use of Estimates**

These unauditedconsolidated financial statements have been prepared in conformity with GAAP,which requires management to make estimates and assumptions about future eventsthat affect the reported amounts of assets and liabilities, disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from theseestimates.

**Prepaid Expenses andOther Current Assets**

In connection with themanagement of multi-site clinical trials, Covance pays on behalf of itscustomers fees to investigators, volunteers and other out-of-pocket costs (suchas travel, printing, meetings, couriers, etc.), for which we are reimbursed atcost, without mark-up or profit. Amounts receivable from customers inconnection with billed and unbilled investigator fees, volunteer payments andother out-of-pocket pass-through costs are included in prepaid expenses andother current assets in the accompanying Consolidated Balance Sheets andtotaled $36.8 million and $31.6 million at September 30, 2006 and December 31,2005, respectively.  See Note 2 “ReimbursableOut-of-Pocket Expenses”.

**Inventory**

Inventories, whichconsist principally of finished goods and supplies, are valued at the lower ofcost (first-in, first-out method) or market.

**Goodwill and OtherIntangible Assets and Impairment**

Goodwill represents costsin excess of the fair value of net tangible and identifiable net intangibleassets acquired in business combinations. In accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 142, *Goodwill andOther Intangible Assets*, Covance performs an annual test for impairmentof goodwill and other indefinite lived intangible assets during the fourthquarter.  The most recent annual test forimpairment performed for 2005 did not identify any instances of impairment andthere were no events through September 30, 2006 that warranted areconsideration of our impairment test results.

5

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

**Revenue Recognition**

Covance recognizesrevenue either as services are performed or products are delivered, dependingupon the nature of the work contracted. Historically, a majority of Covance’snet revenues have been earned under contracts which range in duration from a fewmonths to two years, but can extend in duration up to five years or longer.Service contracts generally take the form of fee-for-service or fixed-pricearrangements. In the case of fee-for-service contracts, revenue is recognizedas services are performed, based upon, for example, hours worked or samplestested. For long-term fixed-price service contracts, revenue isrecognized as services are performed, with performance generally assessed usingoutput measures, such as units-of-work performed to date as compared to thetotal units-of-work contracted. Changes in the scope of work generally resultin a renegotiation of contract pricing terms. Renegotiated amounts are notincluded in net revenues until earned and realization is assured. Estimates ofcosts to complete are made to provide, where appropriate, for losses expectedon contracts. Costs are not deferred in anticipation of contracts beingawarded, but instead are expensed as incurred. In some cases, a portion of thecontract fee is paid at the time the trial is initiated. These advances aredeferred and recognized as revenue as services are performed or products aredelivered, as discussed above. Additional payments may be made based upon theachievement of performance-based milestones over the contract duration.Most contracts are terminable by the client either immediately or upon notice.These contracts typically require payment to Covance of expenses to wind downthe study, fees earned to date and, in some cases, a termination fee or apayment to Covance of some portion of the fees or profits that could have beenearned by Covance under the contract if it had not been terminated early.Termination fees are included in net revenues when realization is assured. Inconnection with the management of multi-site clinical trials, Covance pays onbehalf of its customers fees to investigators, volunteers and otherout-of-pocket costs (such as for travel, printing, meetings, couriers, etc.),for which it is reimbursed at cost, without mark-up or profit. Investigatorfees are not reflected in total revenues or expenses where Covance acts in thecapacity of an agent on behalf of the pharmaceutical company sponsor, passingthrough these costs without risk or reward to Covance. All other out-of-pocketcosts are included in total revenues and expenses.

Unbilled services are recorded for revenue recognized to date andrelate to amounts that are currently unbillable to the customer pursuant tocontractual terms. In general, amounts become billable upon the achievement ofmilestones or in accordance with predetermined payment schedules. Unbilledservices are billable to customers within one year from the respective balancesheet date. Unearned revenue is recorded for cash received from customers forwhich revenue has not been recognized at the balance sheet date.

**Taxes on Income**

Covance uses the asset and liability method of accounting for incometaxes.  Under this method, deferred taxassets and liabilities are recognized for the expected future tax consequencesof differences between the carrying amount of assets and liabilities and theirrespective tax bases using tax rates in effect for the year in which thetemporary differences are expected to reverse. The effect on deferred taxes of a change in enacted tax rates isrecognized in income in the period when the change is effective.

Covance maintains an income tax reserve for exposuresrelating to various income tax matters which is included in accrued expensesand other current liabilities on the consolidated balance sheet.  The balance of this income tax reserve atSeptember 30, 2006 is $6.6 million and relates to exposures for income taxmatters such as transfer pricing, nexus, deemed dividends and the allocation ofoverhead costs across various Federal, state and foreign income taxjurisdictions.  By way of background, anaccrual is established at the time an exposure is identified when it is bothprobable that a liability has been incurred and the amount of the liability canbe reasonably estimated.  The amount ofthe accrual for each item for which an exposure exists is adjusted when either(a) matters are settled at amounts which are different than the amount includedin the reserve or (b) when facts indicate a significant change in either theprobability or estimated amount of the potential exposure. The balance of thisreserve was reduced by $2.5 million during the quarter ended September 30, 2006as a result of several favorable developments arising during the quarter.  These developments included a matter as to whichclosure was reached with a foreign tax authority relating to research anddevelopment tax credits totaling $1.8 million as well as exposures as to whichit is no longer probable that a liability exists relating primarily to transferpricing matters aggregating $0.7 million.

6

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

Covance’s historical policy has been to leave its unremitted foreignearnings invested indefinitely outside the United States. Except for theone-time opportunity provided under the American Jobs Creation Act, pursuant towhich Covance repatriated $103 million in accumulated foreign earnings in thefourth quarter of 2005, Covance intends to continue to leave its unremittedforeign earnings invested indefinitely outside the United States.  As a result, taxes have not been provided onany accumulated foreign unremitted earnings as of September 30, 2006.

**ComprehensiveIncome**

Covance’s totalcomprehensive income, which represents net income plus the change in thecumulative translation adjustment equity account for the periods presented, was$43.5 million and $29.9 million for the three months ended September 30, 2006and 2005, respectively, and $121.9 million and $68.4 million for the ninemonths ended September 30, 2006 and 2005, respectively.

**Earnings Per Share (“EPS”)**

Basic EPS iscomputed by dividing net income available to common stockholders by theweighted average number of shares outstanding during the period.  The computation of diluted EPS is similar tothe computation of basic EPS, except that the denominator is increased toinclude the number of additional common shares that would have been outstandingif the dilutive potential common shares had been issued; computed under thetreasury stock method in accordance with the requirements of SFAS No. 128, *Earnings Per Share*. In computing diluted earnings per share for the three months endedSeptember 30, 2006 and 2005, the denominator was increased by 1,137,825 sharesand 1,198,492 shares, respectively, and for the nine months ended September 30,2006 and 2005, the denominator was increased by 1,216,454 shares and 1,170,939shares, respectively, representing the number of additional common shares thatwould have been outstanding if the dilutive potential common shares had beenissued for stock options outstanding at September 30, 2006 and 2005 withexercise prices less than the average market price of Covance’s Common Stockduring each respective period.  Excludedfrom the computation of diluted EPS for the three months ended September 30,2006 were options to purchase 2,155 shares of common stock at prices rangingfrom $63.79 to $66.38 per share because the exercise prices of such optionswere greater than the average market price of Covance’s common stock duringthis period.  Excluded from thecomputation of diluted EPS for the nine months ended September 30, 2006 wereoptions to purchase 7,634 shares of common stock at prices ranging from $59.52to $66.38 per share because the exercise prices of such options were greaterthan the average market price of Covance’s common stock during thisperiod.  Excluded from the computation ofdiluted EPS for the three months ended September 30, 2005 were options topurchase 8,010 shares of common stock at prices ranging from $49.61 to $52.71per share because the exercise prices of such options were greater than theaverage market price of Covance’s common stock during this period.  Excluded from the computation of diluted EPSfor the nine months ended September 30, 2005 were options to purchase 29,077shares of common stock at prices ranging from $45.23 to $52.71 per sharebecause the exercise prices of such options were greater than the averagemarket price of Covance’s common stock during this period.

**ReimbursableOut-of-Pocket Expenses**

As discussed in Note 2 “PrepaidExpenses and Other Current Assets”, Covance pays on behalf of its customersfees to investigators, volunteers and other out-of-pocket costs for which weare reimbursed at cost, without mark-up or profit.  In connection with the requirements ofFinancial Accounting Standards Board Emerging Issues Task Force Rule No. 01-14(“EITF 01-14”), *Income Statement Characterization ofReimbursements Received for “Out-of-Pocket” Expenses Incurred*,amounts paid to volunteers and other out-of-pocket costs are reflected inoperating expenses, while the reimbursements received are reflected in revenuesin the Consolidated Statements of Income. Covance will continue to exclude from revenue and expense in theConsolidated Statements of Income fees paid to investigators and the associatedreimbursement since Covance acts as an agent on behalf of the pharmaceuticalcompany sponsors with regard to investigator payments, in accordance with theFinancial Accounting Standards Board Emerging Issues Task Force Rule No. 99-19(“EITF 99-19”), *Reporting Revenue Gross as aPrincipal versus Net as an Agent*.

7

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

**Stock-Based Compensation**

TheCompany sponsors several stock-based compensation plans pursuant to whichnon-qualified stock options and restricted stock awards are granted to eligibleemployees.  These plans are describedmore fully in Note 8 herein and Note 10 to our audited consolidated financialstatements included in our Annual Report on Form 10-K for the year ended December31, 2005.

Throughthe year ended December 31, 2005, the Company followed the disclosure-onlyprovisions of Statement of Financial Accounting Standards No. 123,*Accounting for Stock-Based Compensation*, (“SFAS 123”), and,accordingly, accounted for awards under these plans pursuant to the recognitionand measurement principles of Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*, (“APB 25”) andrelated Interpretations, as permitted by SFAS 123. Under APB 25, compensationexpense was recognized in the financial statements relating to awards ofstock.  However, no compensation expensewas recorded in the financial statements for stock option grants, as alloptions have been granted with an exercise price equal to the market value ofthe underlying common stock on the date of grant.  Additionally, no compensation expense wasrecorded in the financial statements for shares purchased by employees underthe Company’s Employee Stock Purchase Plan as that plan was considered to benon-compensatory under APB 25.

EffectiveJanuary 1, 2006, the Company adopted the fair value recognition provisions ofStatement of Financial Accounting Standards No. 123R, *Share-BasedPayments*, (“SFAS 123R”) using the modified prospective transition method.  SFAS 123R revises SFAS 123, supersedes APB 25and amends Statement of Financial Accounting Standards No. 95, *Statement of Cash Flows*. Under the modified prospective transition method, compensation expenseis recognized in the financial statements on a go forward basis for (a) allshare-based payments granted prior to, but not vested as of January 1, 2006,based upon the grant-date fair value estimated in accordance with the originalprovisions of SFAS 123, and (b) share-based payments granted on or subsequentto January 1, 2006, based upon the grant-date fair value estimated inaccordance with the provisions of SFAS 123R. The grant-date fair value of awards expected to vest is expensed on astraight-line basis over the vesting period of the related awards.  Under the modified prospective transitionmethod, results for prior periods are not restated.

**SupplementalCash Flow Information**

Cash paid for interestfor the nine month periods ended September 30, 2006 and 2005 was $0.1 millionand $0.3 million, respectively. Cash paid for income taxes for the nine monthperiods ended September 30, 2006 and 2005 totaled $33.0 million and $14.9million, respectively.  The change inincome taxes payable in the Consolidated Statement of Cash Flows for the ninemonths ended September 30, 2006 reflects as an operating cash outflow theexcess tax benefit received from the exercise of non-qualified stock options asmeasured under SFAS 123R of $6.6 million (a corresponding cash inflow of $6.6 millionhas been reflected in financing cash flows). The change in income taxes payable in the Consolidated Statement of CashFlows for the nine months ended September 30, 2005 reflects the tax benefitfrom employee exercise of non-qualified stock options of $10.0 million asmeasured and accounted for under SFAS 123 and APB 25.  Pursuant to those standards, both thereduction in taxes payable and the increase in equity resulting from the excesstax benefit received are reflected in operating cash flows.

**RecentlyIssued Accounting Standards**

In September 2006, theFinancial Accounting Standards Board (the “FASB”) issued Statement of FinancialAccounting Standards No. 158, *Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans, anamendment of FASB Statements No. 87, 88, 106 and 132(R),* (“SFAS 158”).SFAS 158 requires an employer to recognize the overfunded or underfunded statusof a defined benefit postretirement plan — measured as the difference betweenthe fair value of plan assets and the projected benefit obligation — as anasset or liability, respectively, in its balance sheet and to recognize changesin the funded status of the plan in the year in which such changes occurthrough other comprehensive income. The financial statement recognition anddisclosure provisions of SFAS 158 are effective for fiscal years ending afterDecember 15, 2006, which will result in Covance recording the underfundedstatus of its plans as a liability with a corresponding decrease, net of tax,in the accumulated other comprehensive income equity account on its balancesheet at December 31, 2006 and recognizing future 

8

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

changes in thefunded status of its plans in other comprehensive income beginning with theyear ending December 31, 2007. SFAS 158 also requires, effective for fiscalyears ending after December 15, 2008, that the measurement of the overfunded orunderfunded status of the plan be made as of the employer’s fiscal year end andnot as of an earlier measurement date. Covance will be required to conform the measurement dates of its plansto December 31st  for its fiscal year ending December 31, 2008.

In September 2006, theFASB issued SFAS No. 157, *Fair ValueMeasurements,* (“SFAS 157”). SFAS 157, which applies whenever otherstandards require (or permit) fair value measurement, defines fair value andprovides guidance for using fair value to measure assets and liabilities.  SFAS 157 also requires expanded disclosuresabout the extent to which companies measure assets and liabilities at fairvalue, the information used in those measurements and the effect of fair valuemeasurements on earnings. Covance will be required to adopt SFAS 157, which iseffective for fiscal years beginning after November 15, 2007, no later than thequarter beginning January 1, 2008. Covance is currently in the process ofevaluating SFAS 157, and has not yet determined the impact, if any, SFAS 157will have on its consolidated results of operations or financial position.

In June 2006, the FASBissued Interpretation No. 48, *Accounting forUncertainty in Income Taxes — an Interpretation of FASB Statement No. 109*(“FIN 48”).  This authoritativeinterpretation clarifies and standardizes the manner by which companies will berequired to account for uncertain tax positions.  Adoption of FIN 48 is required for fiscalyears beginning after December 15, 2006. Covance will be required to adopt FIN 48 no later than the quarterbeginning January 1, 2007.  Covance iscurrently in the process of evaluating the Interpretation and has not yetdetermined the impact, if any, FIN 48 will have on its consolidated results ofoperations or financial position.

**3.  TreasuryStock**

In June 2004, the CovanceBoard of Directors authorized the repurchase of an additional 3.0 millionshares under Covance’s stock repurchase program.  At September 30, 2006, there areapproximately 0.5 million shares remaining for purchase under the 2004authorization.  Covance also reacquiresshares of its common stock in connection with certain employee benefit planswhen employees tender shares either in connection with reload stock options orto satisfy income tax withholdings associated with the vesting of stockawards.  The following table sets forththe treasury stock activity during the nine month periods ended September 30,2006 and 2005.
| ** **                              | ** ** | **Nine Months Ended September 30** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                               | ** ** | **2005** | ** ** |
| **(amounts in thousands)**    | ** ** | **$**                                                  | ** ** | **# shares** | ** ** | **$ ** | ** ** | **# shares** | ** ** |
| Shares  repurchased in connection with: |       |                                                   |       |   |   |   |   |   |   |
| Board approved buyback programs         |       | $                                                      | 7,799      |   | 134.3 |   | $ | 53,210 |   | 1,195.5 |   |
| Employee benefit plans                  |       | 906                                                    |       | 15.7 |   | 2,003 |   | 44.9 |   |
| Total                                   |       | $                                                      | 8,705      |   | 150.0 |   | $ | 55,213 |   | 1,240.4 |   |

 

**4.  EquityMethod Investees**

Covance has a 47%minority equity position in Noveprim Ltd., an existing supplier of researchproducts, which was acquired in March 2004 at a cost of $20.7 million.  The excess of the purchase price over theunderlying equity in Noveprim’s net assets at the date of acquisition of $13.8million represents goodwill and is included in the carrying value of Covance’sinvestment.  This investment is reflectedin Other Assets on the Consolidated Balance Sheet.  During the three and nine month periods endedSeptember 30, 2006, Covance recognized $0.2 million and $1.0 million,respectively, representing its share of Noveprim’s earnings, less anelimination of profit on inventory purchased from Noveprim Limited and still onhand at Covance at September 30, 2006. During the three and nine month periods ended September 30, 2005,Covance recognized $0.2 million and $0.9 million, respectively, representingits share of Noveprim’s earnings, less an elimination of profit on inventorypurchased from Noveprim Limited and still on hand at Covance at September 30,2005.  The carrying value of Covance’sinvestment in Noveprim as of September 30, 2006 and December 31, 2005 was $23.8million and $21.7 million, respectively.

9

----

**COVANCE INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

Covance has aminority equity position (approximately 21% at September 30, 2006) inBio-Imaging Technologies, Inc. (“BITI”). BITI uses proprietary medical imaging technologies to process andanalyze medical images, and also provides other services, including thedata-basing and regulatory submission of medical images, quantitative data andtext.  During the three and nine monthperiods ended September 30, 2006, Covance recognized income of $0.02 millionand losses of $0.06 million, respectively, representing its share of BITI’searnings.  During the three and ninemonth periods ended September 30, 2005, Covance recognized losses of $0.2million and $0.4 million, respectively, representing its share of BITI’slosses.  The carrying value of Covance’sinvestment in BITI as of September 30, 2006 and December 31, 2005 was $0.4million and $0.5 million, respectively, while the fair market value was $10.0million and $7.6 million, respectively.

**5.  Acquisitions**

OnMay 31, 2006, Covance acquired the stock of Radiant Research Inc. (“Radiant”)in a merger transaction for cash payments aggregating approximately $66.5million (including direct acquisition costs of $0.5 million, which have alreadybeen paid, and a working capital adjustment of $1.0 million which will be paidin October 2006).  Radiant operates eightearly development clinical sites performing Phase I/IIa clinical trialservices.  Results of operations forRadiant, which are now part of Covance’s Early Development segment serviceoffering, and the fair value of Radiant’s assets and liabilities acquired, areincluded in Covance’s consolidated financial statements beginning June 1, 2006.

OnMay 31, 2006, Covance also acquired certain assets and liabilities of SignetLaboratories, Inc. (“Signet”) for cash payments totaling $9.1 million(including direct acquisition costs of $0.2 million).  Signet specializes in the development ofmonoclonal antibodies and diagnostic assays for cancer, infectious diseases andneurodegenerative diseases.  Results ofoperations for Signet, which are now part of Covance’s Early Developmentsegment service offering, and the fair value of Signet’s assets and liabilitiesacquired, are included in Covance’s consolidated financial statements beginningJune 1, 2006.

Thetable below summarizes the preliminary purchase price allocations for theRadiant and Signet acquisitions:

|                                                                                 | ** ** | **Radiant** | ** ** | **Signet** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|
| Estimated fair value of  net tangible assets acquired.                          |       | $           | 9,115      |       | $          | 352 |   |
| Fair value of  intangible assets acquired (8 year weighted average useful life) |       | 6,820       |       | 850        |       |
| Goodwill                                                                        |       | 50,573      |       | 7,895      |       |
| Net assets acquired                                                             |       | $           | 66,508     |       | $          | 9,097 |   |

 

The purchase priceallocations are based upon preliminary estimates, using available informationand making assumptions management believes are reasonable.  Accordingly, these purchase price allocationsare subject to finalization within one year of each acquisition.  The goodwill resulting from the Signetacquisition is expected to be deductible for tax purposes, while the goodwillresulting from the merger with Radiant is not expected to be deductible for taxpurposes.

In August 2005, Covanceacquired GFI Clinical Services, an 80 bed Phase I clinic, from WestPharmaceutical Services, Inc. for a cash payment of $5.7 million.  The goodwill resulting from this transactionaggregated $4.0 million.

In June 2005,Covance acquired the business of an antibody products provider for a cashpayment of $0.9 million.  The goodwillresulting from this transaction aggregated $0.4 million.

10

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

**6.  Goodwill andIntangible Assets**

The followingtable sets forth changes in the carrying amount of goodwill by operatingsegment for the year ended December 31, 2005 and nine months ended September30, 2006, respectively:

|                                      | ** ** | **Early  Development** | ** ** | **Late-Stage  Development** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|------------------------|------------|-----------------------------|------------|-----------|------------|
| Balance, December 31,  2004          |       | $                      | 6,721      |                        | $          | 50,155    |       | $ | 56,876 |   |
| Goodwill acquired  during the year   |       | 4,386                  |       | —                      |       | 4,386     |       |
| Balance, December 31,  2005          |       | 11,107                 |       | 50,155                      |       | 61,262    |       |
| Goodwill acquired  during the period |       | 58,468                 |       | —                      |       | 58,468    |       |
| Balance, September 30, 2006          |       | $                      | 69,575     |                        | $          | 50,155    |       | $ | 119,730 |   |

 

The following tablesummarizes the Company’s acquired amortizable intangible assets, which arereflected in Other Assets on the Consolidated Balance Sheet, as of September30, 2006:

|                                                                                                                      | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Value** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------|------------|-------------------------------|------------|--------------------------|------------|
| Customer Lists  (10 year weighted average useful life)                                                               |       | $        | 4,510      |                          | $          | (150                     | )          | $ | 4,360 |   |
| Technology (5  year weighted average useful life)                                                                    |       | 2,340    |       | (151                          | )          | 2,189                    |       |
| Other - Patient  List, Backlog and Non-Compete Agreements (weighted average useful lives  ranging from 1 to 4 years) |       | 820      |       | (151                          | )          | 669                      |       |
| Total                                                                                                                |       | $        | 7,670      |                          | $          | (452                     | )          | $ | 7,218 |   |

 

Amortization expense forthe three and nine month periods ended September 30, 2006 was $0.3 million and$0.5 million, respectively.  Amortizationexpense expected to be recorded for each of the next five years is as follows:

| 2007 |   | $ | 1,202 |   |
|------|--------|---|-------|--------|
| 2008 |   | $ | 1,047 |   |
| 2009 |   | $ | 1,016 |   |
| 2010 |   | $ | 944   |   |
| 2011 |   | $ | 685   |   |

 

11

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

**7.  DefinedBenefit Plans**

Covance sponsors various pension and otherpost-retirement benefit plans.  Inaccordance with the interim disclosure provisions of SFAS No. 132 (revised2003), *Employers’ Disclosure About Pensionsand Other Post-Retirement Benefits,* the interim disclosures requiredare shown below.

**DefinedBenefit Pension Plans**

Covance sponsors twodefined benefit pension plans for the benefit of its employees at two UnitedKingdom subsidiaries and one defined benefit pension plan for the benefit of itsemployees at a German subsidiary, all of which are legacy plans of previouslyacquired companies.  Benefit amounts forall three plans are based upon years of service and compensation.  The German plan is unfunded while the UKplans are funded.  Covance’s fundingpolicy has been to contribute annually a fixed percentage of the eligibleemployee’s salary at least equal to the local statutory fundingrequirements.  Pension plan assets areadministered by the plans’ trustees and are principally invested in equity anddebt securities.  The components of netperiodic pension expense for these plans for the three and nine month periodsended September 30, 2006 and 2005 are as follows:
| ** **                                               | ** ** | **United Kingdom Plans**                  | ** ** | **German Plan**                                | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                               | ** ** | **Three Months Ended  September 30** | ** ** | **Three Months Ended  September 30** | ** ** |
| ** **                                               | ** ** | **2006**                                            | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Components of Net  Periodic Pension Cost:                |       |                                                |       |                                                |       |   |   |   |   |
| Service cost                                             |       | $                                                   | 1,520      |                                                | $          | 1,205 |   | $ | 102 |   | $ | 80 |   |
| Interest cost                                            |       | 1,627                                               |       | 1,373                                               |       | 77 |   | 64 |   |
| Expected return  on plan assets                          |       | (1,850                                              | )          | (1,396                                              | )          | — |   | — |   |
| Amortization of  net actuarial loss                      |       | 482                                                 |       | 375                                                 |       | 13 |   | 1 |   |
| Participant  contributions                               |       | (586                                                | )          | (546                                                | )          | — |   | — |   |
| Net periodic  pension cost                               |       | $                                                   | 1,193      |                                                | $          | 1,011 |   | $ | 192 |   | $ | 145 |   |
|                                                     |       |                                                |       |                                                |       |   |   |   |   |
| Assumptions Used to  Determine Net PeriodicPension Cost: |       |                                                |       |                                                |       |   |   |   |   |
| Discount rate                                            |       | 5.00                                                | %          | 5.75                                                | %          | 4.65 | % | 5.25 | % |
| Expected rate of  return on assets                       |       | 6.75                                                | %          | 6.75                                                | %          | n/a |   | n/a |   |
| Salary increases                                         |       | 4.00                                                | %          | 4.00                                                | %          | 2.50 | % | 2.50 | % |

 
| ** **                                               | ** ** | **United Kingdom Plans**                 | ** ** | **German Plan**                               | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                               | ** ** | **Nine Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
| ** **                                               | ** ** | **2006**                                           | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Components of Net  Periodic Pension Cost:                |       |                                               |       |                                               |       |   |   |   |   |
| Service cost                                             |       | $                                                  | 4,371      |                                               | $          | 3,685 |   | $ | 299 |   | $ | 244 |   |
| Interest cost                                            |       | 4,674                                              |       | 4,200                                              |       | 223 |   | 196 |   |
| Expected return  on plan assets                          |       | (5,314                                             | )          | (4,271                                             | )          | — |   | — |   |
| Amortization of  net actuarial loss                      |       | 1,384                                              |       | 1,146                                              |       | 37 |   | 4 |   |
| Participant  contributions                               |       | (1,684                                             | )          | (1,670                                             | )          | — |   | — |   |
| Net periodic  pension cost                               |       | $                                                  | 3,431      |                                               | $          | 3,090 |   | $ | 559 |   | $ | 444 |   |
|                                                     |       |                                               |       |                                               |       |   |   |   |   |
| Assumptions Used to  Determine Net PeriodicPension Cost: |       |                                               |       |                                               |       |   |   |   |   |
| Discount rate                                            |       | 5.00                                               | %          | 5.75                                               | %          | 4.65 | % | 5.25 | % |
| Expected rate of  return on assets                       |       | 6.75                                               | %          | 6.75                                               | %          | n/a |   | n/a |   |
| Salary increases                                         |       | 4.00                                               | %          | 4.00                                               | %          | 2.50 | % | 2.50 | % |

 

12

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

**SupplementalExecutive Retirement Plan**

In addition tothese foreign defined benefit pension plans, Covance also has a non-qualifiedSupplemental Executive Retirement Plan (“SERP”).  The SERP, which is not funded, is intended toprovide retirement benefits for certain executive officers of Covance.  Benefit amounts are based upon years ofservice and compensation of the participating employees.  The components of net periodic pension costfor the three and nine month periods ended September 30, 2006 and 2005 are asfollows:
| ** **                                                | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Components of Net  Periodic Pension Cost:                 |       |                                                |       |                                               |       |   |   |   |   |
| Service cost                                              |       | $                                                   | 231        |                                               | $          | 277 |   | $ | 694 |   | $ | 831 |   |
| Interest cost                                             |       | 164                                                 |       | 146                                                |       | 492 |   | 439 |   |
| Amortization of  prior service cost                       |       | 19                                                  |       | 19                                                 |       | 57 |   | 57 |   |
| Amortization of  net actuarial loss                       |       | 8                                                   |       | —                                             |       | 24 |   | — |   |
| Net periodic  pension cost                                |       | $                                                   | 422        |                                               | $          | 442 |   | $ | 1,267 |   | $ | 1,327 |   |
|                                                      |       |                                                |       |                                               |       |   |   |   |   |
| Assumptions Used to  Determine Net Periodic Pension Cost: |       |                                                |       |                                               |       |   |   |   |   |
| Discount rate                                             |       | 5.50                                                | %          | 6.00                                               | %          | 5.50 | % | 6.00 | % |
| Salary increases                                          |       | 4.00                                                | %          | 4.00                                               | %          | 4.00 | % | 4.00 | % |

 

**Post-EmploymentRetiree Health and Welfare Plan**

Covance alsosponsors a post-employment retiree health and welfare plan for the benefit ofeligible employees at certain U.S. subsidiaries who retire after satisfyingservice and age requirements.  This planis funded on a pay-as-you-go basis and the cost of providing these benefits isshared with the retirees.  The componentsof net periodic post-retirement benefits cost for the three and nine monthperiods ended September 30, 2006 and 2005 are as follows:
| ** **                                                                | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Components of Net  Periodic Post-retirement Benefits Cost:                |       |                                                |       |                                               |       |   |   |   |   |
| Service cost                                                              |       | $                                                   | 44         |                                               | $          | 49 |   | $ | 132 |   | $ | 147 |   |
| Interest cost                                                             |       | 78                                                  |       | 90                                                 |       | 234 |   | 269 |   |
| Amortization of  net actuarial loss                                       |       | 13                                                  |       | 36                                                 |       | 39 |   | 108 |   |
| Net periodic  post-retirement benefits cost                               |       | $                                                   | 135        |                                               | $          | 175 |   | $ | 405 |   | $ | 524 |   |
|                                                                      |       |                                                |       |                                               |       |   |   |   |   |
| Assumptions Used to  Determine Net Periodic Post-retirement Benefit Cost: |       |                                                |       |                                               |       |   |   |   |   |
| Discount rate                                                             |       | 5.50                                                | %          | 6.00                                               | %          | 5.50 | % | 6.00 | % |
| Health care cost trend  rate                                              |       | 9.00                                                | %(a)       | 9.00                                               | %(a)       | 9.00 | %(a) | 9.00 | %(a) |

----

(a) decreasing toultimate trend of 5.00% in 2010

13

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

**8.  Stock Compensation**

In June 2002,Covance’s Board of Directors adopted the 2002 Employee Stock Option Plan (the “2002ESOP”). The 2002 ESOP will expire on June 24, 2012. The 2002 ESOPauthorizes the Compensation and Organization Committee of the Board ofDirectors (the “Compensation Committee”), or such committee as is appointed bythe Covance Board of Directors, to administer the 2002 ESOP, to grant awards toemployees of Covance or entities in which Covance has a controlling orsignificant interest, except that officers as defined in Rule 16(a)-1(f)of the Securities Exchange Act of 1934, and members of the Board of Directorsare not eligible to receive awards. The 2002 ESOP authorizes the CompensationCommittee to grant the following awards to eligible employees: options topurchase common stock and stock appreciation rights. The exercise period forstock options granted under the 2002 ESOP is determined by the CompensationCommittee at the time of grant, and is generally ten years from the date ofgrant.  The vesting period for stockoptions granted under the 2002 ESOP is determined by the Compensation Committeeat the time of grant and options vest over a two year period. No stockappreciation rights have ever been granted under the 2002 ESOP. The number ofshares of Covance common stock initially available for grant under the 2002ESOP totaled 5.9 million. The Company issues authorized but previouslyunissued shares when options are exercised. At September 30, 2006, there wereapproximately 3.0 million shares remaining available for grants or awards underthe 2002 ESOP.

InMay 2002, Covance’s shareholders approved the 2002 Employee Equity ParticipationPlan (the “2002 EEPP”) in replacement of the 2000 Employee Equity ParticipationPlan (the “2000 EEPP”). The 2002 EEPP became effective on May 7, 2002 andwill expire on May 6, 2012. The 2002 EEPP authorizes the CompensationCommittee, or such committee as is appointed by the Covance Board of Directors,to administer the 2002 EEPP, to grant awards to employees and consultants ofCovance or entities in which Covance has a controlling or significant interest.The 2002 EEPP authorizes the Compensation Committee to grant the followingawards to eligible employees: options to purchase common stock; stockappreciation rights; and other stock awards either singly or incombination.  The exercise period forstock options granted under the 2002 EEPP is determined by the CompensationCommittee at the time of grant, and is generally ten years from the dateof grant.  The vesting period for stockoptions and stock awards granted under the 2002 EEPP is determined by theCompensation Committee at the time of grant. Options vest over a three yearperiod for senior executives and over a two year period for all otheremployees. Stock awards generally vest over a three year period for allemployees. The number of shares of Covance common stock initially available forgrant under the 2002 EEPP totaled approximately 3.25 million plusapproximately 0.9 million shares remaining available under the 2000 EEPPat the time the 2002 EEPP was approved. Effective upon approval of the 2002EEPP, no further grants or awards were permitted under the 2000 EEPP. Allgrants and awards under the 2000 EEPP remaining outstanding are nowadministered and paid in accordance with the provisions of the 2000 EEPP out ofshares issuable under the 2002 EEPP. The Company issues authorized but previouslyunissued shares when options are exercised. At September 30, 2006 there wereapproximately 3.6 million shares remaining available for grants or awards underthe 2002 EEPP.

EffectiveJanuary 1, 2006, the Company adopted the fair value recognition provisions ofSFAS 123R using the modified prospective transition method.  SFAS 123R revises SFAS 123, supersedes APB 25and amends Statement of Financial Accounting Standards No. 95, *Statement of Cash Flows*. Under the modified prospective transition method, compensation expenseis recognized in the financial statements on a go forward basis for (a) allshare-based payments granted prior to, but not vested as of January 1, 2006,based upon the grant-date fair value estimated in accordance with the original provisionsof SFAS 123, and (b) share-based payments granted on or subsequent to January1, 2006, based upon the grant-date fair value estimated in accordance with theprovisions of SFAS 123R.  The grant-datefair value of awards expected to vest is expensed on a straight-line basis overthe vesting period of the related awards. Under the modified prospective transition method, results for priorperiods are not restated.

Asa result of the adoption of SFAS 123R, both income from operations and incomebefore taxes for the three and nine month periods ended September 30, 2006 include incremental stock-basedcompensation expense of $3.8 million and $11.6 million, respectively.  For the three months ended September 30, 2006, the after tax impact of thisincremental stock-based compensation expense on net income, basic and dilutedearnings per share was $2.6 million, $0.04 and $0.04 respectively.  For the nine months ended September 30, 2006, the after tax impact of thisincremental stock-based compensation expense on net income, basic and dilutedearnings per share was $7.9 million, $0.12 and $0.12 respectively.  Results of operations for the three monthperiod ended September 30, 2006include $5.8 million ($3.9 million net of tax benefit of $1.9 million) of totalstock-

14

----

**COVANCE INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

based compensation expense, $1.7 million of which has been included incost of revenue and $4.1 million of which has been included in selling, generaland administrative expenses.  Results ofoperations for the nine month period ended September 30, 2006 include $15.2 million ($10.3 millionnet of tax benefit of $4.9 million) of total stock-based compensation expense,$5.2 million of which has been included in cost of revenue and $10.0million of which has been included in selling, general and administrativeexpenses.

Priorto January 1, 2006, Covance followed the disclosure-only provisions of SFAS 123and, accordingly, accounted for awards under its share based compensation planspursuant to the recognition and measurement principles of APB 25 and relatedInterpretations, as permitted by SFAS 123. Under APB 25, compensation expense was recognized in the financialstatements for the fair value of stock awards. However, no compensation expense was recorded in the financialstatements for stock option grants, as all options have been granted with anexercise price equal to the market value of the underlying common stock on thedate of grant. Additionally, no compensation expense was recorded in thefinancial statements for shares purchased by employees under the Company’sEmployee Stock Purchase Program as that plan was considered to be non-compensatoryunder APB 25. The following table illustrates the effect on net income andearnings per share for the three and nine month periods ended September 30, 2005 had Covance applied the fair valuerecognition provisions of SFAS 123 to all of its stock-basedemployee compensation plans.
| ** **                                                                                                                                    | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Net income, as reported                                                                                                                       |       | $                                                      | 31,232     |                                                  | $          | 89,646 |   |
| Add: Stock award-based  employee compensation included in reported net income, net of related tax  effects                                    |       | 1,339                                                  |       | 3,281                                                 |       |
| Deduct: Total stock-based  employee compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (4,173                                                 | )          | (12,538                                               | )          |
| Pro forma net income                                                                                                                          |       | $                                                      | 28,398     |                                                  | $          | 80,389 |   |
|                                                                                                                                          |       |                                                   |       |                                                  |       |
| Earnings per share:                                                                                                                           |       |                                                   |       |                                                  |       |
| Basic—as  reported                                                                                                                       |       | $                                                      | 0.50       |                                                  | $          | 1.43 |   |
| Basic—pro forma                                                                                                                          |       | $                                                      | 0.45       |                                                  | $          | 1.28 |   |
|                                                                                                                                          |       |                                                   |       |                                                  |       |
| Diluted—as  reported                                                                                                                     |       | $                                                      | 0.49       |                                                  | $          | 1.41 |   |
| Diluted—pro forma                                                                                                                        |       | $                                                      | 0.45       |                                                  | $          | 1.26 |   |

 

*Options* - Thegrant-date fair value of stock option awards is estimated using an option pricingmodel.  For stock options granted priorto January 1, 2006, the Company used the Black-Scholes-Merton option pricingformula to estimate the grant-date fair value of such awards.  For stock options granted on or subsequent toJanuary 1, 2006, the Company is using the Lattice-Binomial option pricingformula to estimate the grant-date fair value of stock option awards.  The Company changed to the Lattice-Binomialoption pricing formula as it believes such formula may result in a betterestimate of fair value than the Black-Scholes-Merton formula.  In order to estimate the grant-date fairvalue, 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 priceof the underlying stock, (c) the risk-free interest rate for the expected termof the option and (d) pre-vesting forfeiture rates.  The expected term of the option is based uponthe contractual term, taking into account expected employee exercise andexpected post-vesting employment termination behavior.  The expected volatility of the price of theunderlying stock is based upon the historical volatility of the Company’s stockcomputed over a period of time equal to the expected term of the option.  The risk free interest rate is based upon theimplied yields currently available from the U.S. Treasury zero-coupon yieldcurve for issues with a remaining duration equal to the expected term of theoption.  Pre-vesting forfeiture rates areestimated based upon past voluntary termination behavior and past optionforfeitures.

15

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

Thefollowing table sets forth the weighted-average assumptions used to calculatethe fair value of options granted for the three and nine month periods ended September30, 2006 and 2005:
| ** **                        | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected stock  price volatility  |       | 43.6%                                               |       | 43.6%                                              |       | 43.6% |   | 43.6% |   |
| Risk free  interest rate(s)       |       | 3.91%  - 4.54%                                      |       | 4.05%                                              |       | 3.91%  - 4.54% |   | 3.67% |   |
| Expected life of  options (years) |       | 4.33                                                |       | 5.0                                                |       | 4.33 |   | 5.0 |   |

 

Thefollowing table sets forth Covance’s stock option activity as of and for thenine month period ended September 30,2006:
| ** **                                                  | ** ** | **Number  of Shares  (in thousands)** | ** ** | **Weighted  Average  Price** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic Value  (in millions)** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| Options  outstanding, December 31, 2005                     |       | 3,841.9                                         |       | $                            | 28.58      |                                                    |       |                                                    |       |   |
| Granted                                                     |       | 387.5                                           |       | $                            | 56.37      |                                                    |       |                                                    |       |   |
| Exercised                                                   |       | (913.5                                          | )          | $                            | 27.42      |                                                    |       |                                                    |       |   |
| Forfeited                                                   |       | (231.5                                          | )          | $                            | 29.25      |                                                    |       |                                                    |       |   |
| Options  outstanding, September 30, 2006                    |       | 3,084.4                                         |       | $                            | 32.33      |                                                    | 6.8 years  |                                                    | $          | 105.0 |   |
|                                                        |       |                                            |       |                         |       |                                                    |       |                                                    |       |
| Vested and  unvested expected to vest at September 30, 2006 |       | 2,978.3                                         |       | $                            | 32.60      |                                                    | 6.8 years  |                                                    | $          | 100.6 |   |
| Exercisable at  September 30, 2006                          |       | 2,260.7                                         |       | $                            | 26.49      |                                                    | 6.0 years  |                                                    | $          | 90.2 |   |

 

Theweighted-average grant-date fair value per share of options granted during thethree month periods ended September30, 2006 and 2005 were $21.17 and $20.55, respectively.  The weighted-average grant-date fair valueper share of options granted during the nine month periods ended September 30, 2006 and 2005 were $21.99 and $18.18,respectively.  As of September 30, 2006, the total unrecognized compensationcost related to non-vested stock options granted was $9.6 million and isexpected to be recognized over a weighted average period of 1.64 years.

Thefollowing table sets forth the aggregate intrinsic value of options exercisedand the aggregate grant-date fair value of shares which vested for the threeand nine month periods ended September30, 2006 and 2005:
| ** **                                        | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| **(in millions)**                            | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Aggregate  intrinsic value of options exercised   |       | $                                                   | 6.2        |                                               | $          | 6.0 |   | $ | 29.0 |   | $ | 31.9 |   |
| Aggregate grant-date  fair value of shares vested |       | $                                                   | 1.3        |                                               | $          | 3.0 |   | $ | 14.2 |   | $ | 18.1 |   |

 

16

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

Cashproceeds from stock options exercised during the nine month periods endedSeptember 30, 2006 and 2005 totaled $25.0 million and $27.0 million,respectively.  Prior to the adoption of SFAS 123R, theCompany presented the tax benefit of deductions resulting from the exercise ofstock options as an operating cash flow in the Statements of Cash Flows inaccordance with SFAS 123 and APB 25.  Forthe nine months ended September 30, 2005, the tax benefit realized andincluded in operating cash flows totaled $10.0 million.  SFAS 123R requires that the cash flowsresulting from tax benefits realized on tax deductions “in excess of” thecompensation expense recognized (either in the financial statements or the proforma footnote disclosures) for stock options exercised in the period beclassified as a financing cash flow.  The“excess tax benefit” classified as a financing cash inflow during the ninemonths ended September 30, 2006 was $6.6 million and would have beenclassified as an operating cash inflow under SFAS 123.  The actual tax benefit realized on stockoptions exercised during the nine month period ended September 30, 2006 was $11.6 million.  Thedifference between the actual tax benefit received and the “excess tax benefit”computed in accordance with SFAS 123R of $5.0 million continues to beclassified as an operating cash inflow.

*Restricted Stock Awards*— Restricted stock awards are granted subject tocertain restrictions, including in some cases service conditions (restrictedstock) and in other cases service and performance conditions (performanceshares).  The grant-date fair value ofrestricted stock and performance share awards, which has been determined basedupon the market value of Covance’s shares on the grant date, is expensed overthe vesting period.

The following table setsforth Covance’s performance shares and restricted stock activity as of and forthe nine month period ended September 30,2006:
| ** **                       | ** ** | **Performance Shares**                     | ** ** | **Restricted Stock**                               | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **Number  of Shares  (in thousands)** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** | **Number  of Shares  (in thousands)** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
| Nonvested at  December 31, 2005  |       | 175.2                                           |       | $                                                       | 34.12      |   | 30.0 |   | $ | 44.99 |   |
| Granted                          |       | 157.9                                           |       | $                                                       | 49.27      |   | 191.3 |   | $ | 56.77 |   |
| Vested                           |       | (8.7                                            | )          | $                                                       | 36.35      |   | (0.9 | ) | $ | 56.18 |   |
| Forfeited                        |       | (21.9                                           | )          | $                                                       | 34.20      |   | (16.2 | ) | $ | 54.16 |   |
| Nonvested at September  30, 2006 |       | 302.5                                           |       | $                                                       | 41.95      |   | 204.2 |   | $ | 55.25 |   |

 

The blendedweighted average grant-date fair value of performance shares and restrictedstock awards granted during the three and nine months ended September 30, 2006 was $61.65 and $53.38,respectively and during the nine months ended September30, 2005 was $36.39.  There wereno performance shares or restricted stock awards granted during the threemonths ended September 30, 2005. As of September30, 2006, the total unrecognized compensation cost related to non-vestedperformance shares and restricted stock awards was $17.0 million.  This cost is expected to be recognized over aweighted average period of  2.3 years.

*Employee Stock Purchase Plan*- Covance also has an employee stock purchase plan(the “ESPP”) pursuant to which Covance may make available for sale to employeesshares of its common stock at a price equal to 85% of the lower of the marketvalue on the first or last day of each calendar quarter. The ESPP, administeredby the Compensation Committee, is intended to give Covance employees theopportunity to purchase shares of Covance common stock through payrolldeductions. A maximum of 3.0 million shares may be purchased by Covanceemployees under the ESPP.

17

----

**COVANCEINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)(UNAUDITED)September 30, 2006 and 2005(dollars in thousands, unless otherwise indicated)**

**9.  Segment Information**

Covance has tworeportable segments: early development and late-stage development. Earlydevelopment services, which includes Covance’s preclinical and clinicalpharmacology service capabilities, involve evaluating a new compound for safetyand early effectiveness as well as evaluating the absorption, distribution,metabolism and excretion of the compound in the human body.  It is at this stage that a pharmaceuticalcompany, based on available data, will generally decide whether to continue furtherdevelopment of a drug.  Late-stagedevelopment services, which include Covance’s central laboratory, clinicaldevelopment, periapproval, cardiac safety services, and market access services,are geared toward demonstrating the clinical effectiveness of a compound intreating certain diseases or conditions, obtaining regulatory approval andmaximizing the drug’s commercial potential.

The accountingpolicies of the reportable segments are the same as those described in Note2.  Segment net revenues, operatingincome and total assets for the three and nine months ended September 30, 2006 and 2005 are as follows:
| ** **                                   | ** ** | **Early  Development** | ** ** | **Late-Stage  Development** | ** ** | **Other  Reconciling Items** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|------------------------|------------|-----------------------------|------------|-----------------------------------|------------|-----------|------------|
| ***Three  months ended September 30, 2006*** |       |                   |       |                        |       |                              |       |      |       |
| Total revenues from external customers       |       | $                      | 167,389    |                        | $          | 174,089                           |       | $         | 14,681     |   (a) | $ | 356,159 |   |
| Operating income                             |       | $                      | 40,330     |                        | $          | 30,433                            |       | $         | (21,727    | ) (b) | $ | 49,036 |   |
| Total assets                                 |       | $                      | 717,275    |                        | $          | 404,495                           |       | $         | 132,259    |   (c) | $ | 1,254,029 |   |
|                                         |       |                   |       |                        |       |                              |       |      |       |
| ***Three  months ended September 30, 2005*** |       |                   |       |                        |       |                              |       |      |       |
| Total revenues from external customers       |       | $                      | 140,508    |                        | $          | 154,860                           |       | $         | 11,759     |   (a) | $ | 307,127 |   |
| Operating income                             |       | $                      | 36,639     |                        | $          | 24,300                            |       | $         | (16,825    | ) (b) | $ | 44,114 |   |
| Total assets                                 |       | $                      | 538,589    |                        | $          | 422,486                           |       | $         | 33,118     |   (c) | $ | 994,193 |   |
| *** ***                                 |       |                   |       |                        |       |                              |       |      |       |
| ***Nine  months ended September 30, 2006***  |       |                   |       |                        |       |                              |       |      |       |
| Total revenues from external customers       |       | $                      | 465,577    |                        | $          | 531,650                           |       | $         | 49,744     |   (a) | $ | 1,046,971 |   |
| Operating income                             |       | $                      | 114,964    |                        | $          | 90,946                            |       | $         | (63,990    | ) (b) | $ | 141,920 |   |
| Total assets                                 |       | $                      | 717,275    |                        | $          | 404,495                           |       | $         | 132,259    |   (c) | $ | 1,254,029 |   |
|                                         |       |                   |       |                        |       |                              |       |      |       |
| ***Nine  months ended September 30, 2005***  |       |                   |       |                        |       |                              |       |      |       |
| Total revenues from external customers       |       | $                      | 411,225    |                        | $          | 459,371                           |       | $         | 36,726     |   (a) | $ | 907,322 |   |
| Operating income                             |       | $                      | 102,333    |                        | $          | 76,839                            |       | $         | (52,276    | ) (b) | $ | 126,896 |   |
| Total assets                                 |       | $                      | 538,589    |                        | $          | 422,486                           |       | $         | 33,118     |   (c) | $ | 994,193 |   |

----

(a)           Represents revenues associated with reimbursableout-of-pocket expenses.

(b)           Represents corporate expenses (primarily informationtechnology, marketing, communications, human resources, finance andlegal).  Beginning in 2006, incrementalstock based compensation expense under SFAS 123R is now recorded in results ofoperations and has been included in corporate expenses.

(c)           Represents corporate assets.

18

----

**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

You should read thefollowing discussion together with the unaudited Covance consolidated financialstatements and the accompanying notes included in this Quarterly Report on Form10-Q for the quarter ended September 30,2006.

**Overview**

Covance is a leading drugdevelopment services company providing a wide range of early-stage andlate-stage product development services on a worldwide basis primarily to thepharmaceutical, biotechnology and medical device industries.  Covance also provides services such aslaboratory testing to the chemical, agrochemical and food industries. Theforegoing services comprise two reportable segments for financial reportingpurposes: early development services, which includes preclinical and clinicalpharmacology service offerings; and late-stage development services, whichincludes central laboratory, clinical development, periapproval, cardiac safetyservices, and market access services. Although each segment has separate services within it, they can becombined in joint service offerings and we believe clients increasingly areinterested in opportunities for such combined services.  Covance believes it is one of the largestdrug development services companies, based on annual net revenues, and one of afew that is capable of providing comprehensive global product developmentservices. Covance offers its clients high quality services designed to providedata to clients as rapidly as possible and reduce product developmenttime.  We believe this enables Covance’scustomers to introduce their products into the marketplace faster and as aresult, maximize the period of market exclusivity and monetary return on theirresearch and development investments. Additionally, Covance’s comprehensiveservices and broad experience provide its customers with a variable costalternative to fixed cost internal development capabilities.

**Critical Accounting Policies**

Covance’sconsolidated financial statements are prepared in accordance with U.S.generally accepted accounting principles (“GAAP”), which require management tomake estimates and assumptions about future events that affect the amountsreported in the financial statements and the accompanying notes.  Actual results could differ from theseestimates.  The following discussionhighlights what we believe to be the critical accounting policies and judgmentsmade in the preparation of these consolidated financial statements.

***Revenue Recognition.***Covance recognizes revenueeither as services are performed or products are delivered, depending upon thenature of the work contracted. Historically, a majority of Covance’s net revenues have been earnedunder contracts which range in duration from a few months to two years, but canextend in duration up to five years or longer. Service contracts generally take the form of fee-for-service orfixed-price arrangements.  In the case offee-for-service contracts, revenue is recognized as services are performed, basedupon, for example, hours worked or samples tested.  For long-term fixed-price service contracts,revenue is recognized as services are performed, with performance generallyassessed using output measures, such as units-of-work performed to date as comparedto the total units-of-work contracted. Changes in the scope of work generally result in a renegotiation ofcontract pricing terms.  Renegotiatedamounts are not included in net revenues until earned and realization isassured.  Estimates of costs to completeare made to provide, where appropriate, for losses expected on contracts.  Costs are not deferred in anticipation ofcontracts being awarded, but instead are expensed as incurred.  In some cases, a portion of the contract feeis paid at the time the trial is initiated. These advances are deferred and recognized as revenue as services areperformed or products are delivered, as discussed above.  Additional payments may be made based uponthe achievement of performance-based milestones over the contractduration.  Most contracts are terminableby the client either immediately or upon notice.  These contracts typically require payment toCovance of expenses to wind down the study, fees earned to date and, in somecases, a termination fee or a payment to Covance of some portion of the fees orprofits that could have been earned by Covance under the contract if it had notbeen terminated early.  Termination feesare included in net revenues when realization is assured.

***Bad Debts. ***Covanceendeavors to assess and monitor the creditworthiness of its customers to whichit grants credit terms in the ordinary course of business.  Covance maintains a provision for doubtfulaccounts relating to amounts due that may not be collected.  This bad debt provision is monitored on amonthly basis and adjusted as circumstances warrant.  Since the recorded bad debt provision isbased upon management’s judgment, actual bad debt write-offs may be greater orless than the amount recorded. Historically bad debt write-offs have not been material.

19

----

***Taxeson Income.***Since Covance conducts operations on a globalbasis, its effective tax rate has and will continue to depend upon thegeographic distribution of its pre-tax earnings among locations with varyingtax rates. Covance’s profits are further impacted by changes in the tax ratesof the various jurisdictions. In particular, as the geographic mix of Covance’spre-tax earnings among various tax jurisdictions changes, Covance’s effectivetax rate may vary from period to period. In addition, Covance’s policy is to provide income taxes on earnings offoreign subsidiaries only to the extent those earnings are taxable or areexpected to be remitted.  Covance’shistorical policy has been to leave its unremitted foreign earnings investedindefinitely outside the United States. Except for the amounts repatriated inthe fourth quarter of 2005 under the American Jobs Creation Act of 2004 (the “Act”),Covance intends to continue to leave its unremitted foreign earnings investedindefinitely outside the United States. As a result, taxes have not been provided on any accumulated foreignunremitted earnings as of September 30,2006.

Covance maintains anincome tax reserve for exposures relating to various income tax matters whichis included in accrued expenses and other current liabilities on theconsolidated balance sheet.  The balanceof this income tax reserve at September 30, 2006 is $6.6 million and relates toexposures for income tax matters such as transfer pricing, nexus, deemeddividends and the allocation of overhead costs across various Federal, stateand foreign income tax jurisdictions. By way of background, an accrual isestablished at the time an exposure is identified when it is both probable thata liability has been incurred and the amount of the liability can be reasonablyestimated.  The amount of the accrual foreach item for which an exposure exists is adjusted when either (a) matters aresettled at amounts which are different than the amount included in the reserveor (b) when facts indicate a significant change in either the probability orestimated amount of the potential exposure. While Covance believes that it has identified all reasonablyidentifiable exposures and that the reserve it has established for identifiableexposures is appropriate under the circumstances, it is possible thatadditional exposures exist and that exposures will be settled at amountsdifferent than the amounts reserved.  Itis also possible that changes in estimates in the future could cause Covance toeither materially increase or reduce the carrying amount of its income taxreserve.  The balance of this reserve wasreduced by $2.5 million during the quarter ended September 30, 2006 as a resultof several favorable developments arising during the quarter.  These developments included a matter as towhich closure was reached with a foreign tax authority relating to research anddevelopment tax credits totaling $1.8 million as well as exposures as to whichit is no longer probable that a liability exists relating primarily to transferpricing matters aggregating $0.7 million.

***StockBased Compensation.***The Company sponsors severalstock-based compensation plans pursuant to which non-qualified stock optionsand restricted stock awards are granted to eligible employees.  Through the year ended December 31, 2005, theCompany followed the disclosure-only provisions of Statement of FinancialAccounting Standards No. 123,*Accounting forStock-Based Compensation*, (“SFAS 123”), and, accordingly, accountedfor awards under these plans pursuant to the recognition and measurementprinciples of Accounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees*, (“APB 25”) and relatedInterpretations, as permitted by SFAS 123. Under APB 25, compensation expense was recognized in the financialstatements relating to awards of stock. However, no compensation expense was recorded in the financialstatements for stock option grants, as all options have been granted with anexercise price equal to the market value of the underlying common stock on thedate of grant. Additionally, no compensation expense was recorded in thefinancial statements for shares purchased by employees under the Company’sEmployee Stock Purchase Plan (pursuant to which employees are able to purchaseshares of the Company’s common stock at a price equal to 85% of the lower ofthe market value on the first or last day of each calendar quarter) as thatplan was considered to be non-compensatory under APB 25.

Effective January 1, 2006,the Company adopted the fair value recognition provisions of Statement ofFinancial Accounting Standards No. 123R, *Share-Based Payments*,(“SFAS 123R”) using the modified prospective transition method.  SFAS 123R revises SFAS 123, supersedes APB 25 and amends Statement ofFinancial Accounting Standards No. 95, *Statement of Cash Flows*.  Under that transition method,compensation expense is now recognized in the financial statements on a goforward basis for (a) all share-based payments granted prior to, but not vestedas of January 1, 2006, based upon the grant-date fair value estimated inaccordance with the original provisions of SFAS 123, and (b) share-basedpayments granted on or subsequent to January 1, 2006, based upon the grant-datefair value estimated in accordance with the provisions of SFAS 123R.  The grant-date fair value of awards expectedto vest is expensed on a straight-line basis over the vesting period of therelated awards.  Under the modifiedprospective transition method, results for prior periods have not beenrestated.

Prior to the adoption ofSFAS123R, the Company used stock options as the vehicle through whichstock-based compensation awards were granted to eligible employees, other thanexecutive officers who historically were granted a combination ofperformance-based share awards and stock options.  As a result of the adoption of SFAS 123R, theCompany is now using a mix of restricted share awards and stock options as thevehicles through which stock-based compensation awards are granted to eligibleemployees, other than executive officers who continue to receive a combinationof performance-based share awards and stock options.

20

----

The grant-date fair valueof stock awards is based upon the underlying price of the stock on the date of grant.  The grant-date fair value of stock optionawards must be determined using an option pricing model.  Option pricing models require the use ofestimates and assumptions as to (a) the expected term of the option, (b) theexpected volatility of the price of the underlying stock, (c) the risk-freeinterest rate for the expected term of the option and (d) pre-vestingforfeiture rates.  For stock optionsgranted prior to January 1, 2006, the Company used the Black-Scholes-Mertonoption pricing formula for determining the grant-date fair value of suchawards.  For stock options granted on orsubsequent to January 1, 2006, the Company is using the Lattice-Binomial optionpricing formula for determining the grant-date fair value of stock optionawards.  The Company changed to the Lattice-Binomialoption pricing formula as it believes such formula may result in a betterestimate of fair value than the Black-Scholes-Merton formula.

The expected term of theoption is based upon the contractual term and expected employee exercise andexpected post-vesting employment termination behavior.  The expected volatility of the price of theunderlying stock is based upon the historical volatility of the Company’s stockcomputed over a period of time equal to the expected term of the option.  The risk free interest rate is based upon theimplied yields currently available from the U.S. Treasury zero-coupon yieldcurve for issues with a remaining duration equal to the expected term of theoption.  Pre-vesting forfeiture rates areestimated based upon past voluntary termination behavior and past optionforfeitures.

Thefollowing table sets forth the weighted-average assumptions used to calculatethe fair value of options granted for the three and nine month periods ended September 30, 2006 and 2005: 
| ** **                        | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected stock  price volatility  |       | 43.6%                                               |       | 43.6%                                              |       | 43.6% |   | 43.6% |   |
| Risk free  interest rate(s)       |       | 3.91%  - 4.54%                                      |       | 4.05%                                              |       | 3.91%  - 4.54% |   | 3.67% |   |
| Expected life of  options (years) |       | 4.33                                                |       | 5.0                                                |       | 4.33 |   | 5.0 |   |

 

Changes in any of theseassumptions could impact, potentially materially, the amount of expenserecorded in future periods related to stock based awards.

Asof September 30, 2006, the total unrecognized compensation cost related tonon-vested stock options granted was $9.6 million and is expected to berecognized over a weighted average period of 1.64 years. As of September 30, 2006, the total unrecognizedcompensation cost related to non-vested performance shares and restricted stockawards was $17.0 million and is expected to be recognized over a weightedaverage period of 2.3 years.

***Impairment of Assets.***Covance reviews its long-lived assets other than goodwill and other indefinitelived intangible assets for impairment, whenevents or changes in circumstances occur that indicate that the carrying valueof the asset may not be recoverable.  Theassessment of possible impairment is based upon Covance’s judgment of itsability to recover the asset from the expected future undiscounted cash flowsof the related operations.  Actual futurecash flows may be greater or less than estimated.

Covanceperforms an annual test for impairment of goodwill and other indefinitelived intangible assets during the fourthquarter.  This test is performed bycomparing, at the reporting unit level, the carrying value to its fairvalue.  Covance assesses fair value basedupon its best estimate of the present value of the future cash flows that itexpects to be generated by the reporting unit. The test performed for 2005 did not identify any instances ofimpairment.  However, changes inexpectations as to the present value of the reporting unit’s future cash flowsmight impact subsequent years’ assessments of impairment.

***Defined BenefitPension Plans.*********Covance sponsors defined benefit pension plans for thebenefit of its employees at three foreign subsidiaries as well as anon-qualified supplemental executive retirement plan and a post-employmentretiree health and welfare plan for the benefit of eligible employees atcertain U.S. subsidiaries.  Themeasurement of the related benefit obligation and net periodic benefit costrecorded each year is based upon actuarial computations which require the useof judgment as to certain assumptions.  The more significant of these assumptions are: (a) the appropriatediscount 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 expectedfuture rate of salary increases (for pay-related plans).  Actual results (such as the return on planassets, future rate of salary increases and plan participation rates) willlikely differ from the assumptions used. Those differences, along with changes that may be made in theassumptions used from period to period, will impact the amounts reported in thefinancial statements and footnote disclosures.

21

----

Set forth below is adiscussion of the impact that differences between assumed results and (a)actual results and (b) assumption changes have had on our results of operationsfor the years ended December 31, 2005, 2004 and 2003 and on the financialposition of the plans as of December 31, 2005 and 2004 for our UK definedbenefit pension plans (the largest of our defined benefit-type pensionplans).  
| ** **                                                                 | ** ** | **United Kingdom Plans** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------|------------|
| **(amounts in millions)**                                        | ** ** | **2005**                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net periodic  pension cost                                                 |       | $                                  | 4.1        |   | $ | 4.3 |   | $ | 4.1 |   | $ | 3.0 |   |
|                                                                       |       |                               |       |   |   |   |   |   |   |
| Weighted average  assumptions used to determine net periodic pension cost: |       |                               |       |   |   |   |   |   |   |
| Discount rate                                                              |       | 5.75                               | %          | 6.00 | % | 6.00 | % | 6.50 | % |
| Expected rate of return on assets                                          |       | 6.75                               | %          | 6.00 | % | 6.00 | % | 6.50 | % |
| Salary increases                                                           |       | 4.00                               | %          | 3.50 | % | 3.50 | % | 3.50 | % |
|                                                                            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |

 

The change in the netperiodic benefit cost from period to period is attributable to the following:
| ** **                                                                   | ** ** | **United Kingdom Plans** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------|------------|
| **(amounts in millions)**                                          | ** ** | **2004 to 2005**         | ** ** | **2003 to 2004** | ** ** | **2002 to 2003** | ** ** |
| Change in  discount rate                                                     |       | $                                  | 0.4        |   | — |   | $ | 0.5 |   |
| Change in  expected rate of return on assets                                 |       | (0.6                               | )          | — |   | 0.3 |   |
| Change in rate  of salary increases                                          |       | 0.4                                |       | — |   | — |   |
| Other, including  differences between actual experience and assumptions used |       | (0.4                               | )          | $ | (0.3 | ) | — |   |
| Foreign currency  exchange rate changes                                      |       | —                             |       | 0.5 |   | 0.3 |   |
| Net change in periodic  benefit cost                                         |       | $                                  | (0.2       | ) | $ | 0.2 |   | $ | 1.1 |   |

 
| ** **                                                          | ** ** | **United Kingdom Plans** | ** ** |
|---------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Weighted average  assumptions used to determine benefit obligation: | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Discount rate                                                       |       | 5.00                               | %          | 5.75 | % | 6.00 | % |
| Salary increases                                                    |       | 4.00                               | %          | 4.00 | % | 3.50 | % |

 

The change in theprojected benefit obligation from period to period is attributable to thefollowing:
| ** **                                                                   | ** ** | **United Kingdom Plans** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------|------------|
| **(amounts in millions)**                                          | ** ** | **2004 to 2005**         | ** ** | **2003 to 2004** | ** ** |
| Benefit  obligation, beginning of year                                       |       | $                                  | 103.3      |   | $ | 79.4 |   |
| Service/interest  cost components of net periodic benefit cost in year       |       | 10.5                               |       | 9.6 |   |
| Benefits paid                                                                |       | (1.2                               | )          | (1.5 | ) |
| Reduction in  discount rate                                                  |       | 18.6                               |       | 5.2 |   |
| Change in rate  of salary increases                                          |       | —                             |       | 2.4 |   |
| Other, including  differences between actual experience and assumptions used |       | (0.5                               | )          | 0.6 |   |
| Foreign currency  exchange rate changes                                      |       | (10.9                              | )          | 7.6 |   |
| Benefit obligation, end  of year                                             |       | $                                  | 119.8      |   | $ | 103.3 |   |

** **

22

----

**Foreign Currency Risks**

Since Covance operates on a global basis, it isexposed to various foreign currency risks. Two specific risks arise from thenature of the contracts Covance executes with its customers since from time totime contracts are denominated in a currency different than the particularCovance subsidiary’s local currency. These risks are generally applicable onlyto a portion of the contracts executed by Covance’s foreign subsidiariesproviding clinical services. The first risk occurs as revenue recognized forservices rendered is denominated in a currency different from the currency inwhich the subsidiary’s expenses are incurred. As a result, the subsidiary’s netrevenues and resultant earnings can be affected by fluctuations in exchangerates.  Historically, fluctuations inexchange rates from those in effect at the time contracts were executed havenot had a material effect upon Covance’s consolidated financial results.  See “Risk Factors”.

Thesecond risk results from the passage of time between the invoicing of customersunder these contracts and the ultimate collection of customer payments againstsuch invoices. Because the contract is denominated in a currency other than thesubsidiary’s local currency, Covance recognizes a receivable at the time ofinvoicing for the local currency equivalent of the foreign currency invoiceamount. Changes in exchange rates from the time the invoice is prepared andpayment from the customer is received will result in Covance receiving eithermore or less in local currency than the local currency equivalent of theinvoice amount at the time the invoice was prepared and the receivableestablished. This difference is recognized by Covance as a foreign currencytransaction gain or loss, as applicable, and is reported in other expense(income) in Covance’s Consolidated Statements of Income.

Finally, Covance’sconsolidated 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 financialresults into U.S. dollars for purposes of reporting Covance’s consolidatedfinancial results. The process by which each foreign subsidiary’s financialresults are translated into U.S. dollars is as follows: income statementaccounts are translated at average exchange rates for the period; balance sheetasset and liability accounts are translated at end of period exchange rates;and equity accounts are translated at historical exchange rates. Translation ofthe balance sheet in this manner affects the stockholders’ equity account,referred to as the cumulative translation adjustment account. This accountexists only in the foreign subsidiary’s U.S. dollar balance sheet and is necessaryto keep the foreign balance sheet stated in U.S. dollars in balance.  At September 30, 2006 the accumulated othercomprehensive income — cumulative translation account balance was $28.6million.

**Operating Expenses and Reimbursable Out-of-Pockets**

Covance segregates its recurringoperating expenses among four categories: cost of revenue; reimbursedout-of-pocket expenses; selling, general and administrative expenses; anddepreciation and amortization. Cost of revenue includes direct labor and relatedbenefits, other direct costs, shipping and handling fees, and an allocation offacility charges and information technology costs, and excludes depreciationand amortization. Cost of revenue, as a percentage of net revenues, tends andis expected to fluctuate from one period to another, as a result of changes inlabor utilization and the mix of service offerings involving hundreds ofstudies conducted during any period of time. Selling, general andadministrative expenses consist primarily of administrative payroll and relatedbenefit charges, advertising and promotional expenses, administrative traveland an allocation of facility charges and information technology costs, andexcludes depreciation and amortization.

In connection with themanagement of multi-site clinical trials, Covance pays on behalf of itscustomers fees to investigators, volunteers and other out-of-pocket costs (suchas for travel, printing, meetings, couriers, etc.), for which it is reimbursedat cost, without mark-up or profit. Investigator fees are not reflected in total revenues or expenses whereCovance acts in the capacity of an agent on behalf of the pharmaceuticalcompany sponsor, passing through these costs without risk or reward toCovance.  All other out-of-pocket costsare included in total revenues and expenses.

**Quarterly Results**

Covance’s quarterlyoperating results are subject to variation, and are expected to continue to besubject to variation, as a result of factors such as (1) delays in initiatingor completing significant drug development trials, (2) termination or reductionin size of drug development trials, (3) acquisitions and divestitures, (4)changes in the mix of our services, and (5) exchange rate fluctuations. Delaysand terminations of trials are often the result of actions taken by Covance’scustomers or regulatory authorities and are not typically controllable byCovance. Since a large amount of Covance’s operating costs are relatively fixedwhile revenue is subject to fluctuation, moderate variations in the commencement,progress or completion of drug development trials may cause significantvariations in quarterly results.

23

----

**Results of Operations**

**Items AffectingComparability Between Periods**

Prior to 2006, theCompany followed the disclosure-only provisions of SFAS 123, and, accordingly,accounted for awards under these plans pursuant to the recognition andmeasurement principles of APB 25 and related Interpretations, as permitted bySFAS 123.  Under APB 25, compensationexpense was recognized in the financial statements relating to awards ofstock.  However, no compensation expensewas recorded in the financial statements for stock option grants, as alloptions have been granted with an exercise price equal to the market value ofthe underlying common stock on the date of grant. Additionally, no compensationexpense was recorded in the financial statements for shares purchased byemployees under the Company’s Employee Stock Purchase Plan (pursuant to whichemployees are able to purchase shares of the Company’s common stock at a priceequal to 85% of the lower of the market value on the first or last day of eachcalendar quarter) as that plan was considered to be non-compensatory under APB25.  Covance reflected the expenseassociated with the fair value of stock-based awards in its required pro formafootnote disclosure under SFAS 123 in its SEC filings.

Effective January 1, 2006,the Company adopted the fair value recognition provisions of SFAS 123R usingthe modified prospective transition method. SFAS 123R revisesSFAS 123, supersedes APB 25 and amends Statement of Financial AccountingStandards No. 95, *Statement of Cash Flows*.  Under that transition method,compensation expense is now recognized in the financial statements on a goforward basis for (a) all share-based payments granted prior to, but not vestedas of January 1, 2006, based upon the grant-date fair value estimated inaccordance with the original provisions of SFAS 123, and (b) share-basedpayments granted on or subsequent to January 1, 2006, based upon the grant-datefair value estimated in accordance with the provisions of SFAS 123R.  The grant-date fair value of awards expectedto vest is expensed on a straight-line basis over the vesting period of therelated awards.  Under the modifiedprospective transition method, results for prior periods have not beenrestated.

Management believes thatit may be useful for investors, in evaluating current period financialperformance, to compare to 2005 results that include stock-based compensationcomputed in accordance with SFAS 123. Management does not assert that such pro forma numbers are superior tothe 2005 “as reported” results; however, the pro forma numbers may helpinvestors compare results including stock option expense across both periods.

Although the Company isnow using the Lattice-Binomial option pricing formula for valuing stock optionsgranted beginning in 2006 (whereas previously the Company had used theBlack-Scholes-Merton option pricing formula), management believes that theLattice-Binomial and the Black-Scholes-Merton option pricing formulas, with theassumptions used by the Company, result in fair values which are substantiallysimilar in all material respects.  As aresult, the Company believes that the 2006 “as reported” amounts under SFAS123R are comparable to the 2005 “pro forma” amounts as previously disclosedunder SFAS 123.

***Three Months Ended September 30, 2006 Compared with Three Months EndedSeptember 30, 2005. ***Netrevenues increased 15.6% to $341.5 million for the three months ended September30, 2006 from $295.4 million for the corresponding 2005 period.  Excluding the impact of foreign exchange ratevariances between both periods net revenues increased 14.3% as compared to thecorresponding 2005 period.  Net revenuesfrom Covance’s early development segment grew 19.1%, or 17.6% excluding theimpact of foreign exchange rate variances between both periods, driven bycontinued strong performance of our global toxicology and chemistryservices.  Net revenues from Covance’slate-stage development segment grew 12.4%, or 11.3% excluding the impact offoreign exchange rate variances between both periods, driven by our centrallaboratory and clinical development services.

Cost of revenue increased 14.8% to $223.7 million or65.5% of net revenues for the three months ended September 30, 2006 as comparedto $194.8 million or 66.0% of net revenues for the corresponding 2005period.  Comparisons to the prior yearare impacted by the inclusion of $1.7 million in stock-based compensation incost of revenue in the 2006 period pursuant to SFAS 123R.  These expenses reduced 2006 gross margins by50 basis points to 34.5% of net revenues. Had stock-based compensation been included in cost of revenue for thethree months ended September 30, 2005 under SFAS 123, cost of revenue wouldhave been $1.9 million higher and gross margins would have been 60 basis pointslower or 33.4% of net revenue on a pro forma basis.

Overall,selling, general and administrative expenses increased 21.3% to $54.2 millionfor the three months ended September 30, 2006 from $44.7 million for thecorresponding 2005 period.  As apercentage of net revenues, selling, general and administrative expensesincreased 80 basis points to 15.9% for the three month period ended September30, 2006 from 

24

----

15.1% for the corresponding 2005 period.  Comparisons to the prior year are impacted bythe inclusion of $2.1 million in stock-based compensation in selling, generaland administrative expenses in the 2006 period pursuant to SFAS 123R.  These expenses increased selling, general andadministrative expenses as a percentage of revenue by 60 basis points.  Had incremental stock-based compensation beenincluded in selling, general and administrative expenses for the three monthsended September 30, 2005 under SFAS 123, selling, general and administrativeexpenses would have been $2.3 million higher and selling, general andadministrative expenses as a percentage of revenue would have been 80 basispoints higher or 15.9% of net revenue on a pro forma basis.

Depreciationand amortization increased 24.0% to $14.6 million or 4.3% of net revenues forthe three months ended September 30, 2006 from $11.8 million or 4.0% of netrevenues for the corresponding 2005 period primarily as a result of higherlevels of capital spending over the last twelve months.

Incomefrom operations increased 11.2% to $49.0 million or 14.4% of net revenues forthe three months ended September 30, 2006 from $44.1 million or 14.9% of netrevenues for the corresponding 2005 period. Comparisons to the prior year are impacted by the inclusion of $3.8million in stock-based compensation in operating expenses in the 2006 periodpursuant to SFAS 123R.  These expensesreduced operating margin by 110 basis points. Had incremental stock-based compensation been included in operatingexpenses for the three months ended September 30, 2005 under SFAS 123, operatingexpenses would have been  $4.2 millionhigher and operating margins would have been 140 basis points lower or 13.5% ofnet revenue on a pro forma basis.

Income from operationsfrom Covance’s early development segment increased $3.7 million or 10.1% to$40.3 million or 24.1% of net revenues for the three months ended September 30,2006 from $36.6 million or 26.1% of net revenues for the corresponding 2005period. North American toxicology and chemistry operating margins were verystrong, benefiting from our new toxicology capacity and improving results inbioanalytical chemistry.  Theyear-on-year reduction in operating margins is almost entirely attributable todilution resulting from the acquisition of Radiant Research Inc. in the priorquarter.  Income from operations fromCovance’s late-stage development segment increased $6.1 million or 25.2% to$30.4 million for the three months ended September 30, 2006 from $24.3 millionfor the corresponding 2005 period. Income from operations as a percentage of net revenues increased to17.5% for the three months ended September 30, 2006 from 15.7% for thecorresponding 2005 period*,* drivenby strength in our central laboratory and clinical development services.******Corporate expenseincreased $4.9 million to $21.7 million or 6.4% of net revenues for the threemonths ended September 30, 2006 from $16.8 million or 5.7% of net revenues forthe three months ended September 30, 2005. Comparisons to the prior year are impacted by the inclusion of $3.8million or 1.1% of net revenues in stock-based compensation in corporateexpenses in the 2006 period pursuant to SFAS 123R.  Had incremental stock-based compensation beenincluded in corporate expenses for the three months ended September 30, 2005under SFAS 123, corporate expenses would have been $4.2 million higher,totaling $21.0 million or 7.1% of net revenue on a pro forma basis.  The reduction from 7.1% of net revenues inthe 2005 three month period to 6.4% of net revenues in the 2006 three monthperiod is primarily due to lower stock-based compensation and professional feesin the 2006 period.

Otherincome, net increased $1.1 million to $1.8 million for the three months endedSeptember 30, 2006 from $0.7 million for the corresponding 2005 periodprimarily as a result of a $0.9 million increase in net interest incomeresulting from higher invested cash balances and higher average interest ratesearned on those balances.

Covance’seffective tax rate for the three months ended September 30, 2006 was 25.0%compared to 30.5% for the corresponding 2005 period.  The effective tax rate for the three monthsended September 30, 2006 includes the impact of a $2.5 million reduction inincome tax reserves resulting from several favorable income tax developmentsarising in the third quarter of 2006. These developments include a matter as to which closure was reached witha foreign tax authority relating to research and development tax creditstotaling $1.8 million as well as exposures as to which it is no longer probablethat a liability exists relating primarily to transfer pricing mattersaggregating $0.7 million.  Excluding theimpact of the 2006 tax reserve adjustment, Covance’s effective tax rate for thethree months ended September 30, 2006 would have been 29.9% or 60 basis pointslower than the rate for the comparable 2005 period.  The reduction in the effective tax rate isattributable to a shift in the mix of our pre-tax earnings across various taxjurisdictions, increased research and development tax credits in the United Kingdomand other initiatives*.*

Covancehas a minority equity position (approximately 21% at September 30, 2006) inBio-Imaging Technologies, Inc. (“BITI”). BITI uses proprietary medical imaging technologies to process andanalyze medical images, and also provides other services, including thedata-basing and regulatory submission of medical images, quantitative data andtext.  During the three 

25

----

month periods ended September 30, 2006 and 2005,Covance recognized income of $0.02 million and losses of $0.2 million,respectively, representing its share of BITI’s earnings.

Covancehas a 47% minority equity position in Noveprim Limited, an existing supplier ofresearch products.  For each of the threemonth periods ended September 30, 2006 and 2005, Covance recognized $0.2million, representing its share of Noveprim’s earnings, less an elimination ofprofit on inventory purchased from Noveprim Limited and still on hand atCovance at September 30, 2006 and 2005.

Netincome of $38.3 million for the three months ended September 30, 2006 increased$7.0 million or 22.6% as compared to $31.2 million for the corresponding 2005period. Comparisons to the prior year are impacted by the inclusion of $2.6million in stock-based compensation in the 2006 period pursuant to SFAS 123R.  Had incremental stock-based compensation beenincluded in net income for the three months ended September 30, 2005 under SFAS123, net income would have decreased by $2.8 million to $28.4 million on aproforma basis.

***Nine Months Ended September 30, 2006 Compared with Nine Months EndedSeptember 30, 2005. ***Netrevenues increased 14.5% to $997.2 million for the nine months ended September30, 2006 from $870.6 million for the corresponding 2005 period. Excluding theimpact of foreign exchange rate variances between both periods, net revenuesincreased 16.3 % as compared to the corresponding 2005 period.  Net revenues from Covance’s early developmentsegment grew 13.2%, or 14.3% excluding the impact of foreign exchange ratevariances between both periods, driven primarily by toxicology, chemistry andclinical pharmacology services.  Netrevenues from Covance’s late-stage development segment increased 15.7%, or18.1% excluding the impact of foreign exchange rate variances between bothperiods, primarily driven by growth in central laboratory services.

Cost of revenue increased 14.3% to $660.0 million or66.2% of net revenues for the nine months ended September 30, 2006 as comparedto $577.3 million or 66.3% of net revenues for the corresponding 2005 period.  Comparisons to the prior year are impacted bythe inclusion of $5.2 million in stock-based compensation in cost of revenue inthe 2006 period pursuant to SFAS 123R. These expenses reduced 2006 gross margins by 50 basis points to 33.8% ofnet revenues.  Had stock-basedcompensation been included in cost of revenue for the nine months endedSeptember 30, 2005 under SFAS 123, cost of revenue would have been $6.1 millionhigher and gross margins would have been 70 basis points lower or 33.0% of netrevenue on a pro forma basis.

Overall,selling, general and administrative expenses increased 17.1% to $153.8 millionfor the nine months ended September 30, 2006 from $131.3 million for thecorresponding 2005 period.  As apercentage of net revenues, selling, general and administrative expensesincreased 30 basis points to 15.4% for the nine months ended September 30, 2006from 15.1% for the corresponding 2005 period. Comparisons to the prior year are impacted by the inclusion of $6.4million in stock-based compensation in selling, general and administrativeexpenses in the 2006 period pursuant to SFAS 123R.  These expenses increased selling, general andadministrative expenses as a percentage of revenue by 60 basis points.  Had incremental stock-based compensation beenincluded in selling, general and administrative expenses for the nine monthsended September 30, 2005 under SFAS 123, selling, general and administrativeexpenses would have been $7.5 million higher and selling, general andadministrative expenses as a percentage of revenue would have been 80 basispoints higher or 15.9% of net revenue on a pro forma basis.

Depreciationand amortization increased 18.2% to $41.5 million or 4.2% of net revenues forthe nine months ended September 30, 2006 from $35.1 million or 4.0% of netrevenues for the corresponding 2005 period as a result of higher levels ofcapital spending over the last twelve months.

Incomefrom operations increased 11.8% to $141.9 million or 14.2% of net revenues forthe nine months ended September 30, 2006 from $126.9 million or 14.6% of netrevenues for the corresponding 2005 period. Comparisons to the prior year are impacted by the inclusion of $11.6million in stock-based compensation in operating expenses in the 2006 periodpursuant to SFAS 123R.  These expensesreduced operating margin by 120 basis points. Had incremental stock-based compensation been included in operatingexpenses for the nine months ended September 30, 2005 under SFAS 123, operatingexpenses would have been $13.6 million higher and operating margins would havebeen 160 basis points lower or 13.0% of net revenue on a pro forma basis.

Incomefrom operations from Covance’s early development segment increased $12.6million or 12.3% to $115.0 million or 24.7 % of net revenues for the ninemonths ended September 30, 2006 from $102.3 million or 24.9% of net revenues 

26

----

for the corresponding 2005 period driven primarily bystrength in toxicology and chemistry services, partially offset by softness inresearch products and global clinical pharmacology as well as dilutionresulting from the acquisition of Radiant Research Inc. in the second quarterof 2006*.* Income from operationsfrom Covance’s late-stage development segment increased $14.1 million or 18.4%to $90.9 million for the nine months ended September 30, 2006 from $76.8million for the corresponding 2005 period. Income from operations as a percentage of net revenues increased to17.1% for the nine months ended September 30, 2006 from 16.7% for thecorresponding 2005 period, driven by growth in our central laboratoryservices.  Corporate expense increased$11.7 million to $64.0 million or 6.4% of net revenues for the nine monthsended September 30, 2006 from $52.2 million or 6.0% of net revenues for thenine months ended September 30, 2005. Comparisons to the prior year are impacted by the inclusion of $11.6million or 1.2% of net revenues in stock-based compensation in corporateexpenses in the 2006 period pursuant to SFAS 123R.  Had incremental stock-based compensation beenincluded in corporate expenses for the nine months ended September 30, 2005under SFAS 123, corporate expenses would have been $13.6 million higher,totaling $65.8 million or 7.6% of net revenues on a pro forma basis.  The reduction from 7.6% of net revenues inthe 2005 nine month period to 6.4% of net revenues in the 2006 nine monthperiod is primarily attributable to lower stock-based compensation, incentivecompensation and professional fees in the 2006 period.

Otherincome, net increased $3.5 million to $5.2 million for the nine months endedSeptember 30, 2006 from $1.8 million for the corresponding 2005 period. Thisincrease is primarily the result of a $2.5 million increase in net interestincome resulting from higher invested cash balances and higher average interestrates earned on those balances.

Covance’seffective tax rate for the nine months ended September 30, 2006 was 28.1%compared to 30.7% for the corresponding 2005 period.  The effective tax rate for the nine monthsended September 30, 2006 includes the impact of a $2.5 million reduction inincome tax reserves resulting from several favorable income tax developmentsarising in the third quarter of 2006. These developments include a matter as to which closure was reached witha foreign tax authority relating to research and development tax creditstotaling $1.8 million as well as exposures as to which it is no longer probablethat a liability exists relating primarily to transfer pricing mattersaggregating $0.7 million.  Excluding theimpact of the 2006 tax reserve adjustment, Covance’s effective tax rate for thenine months ended September 30, 2006 would have been 29.8% or 90 basis pointslower than the rate for the comparable 2005 period.  The reduction in the effective tax rate isattributable to a shift in the mix of our pre-tax earnings across various taxjurisdictions, increased research and development tax credits in the UnitedKingdom and other initiatives*.*

Covancehas a minority equity position (approximately 21% at September 30, 2006) inBio-Imaging Technologies, Inc. (“BITI”). BITI uses proprietary medical imaging technologies to process andanalyze medical images, and also provides other services, including thedata-basing and regulatory submission of medical images, quantitative data andtext.  During the nine month periodsended September 30, 2006 and 2005, Covance recognized losses of $0.1 millionand $0.4 million, respectively, representing its share of BITI’s losses.

Covancehas a 47% minority equity position in Noveprim Limited, an existing supplier ofresearch products.  For the nine monthperiods ended September 30, 2006 and 2005, Covance recognized $1.0 million and$0.9 million, respectively, representing its share of Noveprim’s earnings, lessan elimination of profit on inventory purchased from Noveprim Limited and stillon hand at Covance at September 30, 2006 and 2005.

Netincome of $106.7 million for the nine months ended September 30, 2006 increased$17.0 million or 19.0% as compared to $89.6 million for the corresponding 2005period. Comparisons to the prior year are impacted by the inclusion of $7.9million in stock-based compensation in the 2006 period pursuant to SFAS123R.  Had incremental stock-basedcompensation been included in net income for the nine months ended September30, 2005 under SFAS 123, net income would have decreased by $9.2 million to$80.4 million on a proforma basis.

**Liquidity and CapitalResources**

Covance’sexpected primary cash needs on both a short and long-term basis are for capitalexpenditures, expansion of services, possible future acquisitions, geographicexpansion, working capital and other general corporate purposes, includingpossible share repurchases.  Covance’s$75.0 million revolving credit facility (the “Credit Facility”) expires in June2009 and may be expanded to $125.0 million at Covance’s election. Covancebelieves cash from operations will provide sufficient liquidity for theforeseeable future.  At September 30,2006, there were no outstanding borrowings and $0.8 million of outstandingletters of credit under the Credit Facility. Interest on all outstanding borrowings under the Credit Facility isbased upon the London Interbank Offered Rate (“LIBOR”) plus a 75 basis pointmargin.  The Credit Facility containsvarious financial and other covenants. At September 30, 2006, Covance was in compliance with the terms of theCredit Facility.  The 

27

----

Credit Facility is collateralized by guarantees ofcertain of Covance’s domestic subsidiaries and a pledge of 65 percent of thecapital stock of certain of Covance’s foreign subsidiaries.

Duringthe nine months ended September 30, 2006, Covance’s operations provided netcash of $165.3 million, an increase of $65.8 million from the corresponding2005 period.  The change in net operatingassets used $3.0 million in cash during the nine months ended September 30,2006, primarily due an increase in prepaid expenses and other current assetsand unbilled services, partially offset by an increase in accrued expenses andincome taxes payable*,* while thisnet change used $33.2 million in cash during the nine months ended September30, 2005, primarily due to an increase in net days sales outstanding andprepaid expenses and other current liabilities, offset by an increase in incometaxes payable.  Covance’s ratio ofcurrent assets to current liabilities was 2.30 at September 30, 2006 and 2.16at December 31, 2005.

  Investing activities for the nine monthsended September 30, 2006 used $145.6 million, compared to using $100.9 millionfor the corresponding 2005 period. Capital spending for the first nine months of 2006 totaled $71.8million, and was primarily for the expansion of our Madison, WI and Harrogate,UK facilities, outfitting of new facilities, purchase of new equipment, upgradeof existing equipment and software for newly hired employees.  Capital spending for the corresponding 2005period totaled $94.3 million, and was primarily for the expansion of ourMadison, WI and Harrogate, UK facilities, outfitting of new facilities,purchase of new equipment, upgrade of existing equipment and software for newlyhired employees. Investing activities for the nine months ended September 30,2006 included the acquisitions of Radiant Research Inc. and SignetLaboratories, Inc. for approximately $74.6 million.  Investing activities for the nine monthsended September 30, 2005 included the acquisitions of an antibody productsprovider and an 80 bed Phase I clinic for cash payments totaling $6.6 million.

OnMay 31, 2006, Covance acquired the stock of Radiant Research Inc. (“Radiant”)in a merger transaction for cash payments aggregating approximately $66.5million (including direct acquisition costs of $0.5 million, which have alreadybeen paid, and a working capital adjustment of $1.0 million which will be paidin October 2006).  Radiant operates eightearly development clinical sites performing Phase I/IIa clinical trialservices.  Results of operations forRadiant, which are now part of Covance’s Early Development segment serviceoffering, and the fair value of Radiant’s assets and liabilities acquired, areincluded in Covance’s consolidated financial statements June 1, 2006. The fairvalue of Radiant’s net assets was $9.1 million. Intangible assets acquired were valued at $6.8 million. The remainingpurchase price of $50.6 million represents goodwill. Radiant is expected to beaccretive to earnings in 2007.

OnMay 31, 2006, Covance also acquired certain assets and liabilities of SignetLaboratories, Inc. (“Signet”) for cash payments totaling $9.1 million (includingdirect acquisition costs of $0.2 million). Signet specializes in the development of monoclonal antibodies anddiagnostic assays for cancer, infectious diseases and neurodegenerativediseases.  Results of operations forSignet, which are now part of Covance’s Early Development segment serviceoffering, and the fair value of Signet’s assets and liabilities acquired, areincluded in Covance’s consolidated financial statements beginning June 1,2006.  The fair value of Signet’s netassets was $0.4 million*.*  Intangible assets acquired were valued at$0.9 million. The remaining purchase price of $7.9 million represents goodwill.Signet is expected to be accretive to earnings in 2006.

Financing activities forthe nine months ended September 30, 2006 provided $26.2 million and wereprimarily comprised of proceeds from the exercise of stock options of $25.0million, excess tax benefits realized on the exercise of stock options of $6.6million (which are now required to be included in financing cash flows pursuantto SFAS 123R) and employee contributions to Covance’s employee stock purchaseplan of $3.3 million, partially offset by the purchase into treasury of 150,017shares for an aggregate cost of $8.7 million, primarily in connection with a3.0 million share buyback program authorized by Covance’s Board of Directors inJune 2004. Financing activities for the nine months ended September 30, 2005used $25.5 million and consisted primarily of the purchase of 1,240,446 sharesof Covance common stock for an aggregate cost of $55.2 million, primarily inconnection with a 3.0 million share buyback program authorized by Covance’sBoard of Directors in June 2004, partially offset by $29.7 million receivedfrom stock option exercises and employee contributions to Covance’snon-compensatory employee stock purchase plan.

On April 22, 2006,Covance and IBM amended the terms of the contract under which IBM had beenproviding certain information technology services to Covance.  Pursuant to the terms of the amendedcontract, Covance will in-source certain elements of its information technologyinfrastructure support which were being provided by IBM.  IBM will continue to provide informationtechnology support services in areas including help desk and desktop computersupport on a worldwide basis.  Thisamended contract is not expected to have a material impact upon Covance’sliquidity.

28

----

**Inflation**

While most of Covance’snet revenues are earned under contracts, the long-term contracts (those inexcess of one year) generally include an inflation or cost of living adjustmentfor the portion of the services to be performed beyond one year from thecontract date. As a result, Covance believes that the effects of inflationgenerally do not have a material adverse effect on its operations or financialcondition.

**RecentlyIssued Accounting Standards**

In September 2006, theFinancial Accounting Standards Board (the “FASB”) issued Statement of FinancialAccounting Standards No. 158, *Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans, anamendment of FASB Statements No. 87, 88, 106 and 132(R),* (“SFAS 158”).SFAS 158 requires an employer to recognize the overfunded or underfunded statusof a defined benefit postretirement plan — measured as the difference betweenthe fair value of plan assets and the projected benefit obligation — as anasset or liability, respectively, in its balance sheet and to recognize changesin the funded status of the plan in the year in which such changes occurthrough other comprehensive income.  Thefinancial statement recognition and disclosure provisions of SFAS 158 areeffective for fiscal years ending after December 15, 2006, which will result inCovance recording the underfunded status of its plans as a liability with acorresponding decrease, net of tax, in the accumulated other comprehensiveincome equity account on its balance sheet at December 31, 2006 and recognizingfuture changes in the funded status of its plans in other comprehensive incomebeginning with the year ending December 31, 2007. SFAS 158 also requires,effective for fiscal years ending after December 15, 2008, that the measurementof the overfunded or underfunded status of the plan be made as of the employer’sfiscal year end and not as of an earlier measurement date.  Covance will be required to conform themeasurement dates of its plans to December 31st for its fiscal year ending December 31, 2008.

In September 2006, theFASB issued SFAS No. 157, *Fair ValueMeasurements,* (“SFAS 157”). SFAS 157, which applies whenever otherstandards require (or permit) fair value measurement, defines fair value andprovides guidance for using fair value to measure assets and liabilities.  SFAS 157 also requires expanded disclosuresabout the extent to which companies measure assets and liabilities at fairvalue, the information used in those measurements and the effect of fair valuemeasurements on earnings. Covance will be required to adopt SFAS 157, which iseffective for fiscal years beginning after November 15, 2007, no later than thequarter beginning January 1, 2008. Covance is currently in the process ofevaluating SFAS 157, and has not yet determined the impact, if any, SFAS 157will have on its consolidated results of operations or financial position.

In June 2006, the FASBissued Interpretation No. 48, *Accounting forUncertainty in Income Taxes — an Interpretation of FASB Statement No. 109*(“FIN 48”).  This authoritativeinterpretation clarifies and standardizes the manner by which companies will berequired to account for uncertain tax positions.  Adoption of FIN 48 is required for fiscalyears beginning after December 15, 2006. Covance will be required to adopt FIN 48 no later than the quarterbeginning January 1, 2007.  Covance iscurrently in the process of evaluating the Interpretation and has not yetdetermined the impact, if any, FIN 48 will have on its consolidated results ofoperations or financial position.

***ForwardLooking Statements.****Statements in thisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations, as well as in certain other parts of this Quarterly Report on Form10-Q that look forward in time, are forward looking statements made pursuant tothe safe harbor provisions of the Private Securities Litigation Reform Act of1995. Forward looking statements include statements concerning plans,objectives, goals, strategies, future events or performance, expectations,predictions, and assumptions and other statements which are other thanstatements of historical facts. All such forward looking statements are basedon the current expectations of management and are subject to, and are qualifiedby, risks and uncertainties that could cause actual results to differmaterially from those expressed or implied by those statements. These risks anduncertainties include, without limitation, competitive factors, outsourcingtrends in the pharmaceutical industry, levels of industry research anddevelopment spending, the Company’s ability to continue to attract and retainqualified personnel, the fixed price nature of contracts or the loss of largecontracts, risks associated with acquisitions and investments, the Company’sability to increase order volume, the pace of translation of orders intorevenue in late-stage development services, difficulties or delays inintegrating the business of Radiant and achieving anticipated efficiencies andsynergies, and other factors described in Covance’s filings with the Securitiesand Exchange Commission, including its Annual Report on Form 10-K.*

29

----

**Item3.  Quantitative and QualitativeDisclosure About Market Risk**

For the nine months endedSeptember 30, 2006, approximately 36% of our net revenues were derived from ouroperations outside the United States.  Wedo not engage in derivative or hedging activities related to our potentialforeign exchange exposures.  See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations —Foreign Currency Risks” for a more detailed discussion of our foreign currencyrisks and exposures.

**Item 4. Controls and Procedures**

Disclosure controls andprocedures.  The Company’s PrincipalExecutive Officer and Principal Financial Officer have reviewed and evaluatedthe effectiveness of the Company’s disclosure controls and procedures as of theend of the period covered in this report. Based on that evaluation, the Principal Executive Officer and thePrincipal Financial Officer have concluded that the Company’s currentdisclosure controls and procedures are effective.  There have been no significant changes in theCompany’s internal controls or in the other factors that significantly affectthose controls.

30

----

**Part II. Other Information**

**Item 1a.  Risk Factors**

This section discussesvarious risk factors that are attendant with our business and the provision ofour services.  If the events outlinedbelow were to occur individually or in the aggregate, our business, results ofoperations, financial condition, and cash flows could be materially adverselyaffected.

**Changes in governmentregulation or in practices relating to the pharmaceutical industry coulddecrease the need for the services we provide.**

Governmental agenciesthroughout the world, but particularly in the United States, strictly regulatethe drug development process.  Ourbusiness involves helping pharmaceutical and biotechnology companies navigatethe regulatory drug approval process. Changes in regulation, such as a relaxation in regulatory requirementsor the introduction of simplified drug approval procedures, or an increase inregulatory requirements that we have difficulty satisfying, or that make ourservices less competitive, could eliminate or substantially reduce the demandfor our services. Also, if the government increases efforts to contain drugcosts and pharmaceutical and biotechnology company profits from new drugs, ourcustomers may spend less, or reduce their growth in spending on research anddevelopment. If health insurers were to change their practices with respect toreimbursements for pharmaceutical products, our customers may spend less, orreduce their growth in spending on research and development.

**Failure to comply with existing regulations couldresult in a loss of revenue or earnings or in increased costs.**

Any failure on ourpart to comply with applicable regulations could result in the termination ofon-going research or the disqualification of data for submission to regulatoryauthorities.  For example, if we were tofail to verify that patient participants were fully informed and have fullyconsented to a particular clinical trial, the data collected from that trialcould be disqualified.  If this were tohappen, we could be contractually required to repeat the trial at no furthercost to our customer, but at substantial cost to us.

**We maybear financial losses because most of our contracts are of a fixed price natureand may be delayed or terminated or reduced in scope for reasons beyond ourcontrol.**

Many of our contracts provide for services on a fixedprice or fee-for-service with a cap basis and they may be terminated or reducedin scope either immediately or upon notice. Cancellations may occur for a variety of reasons, including:

·                                          thefailure of products to satisfy safety requirements;

·                                          unexpectedor undesired results of the products;

·                                          insufficientpatient enrollment;

·                                          insufficientinvestigator recruitment;

·                                          theclient’s decision to terminate the development of a product or to end aparticular study; and

·                                          ourfailure to perform properly our duties under the contract.

The loss, reduction in scope or delay of a largecontract or the loss or delay of multiple contracts could materially adverselyaffect our business, although our contracts frequently entitle us to receivethe costs of winding down the terminated projects, as well as all fees earnedby us up to the time of termination. Some contracts also entitle us to a termination fee.

**We may bear financial risk if we under price ourcontracts or overrun cost estimates.**

Since our contracts are often structured as fixedprice or fee-for-service with a cap, we bear the financial risk if we initiallyunder price our contracts or otherwise overrun our cost estimates.  Such under pricing or significant costoverruns could have a material adverse effect on our business, results ofoperations, financial condition, and cash flows.

**We may not be able to successfully develop andmarket or acquire new services.**

We may seek to develop and market new services thatcomplement or expand our existing business or expand our service offeringsthrough acquisition. If we are unable to develop new services and/or createdemand for those newly developed 

31

----

services, or expand our service offerings throughacquisition, our future business, results of operations, financial condition,and cash flows could be adversely affected.

**Our quarterly operating resultsmay vary.**

Our operating results mayvary significantly from quarter to quarter and are influenced by factors overwhich we have little control such as:

·                  exchangerate fluctuations;

·                  thecommencement, completion or cancellation of large contracts;

·                  theprogress of ongoing contracts;

·                  thetiming of and charges associated with completed acquisitions or other events;and

·                  changes in themix of our services.

We believe that operatingresults for any particular quarter are not necessarily a meaningful indicationof future results.  While fluctuations inour quarterly operating results could negatively or positively affect themarket price of our common stock, these fluctuations may not be related to ourfuture overall operating performance.

**We depend on the pharmaceuticaland biotechnology industries**.

Our revenues dependgreatly on the expenditures made by the pharmaceutical and biotechnologyindustries in research and development. Accordingly, economic factors and industry trends that affect ourclients in these industries also affect our business.  If companies in these industries were toreduce the number of research and development projects they outsource, ourbusiness could be materially adversely affected.

**We operate in a highlycompetitive industry.**

Competitorsin the contract research organization industry range from small,limited-service providers to full service global contract research organizations.  Our main competition consists of in-housedepartments of pharmaceutical companies, full-service contract researchorganizations**,** and universities and teachinghospitals, although to a lesser degree. We compete on a variety of factors, including:

·                  reputation for on-time quality performance andregulatory compliance;

·                  expertise and experience in specific areas;

·                  scope of service offerings;

·                  strengths in various geographic markets;

·                  price;

·                  technological expertise and efficient drugdevelopment processes;

·                  quality of facilities;

·                  ability to acquire, process, analyze and reportdata in an accurate manner;

·                  ability to manage large-scale clinicaltrials both domestically and internationally;

·                  expertise and experience in market accessservices; and

·                  size.

Forinstance, our clinical development services have from time to time experiencedperiods of increased price competition which had a material adverse effect onCovance’s late-stage development profitability and consolidated net revenuesand net income.

There is competitionamong the larger contract research organizations for both clients and potentialacquisition candidates.  Additionally,small, limited-service entities considering entering the contract research organizationindustry will find few barriers to entry, thus further increasing possiblecompetition.  These competitive pressuresmay affect the attractiveness of our services and could adversely affect ourfinancial results.

32

----

**Wemay expand our business through acquisitions.**

We review many acquisitioncandidates and, in addition to acquisitions which we have already made, we arecontinually evaluating new acquisition opportunities.  Factors which may affect our ability to growsuccessfully through acquisitions include:

·                  difficulties and expenses inconnection with integrating the acquired companies and achieving the expectedbenefits;

·                  diversion of management’s attentionfrom current operations;

·                  the possibility that we may beadversely affected by risk factors facing the acquired companies;

·                  acquisitions could be dilutive toearnings, or in the event of acquisitions made through the issuance of ourcommon stock to the shareholders of the acquired company, dilutive to thepercentage of ownership of our existing stockholders;

·                  potential losses resulting fromundiscovered liabilities of acquired companies not covered by theindemnification we may obtain from the seller;

·                  risks of not being able to overcomedifferences in foreign business practices, language and other cultural barriersin connection with the acquisition of foreign companies; and

·                  loss of keyemployees of the acquired companies.

**We may be affected by potentialhealth care reform.**

In recent years the United States Congress and statelegislatures have considered various types of health care reform in order tocontrol growing health care costs.  Weare unable to predict what legislative proposals will be adopted in the future,if any.  Similar reform movements haveoccurred in Europe and Asia.

Implementation of health care reform legislation thatcontain costs could limit the profits that can be made from the development ofnew drugs.  This could adversely affectresearch and development expenditures by pharmaceutical and biotechnology companieswhich could in turn decrease the business opportunities available to us both inthe United States and abroad. In addition, new laws or regulations may create arisk of liability, increase our costs or limit our service offerings.

**We rely on third parties forimportant services.**

We depend on third parties to provide us with servicescritical to our business.  For instance,we have entered into an agreement with IBM to manage certain of our informationtechnology assets including help desk and desktop computer supportworldwide.  The failure of any of thesethird parties to adequately provide the needed services could have a materialadverse effect on our business.

**Our revenues and earnings areexposed to exchange rate fluctuations**.

We derive a large portionof our net revenues from international operations.  For the nine month period ended September 30,2006, we derived approximately 36% of our net revenues from outside the UnitedStates.  Our financial statements aredenominated in U.S. dollars.  As aresult, factors associated with international operations, including changes inforeign currency exchange rates, could significantly affect our results ofoperations, financial condition and cash flows.

**The loss of our key personnelcould adversely affect our business.**

Our success depends to asignificant extent upon the efforts of our senior management team and other keypersonnel. The loss of the services of such personnel could adversely affectour business.  Also, because of thenature of our business, our success is dependent upon our ability to attractand retain technologically qualified personnel. There is substantial competition for qualified personnel, and aninability to recruit or retain qualified personnel may impact our ability togrow our business and compete effectively in our industry.

33

----

**Contractresearch services create a risk of liability.**

In contracting to work ondrug development trials, we face a range of potential liabilities, for example:

·                  errorsor omissions that create harm during a trial to study volunteers or after atrial to consumers of the drug after regulatory approval of the drug;

·                  generalrisks associated with clinical pharmacology facilities, including negativeconsequences from the administration of drugs to clinical trial participants orthe professional malpractice of clinical pharmacology medical care providers;

·                  errorsor omissions from tests conducted for the agrochemical and food industries;

·                  risksthat animals in our breeding facilities may be infected with diseases that maybe harmful and even lethal to themselves and humans despite preventive measurescontained in our company policies for the quarantine and handling of importedanimals; and

·                  errors andomissions during a trial that may undermine the usefulness of a trial or datafrom the trial.

We also contract withphysicians, also referred to as investigators, to conduct the clinical trialsto test new drugs on human volunteers. These tests can create a risk of liability for personal injury or deathto volunteers, resulting from negative reactions to the drugs administered orfrom professional malpractice by third party investigators, particularly tovolunteers with life-threatening illnesses. We believe that our risks in this area are generally reduced by thefollowing:

·                  contractprovisions entitling us to be indemnified or entitling us to a limitation ofliability;

·                  insurancemaintained by our clients, investigators, and by us; and

·                  variousregulatory requirements we must follow in connection with our business.

Contractual indemnifications generally do not protectus against liability arising from certain of our own actions, such asnegligence or misconduct.  We could bematerially and adversely affected if we were required to pay damages or bearthe costs of defending any claim which is not covered by a contractualindemnification provision or in the event that a party who must indemnify usdoes not fulfill its indemnification obligations or which is beyond the levelof our insurance coverage.  There can beno assurance that we will be able to maintain such insurance coverage on termsacceptable to us.

**Reliance on air transportation**.

Our central laboratoriesand certain of our other businesses are heavily reliant on air travel fortransport of clinical trial kits and other material, products and people, and asignificant disruption to the air travel system, or our access to it, couldhave a material adverse effect on our business.

**Certain service offerings and research products are dependenton limited sources of supply of services or products which if interrupted couldaffect our business.**

We depend on a limited number ofsuppliers for certain services and for one of our large animal populations.Disruptions to the continued supply of these services or products may arisefrom export import restrictions or embargoes, foreign political or economicinstability, or otherwise. Disruption of supply could have a material adverseeffect on our business.

**Actionsof animal rights extremists may affect our business**.

Our early development services utilize animals(predominantly rodents) in preclinical testing of the safety and efficacy ofdrugs and also breed and sell animals for biomedical research.  Such activities are required for thedevelopment of new medicines and medical devices under regulatory regimes inthe United States, Europe, Japan and other countries.  Acts of vandalism and other acts by animalrights extremists who object to the use of animals in drug development couldhave a material adverse effect on our business.

**Ouranimal populations may suffer diseases that can damage our inventory, harm ourreputation, result in decreased sales of research products or result in otherliability to us.**

Itis important that our research products be free of diseases, includinginfectious diseases.  The presence ofdiseases can distort or compromise the quality of research results, can causeloss of animals in our inventory, can result in harm to humans or outsideanimal populations if the disease is not contained to animals in inventory, orcan result in other losses.  Such resultscould harm our reputation or have a material adverse effect on our financialcondition, results of operations, and cash flows.

34

----

**Item6.  Exhibits**

| 31.1   | Certification — Joseph L. Herring.***Filed herewith.***                                                                                                                |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | *** ***                                                                                                                                                                |
| 31.2   | Certification — William E. Klitgaard. ***Filed herewith.***                                                                                                            |
|   | *** ***                                                                                                                                                                |
| 32.1   | Certification Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 — Joseph L.  Herring. ***Filed herewith.***    |
|   | *** ***                                                                                                                                                                |
| 32.2   | Certification Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 — William  E. Klitgaard. ***Filed herewith.*** |

 

35

----

**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                              | **COVANCE INC.** |
|------------------------------|------------------|
| ** **                   |             |   | ** ** |
| Dated: November 2, 2006 | By:              | /s/ | Joseph L. Herring |
|                         |             |   | Joseph L. Herring |
|                         |             |   | Chairman of the Board and |
|                         |             |   | Chief Executive Officer |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.
| Signature  | ** **           | **Title**  | ** **                              | **Date**   |
|------------|----------------------|------------|-----------------------------------------|------------|
| ** ** | ** **           | ** ** | ** **                              | ** ** | ** ** |
| /s/        | Joseph L. Herring    |       | Chairman of the Board and               |       |   |
|       | Joseph L. Herring    |       | Chief Executive Officer                 |       | November 2,  2006 |
|       |                 |       | (Principal Executive Officer)           |       |   |
|       |                 |       |                                    |       |   |
| /s/        | William E. Klitgaard |       | Corporate Senior Vice President and     |       |   |
|       | William E. Klitgaard |       | Chief Financial Officer                 |       | November 2,  2006 |
|       |                 |       | (Principal Financial Officer)           |       |   |
|       |                 |       |                                    |       |   |
| /s/        | Michael Giannetto    |       | Corporate Vice President and Controller |       |   |
|       | Michael Giannetto    |       | (Principal Accounting Officer)          |       | November 2,  2006 |

 

 

36

----

**EXHIBIT INDEX**
| Exhibit    | ** ** | ** **                                                                                                                                                                 |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number** | ** ** | **Description**                                                                                                                                                            |
| 31.1       |       | Certification — Joseph L. Herring. ***Filed herewith.***                                                                                                              |
|       |       |                                                                                                                                                                       |
| 31.2       |       | Certification — William E. Klitgaard. ***Filed herewith.***                                                                                                           |
|       |       |                                                                                                                                                                       |
| 32.1       |       | Certification Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 — Joseph L.  Herring. ***Filed herewith.***   |
|       |       |                                                                                                                                                                       |
| 32.2       |       | Certification Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 — William  E. Klitgaard.***Filed herewith.*** |

** **

----