**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
| **x**                                                  | **Quarterly Report Pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934**                                                                                                                                                                                                                                             |
|--------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                   |
| **For the quarterly period ended September 30,  2007** |
|                                                   |
| **or**                                                 |
|                                                   |
| **o**                                                  | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**                                                                                                                                                                                                                                            |
|                                                   |
|                                                   | **For the transition period from                                                    to** |

 

**Commission File Number: 1-12213**

 

**COVANCE INC**.

(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’s telephone 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. (See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act).
| Large  Accelerated Filer x | Accelerated  Filer o | Non-Accelerated  Filer o |
|---------------------------------|---------------------------|-------------------------------|

 

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

YES o             NO x

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

As of October 19,2007, the Registrant had 63,842,874 shares of common stock outstanding.

 

 

----

 

**Covance Inc.**

**Form 10-Q For the Quarterly Period Ended September30, 2007**

 

**INDEX**

 
| ** **                                                                                                           | ** ** | **Page**   |
|----------------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                           | ** ** | ** ** |
| **Part I. Financial****Information**                                                                                 |       |       |
|                                                                                                                 |       |       |
| Item 1.   Financial  Statements (Unaudited)                                                           |       |       |
|                                                                                                                 |       |       |
| Consolidated Balance  Sheets—September 30, 2007 and December 31, 2006                                           |       | 2          |
|                                                                                                                 |       |       |
| Consolidated  Statements of Income—Three and Nine Months ended September 30, 2007 and 2006                      |       | 3          |
|                                                                                                                 |       |       |
| Consolidated  Statements of Cash Flows—Nine Months ended September 30, 2007 and 2006                            |       | 4          |
|                                                                                                                 |       |       |
| Notes to  Consolidated Financial Statements                                                                          |       | 5          |
|                                                                                                                 |       |       |
| Item 2.   Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       | 15         |
|                                                                                                                 |       |       |
| Item 3.   Quantitative  and Qualitative Disclosure About Market Risk                                  |       | 24         |
|                                                                                                                 |       |       |
| Item 4.   Controls  and Procedures                                                                    |       | 24         |
|                                                                                                                 |       |       |
| **Part II. Other  Information**                                                                                      |       |       |
|                                                                                                                 |       |       |
| Item 1a. Risk Factors                                                                                           |       | 25         |
|                                                                                                                 |       |       |
| Item 6.   Exhibits                                                                                    |       | 29         |
|                                                                                                                 |       |       |
| **Signatures**                                                                                                       |       | 30         |

 

1

----

 

**COVANCE INC. ANDSUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**SEPTEMBER 30, 2007 AND DECEMBER 31, 2006**

 
|                                                                                                                                                                                                                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**                                                                                                                                                                                                  | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| ** **                                                                                                                                                                                                                            | ** ** | **(UNAUDITED)**        | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Current Assets:                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                            |       | $                      | 259,831    |                  | $          | 219,810 |   |
| Accounts receivable                                                                                                                                                                                                                   |       | 222,480                |       | 205,473               |       |
| Unbilled services                                                                                                                                                                                                                     |       | 104,990                |       | 89,139                |       |
| Inventory                                                                                                                                                                                                                             |       | 54,789                 |       | 49,628                |       |
| Deferred income taxes                                                                                                                                                                                                                 |       | 4,523                  |       | 4,320                 |       |
| Prepaid expenses and  other current assets                                                                                                                                                                                            |       | 74,145                 |       | 71,196                |       |
| Total Current Assets                                                                                                                                                                                                                  |       | 720,758                |       | 639,566               |       |
| Property and equipment,  net                                                                                                                                                                                                          |       | 577,507                |       | 500,057               |       |
| Goodwill, net                                                                                                                                                                                                                         |       | 119,725                |       | 119,725               |       |
| Other assets                                                                                                                                                                                                                          |       | 41,937                 |       | 38,330                |       |
| Total Assets                                                                                                                                                                                                                          |       | $                      | 1,459,927  |                  | $          | 1,297,678 |   |
| ** **                                                                                                                                                                                                                            |       |                   |       |                  |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                        |       |                   |       |                  |       |
| Current Liabilities:                                                                                                                                                                                                                  |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                                                      |       | $                      | 42,442     |                  | $          | 35,479 |   |
| Accrued payroll and  benefits                                                                                                                                                                                                         |       | 91,729                 |       | 76,657                |       |
| Accrued expenses and  other current liabilities                                                                                                                                                                                       |       | 51,710                 |       | 50,855                |       |
| Unearned revenue                                                                                                                                                                                                                      |       | 122,175                |       | 109,559               |       |
| Income taxes payable                                                                                                                                                                                                                  |       | 11,499                 |       | 17,154                |       |
| Total Current Liabilities                                                                                                                                                                                                             |       | 319,555                |       | 289,704               |       |
| Deferred income taxes                                                                                                                                                                                                                 |       | 30,028                 |       | 31,052                |       |
| Other liabilities                                                                                                                                                                                                                     |       | 63,311                 |       | 53,627                |       |
| Total Liabilities                                                                                                                                                                                                                     |       | 412,894                |       | 374,383               |       |
|                                                                                                                                                                                                                                  |       |                   |       |                  |       |
| 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, 2007 and December 31, 2006                                                                        |       | 3⁄4                 |       | 3⁄4                |       |
| Common Stock - Par  value $0.01 per share; 140,000,000 shares authorized; 74,327,094 and  73,427,001 shares issued and outstanding, including those held in treasury, at  September 30, 2007 and December 31, 2006, respectively |       | 743                    |       | 734                   |       |
| Paid-in capital                                                                                                                                                                                                                       |       | 476,952                |       | 426,806               |       |
| Retained earnings                                                                                                                                                                                                                     |       | 882,197                |       | 757,809               |       |
| Accumulated other  comprehensive income                                                                                                                                                                                               |       | 22,538                 |       | 11,781                |       |
| Treasury stock at cost  (10,493,122 and 9,485,549 shares at September 30, 2007 and December 31,  2006, respectively)                                                                                                             |       | (335,397               | )          | (273,835              | )          |
| Total Stockholders’  Equity                                                                                                                                                                                                      |       | 1,047,033              |       | 923,295               |       |
| Total Liabilities and  Stockholders’ Equity                                                                                                                                                                                      |       | $                      | 1,459,927  |                  | $          | 1,297,678 |   |

 

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

 

2

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**COVANCE INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF INCOME**

**FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30,2007 AND 2006**

**(UNAUDITED)**

 
| ** **                                                                     | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| **(Dollars in thousands, except per share data)**                              | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Net revenues                                                                   |       | $                                                   | 395,989    |                                               | $          | 341,478 |   | $ | 1,135,453 |   | $ | 997,227 |   |
| Reimbursable  out-of-pockets                                                   |       | 18,712                                              |       | 14,681                                             |       | 60,361 |   | 49,744 |   |
| Total revenues                                                                 |       | 414,701                                             |       | 356,159                                            |       | 1,195,814 |   | 1,046,971 |   |
|                                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Cost and expenses:                                                             |       |                                                |       |                                               |       |   |   |   |   |
| Cost of revenue  (excluding depreciation and amortization)                     |       | 258,355                                             |       | 223,662                                            |       | 743,812 |   | 660,045 |   |
| Reimbursed  out-of-pocket expenses                                             |       | 18,712                                              |       | 14,681                                             |       | 60,361 |   | 49,744 |   |
| Selling, general and  administrative (excluding depreciation and amortization) |       | 61,089                                              |       | 54,196                                             |       | 174,972 |   | 153,794 |   |
| Depreciation and  amortization                                                 |       | 16,447                                              |       | 14,584                                             |       | 49,015 |   | 41,468 |   |
| Total costs and  expenses                                                      |       | 354,603                                             |       | 307,123                                            |       | 1,028,160 |   | 905,051 |   |
| Income from operations                                                         |       | 60,098                                              |       | 49,036                                             |       | 167,654 |   | 141,920 |   |
|                                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Other (income) expense,  net:                                                  |       |                                                |       |                                               |       |   |   |   |   |
| Interest income                                                                |       | (2,415                                              | )          | (1,749                                             | )          | (7,150 | ) | (5,371 | ) |
| Interest expense                                                               |       | 117                                                 |       | 56                                                 |       | 379 |   | 183 |   |
| Foreign exchange  transaction (gain) loss, net                                 |       | (284                                                | )          | (95                                                | )          | (238 | ) | (28 | ) |
| Other income, net                                                              |       | (2,582                                              | )          | (1,788                                             | )          | (7,009 | ) | (5,216 | ) |
| Income before taxes and  equity investee earnings                              |       | 62,680                                              |       | 50,824                                             |       | 174,663 |   | 147,136 |   |
| Taxes on income                                                                |       | 18,469                                              |       | 12,726                                             |       | 51,326 |   | 41,389 |   |
| Equity investee  earnings                                                      |       | 403                                                 |       | 178                                                |       | 1,683 |   | 938 |   |
| Net income                                                                     |       | $                                                   | 44,614     |                                               | $          | 38,276 |   | $ | 125,020 |   | $ | 106,685 |   |
|                                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Basic earnings per  share                                                      |       | $                                                   | 0.70       |                                               | $          | 0.60 |   | $ | 1.96 |   | $ | 1.68 |   |
| Weighted average shares  outstanding - basic                                   |       | 63,711,628                                          |       | 63,827,555                                         |       | 63,718,720 |   | 63,542,002 |   |
|                                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Diluted earnings per  share                                                    |       | $                                                   | 0.69       |                                               | $          | 0.59 |   | $ | 1.93 |   | $ | 1.65 |   |
| Weighted average shares  outstanding – diluted                            |       | 64,728,253                                          |       | 64,965,380                                         |       | 64,758,890 |   | 64,758,456 |   |

 

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

 

3

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**COVANCE INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND2006**

**(UNAUDITED)**

 
|                                                                                              | ** ** | **Nine Months Ended September 30** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| **(Dollars in thousands)**                                                                   | ** ** | **2007**                                               | ** ** | **2006** | ** ** |
|                                                                                         |       |                                                   |       |   |   |
| Cash flows from  operating activities:                                                       |       |                                                   |       |   |   |
| Net income                                                                                   |       | $                                                      | 125,020    |   | $ | 106,685 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:           |       |                                                   |       |   |   |
| Depreciation and  amortization                                                               |       | 49,015                                                 |       | 41,468 |   |
| Non-cash compensation  expense associated with employee benefit and stock compensation plans |       | 21,472                                                 |       | 21,990 |   |
| Deferred income tax  (benefit) provision                                                     |       | (2,475                                                 | )          | (658 | ) |
| Gain on sale of  property and equipment                                                      |       | (1,740                                                 | )          | (187 | ) |
| Equity investee  earnings                                                                    |       | (1,683                                                 | )          | (938 | ) |
| Changes in operating  assets and liabilities, net of businesses acquired:                    |       |                                                   |       |   |   |
| Accounts receivable                                                                          |       | (17,007                                                | )          | (998 | ) |
| Unbilled services                                                                            |       | (15,851                                                | )          | (7,364 | ) |
| Inventory                                                                                    |       | (5,161                                                 | )          | (4,087 | ) |
| Accounts payable                                                                             |       | 6,963                                                  |       | 725 |   |
| Accrued liabilities                                                                          |       | 18,901                                                 |       | 10,003 |   |
| Unearned revenue                                                                             |       | 12,616                                                 |       | 1,978 |   |
| Income taxes payable                                                                         |       | (749                                                   | )          | 8,274 |   |
| Other assets and  liabilities, net                                                           |       | (13,222                                                | )          | (11,558 | ) |
| Net cash provided by  operating activities                                                   |       | 176,099                                                |       | 165,333 |   |
|                                                                                         |       |                                                   |       |   |   |
| Cash flows from  investing activities:                                                       |       |                                                   |       |   |   |
| Capital expenditures                                                                         |       | (104,820                                               | )          | (71,755 | ) |
| Acquisition of  businesses                                                                   |       | —                                                 |       | (74,561 | ) |
| Other, net                                                                                   |       | 111                                                    |       | 699 |   |
| Net cash used in  investing activities                                                       |       | (104,709                                               | )          | (145,617 | ) |
|                                                                                         |       |                                                   |       |   |   |
| Cash flows from  financing activities:                                                       |       |                                                   |       |   |   |
| Stock issued under  employee stock purchase and option plans                                 |       | 25,948                                                 |       | 34,901 |   |
| Purchase of treasury  stock                                                                  |       | (61,562                                                | )          | (8,705 | ) |
| Net cash (used in)  provided by financing activities                                         |       | (35,614                                                | )          | 26,196 |   |
|                                                                                         |       |                                                   |       |   |   |
| Effect of exchange rate  changes on cash                                                     |       | 4,245                                                  |       | 3,451 |   |
| Net change in cash and  cash equivalents                                                     |       | 40,021                                                 |       | 49,363 |   |
|                                                                                         |       |                                                   |       |   |   |
| Cash and cash  equivalents, beginning of period                                              |       | 219,810                                                |       | 160,717 |   |
|                                                                                         |       |                                                   |       |   |   |
| Cash and cash  equivalents, end of period                                                    |       | $                                                      | 259,831    |   | $ | 210,080 |   |

 

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

 

4

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** **

**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

** **

**1. Basis of Presentation**

** **

The accompanying unaudited consolidated financialstatements have been prepared in accordance with U.S. generally acceptedaccounting principles (“GAAP”) for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly,they do not include all of the information and footnotes required by GAAP forcomplete financial statements. In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the three and ninemonths ended September 30, 2007 are not necessarily indicative of theresults that may be expected for the year ending December 31, 2007. Thebalance sheet at December 31, 2006 has been derived from the auditedfinancial statements at that date but does not include all of the informationand footnotes required by GAAP for complete financial statements. You shouldread these unaudited consolidated financial statements together with thehistorical consolidated financial statements of Covance Inc. and subsidiaries (“Covance”or the “Company”) for the years ended December 31, 2006, 2005, and 2004included in our Annual Report on Form 10-K for the year ended December 31,2006.

 

**2. Summary of Significant Accounting Policies**

 

**Principles of Consolidation**

** **

These unaudited consolidated financial statementsinclude the accounts of all entities controlled by Covance. All significantintercompany accounts and transactions are eliminated. The equity method ofaccounting is used for investments in affiliates in which Covance owns between20 and 50 percent and does not have the ability to exercise control. See Note4.

 

**Use of Estimates**

** **

These unaudited consolidated financial statements havebeen prepared in conformity with GAAP, which requires management to makeestimates and assumptions about future events that affect the reported amountsof assets and liabilities, disclosure of contingent assets and liabilities atthe date of the financial statements, and the reported amounts of revenues andexpenses during the reporting period. Actual results could differ from theseestimates.

 

**Inventory**

 

Inventories, which consist principally of finishedgoods and supplies, are valued at the lower of cost (first-in, first-outmethod) or market.

 

**Prepaid Expenses and Other Current Assets**

** **

In connection with the management of multi-siteclinical trials, Covance pays on behalf of its customers fees to investigators,volunteers and other out-of-pocket costs (such as travel, printing, meetings,couriers, etc.), for which we are reimbursed at cost, without mark-up orprofit. Amounts receivable from customers in connection with billed andunbilled investigator fees, volunteer payments and other out-of-pocketpass-through costs are included in prepaid expenses and other current assets inthe accompanying consolidated balance sheets and totaled $42.2 million and$37.7 million at September 30, 2007 and December 31, 2006,respectively. See Note 2 “Reimbursable Out-of-Pocket Expenses”.

 

**Goodwill and Other Intangible Assets and Impairment**

** **

Goodwill represents costs in excess of the fair valueof net tangible and identifiable net intangible assets acquired in businesscombinations. In accordance with Statement of Financial Accounting Standards No. 142,*Goodwill and Other Intangible Assets*,Covance performs an annual test for impairment of goodwill and other indefinitelived intangible assets during the fourth quarter. This test is performed bycomparing, at the reporting unit level, the carrying value of the reportingunit to its fair value. Covance assesses fair value based upon its bestestimate of the present value of the future cash flows that it expects to begenerated by the reporting unit. The most recent annual test for impairmentperformed for 2006 did not identify any instances of impairment and there wereno events through September 30, 2007 that warranted a reconsideration ofour impairment test results.

 

5

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**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

**Revenue Recognition**

** **

Covance recognizes revenue either as services areperformed or products are delivered, depending upon the nature of the workcontracted. 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 takethe form of fee-for-service or fixed-price arrangements. In the case offee-for-service contracts, revenue is recognized as services are performed,based upon, for example, hours worked or samples tested. For long-term fixed-priceservice contracts, revenue is recognized as services are performed, withperformance generally assessed using output measures, such as units-of-workperformed to date as compared to the total units-of-work contracted. Changes inthe scope of work generally result in a renegotiation of contract pricingterms. Renegotiated amounts are not included in net revenues until earned andrealization is assured. Estimates of costs to complete are made to provide,where appropriate, for losses expected on contracts. Costs are not deferred inanticipation of contracts being awarded, but instead are expensed as incurred.In some cases, a portion of the contract fee is paid at the time the trial isinitiated. These advances are deferred and recognized as revenue as servicesare performed or products are delivered, as discussed above. Additionalpayments may be made based upon the achievement of performance-basedmilestones over the contract duration. Most contracts are terminable by theclient either immediately or upon notice. These contracts typically requirepayment to Covance of expenses to wind down the study, fees earned to date and,in some cases, a termination fee or a payment to Covance of some portion of thefees or profits that could have been earned by Covance under the contract if ithad not been terminated early. Termination fees are included in net revenueswhen realization is assured. In connection with the management of multi-siteclinical trials, Covance pays on behalf of its customers fees to investigators,volunteers and other out-of-pocket costs (such as for travel, printing,meetings, couriers, etc.), for which it is reimbursed at cost, without mark-upor profit. Investigator fees are not reflected in total revenues or expenseswhere Covance acts in the capacity of an agent on behalf of the pharmaceuticalcompany sponsor, passing through these costs without risk or reward to Covance.All other out-of-pocket costs are included in total revenues and expenses.

 

Unbilled services are recorded for revenue recognizedto date and relate to amounts that are currently unbillable to the customerpursuant to contractual terms. In general, amounts become billable upon theachievement of milestones or in accordance with predetermined paymentschedules. Unbilled services are billable to customers within one year from therespective balance sheet date. Unearned revenue is recorded for cash receivedfrom customers for which revenue has not been recognized at the balance sheetdate.

 

**Taxes on Income**

 

Covance uses the asset and liability method ofaccounting for income taxes. Under this method, deferred tax assets andliabilities are recognized for the expected future tax consequences ofdifferences between the carrying amount of assets and liabilities and theirrespective tax bases using enacted tax rates in effect for the year in which thetemporary differences are expected to reverse. The effect on deferred taxes ofa change in enacted tax rates is recognized in income in the period when thechange is effective.

 

Covance maintains a reserve for uncertain taxpositions. Effective January 1, 2007, the Company adopted the provisionsof Financial Accounting Standards Board Interpretation No. 48, *Accounting for Uncertainty in Income Taxes – anInterpretation of FASB Statement No. 109* (“FIN 48”). Thisauthoritative interpretation clarified and standardized the manner by whichcompanies are required to account for uncertain income tax positions. Under theguidance of FIN 48, the Company may recognize the tax benefit from anuncertain tax position only if it is more likely than not to be sustained uponexamination based on the technical merits of the position. The amount of theaccrual for which an exposure exists is measured as the largest amount ofbenefit determined on a cumulative probability basis that the Company believesis more likely than not to be realized upon ultimate settlement of theposition.

 

On January 1, 2007, the Company recognized a $0.6million increase in its liability for uncertain income tax positions, which wasaccounted for as a reduction to retained earnings, for the cumulative effectchange of adopting FIN 48. The reserve for uncertain income tax positions at January 1,2007, as calculated under the measurement provisions of FIN 48, was $9.1million. Components of the reserve are classified as either a current orlong-term liability in the consolidated balance sheet based on when the Companyexpects each of the items to be settled. Accordingly, the Company recorded acurrent liability of 

 

6

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**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

$3.5 million in accrued expenses and other currentliabilities and a long-term liability of $5.6 million in other liabilities onits balance sheet at January 1, 2007, including accrued interest ofapproximately $1.3 million. Consistent with historical practice, Covancerecords interest and penalties accrued in relation to uncertain income taxpositions as a component of income tax expense.

 

Any changes in the liability for uncertain taxpositions would impact the effective tax rate of Covance. Over the next twelvemonths, it is reasonably possible that the uncertainty surrounding a portion ofthe reserve for uncertain income tax positions, related to certain foreign taxwithholding and income taxes, dividend income, transfer pricing and state taxissues, will be resolved as a result of the expiration of the statute oflimitations or the conclusion of various state and foreign tax audits. If suchresolutions are favorable, Covance would reduce the carrying value of itsreserve for these items by up to $0.7 million. The following tax years remainopen to investigation as of January 1, 2007 for the Company’s major taxjurisdictions:

 

| **Tax Jurisdiction** | ** ** | **Years** | ** ** |
|---------------------------|------------|-----------|------------|
| US Federal and State      |       | 2002-2006 |       |
| United Kingdom            |       | 2004-2006 |       |
| Switzerland               |       | 2002-2006 |       |
| Germany                   |       | 2006      |       |

 

As of September 30, 2007, the balance of thereserve for uncertain income tax positions is $8.2 million, of which $2.0million is recorded as a current liability in accrued expenses and othercurrent liabilities, and $6.2 million is recorded as a long-term liability inother liabilities on the consolidated balance sheet, including accrued interestof $1.3 million. During the three month period ended September 30, 2007,the balance of the reserve for uncertain income tax positions decreased by $0.9million due to the settlement of a US State audit of $0.5 million and therelease of a $0.6 million reserve for previously unrecognized tax benefits injurisdictions where the statute of limitations had lapsed, partially offset bya $0.2 million increase in accrued interest.

 

The Company also maintains a tax reserve related toexposures for non-income tax matters such as value-added tax and state salesand use and other taxes, which are accounted for in accordance with Statementof Financial Accounting Standards No. 5, *Accountingfor Contingencies*. The balance of this reserve at September 30,2007 is $1.0 million and is recorded as a current liability in accrued expensesand other current liabilities on the consolidated balance sheet.

 

While Covance believes that it has identified allreasonably identifiable exposures and that the reserve it has established foridentifiable exposures is appropriate under the circumstances, it is possiblethat additional exposures exist and that exposures may be settled atamounts different than the amounts reserved. It is also possible that changesin facts and circumstances could cause Covance to either materially increase orreduce the carrying amount of its tax reserve.

 

Covance’s historical policy has been to leave itsunremitted foreign earnings invested indefinitely outside the United States.Except for the one-time opportunity provided under the American Jobs CreationAct, pursuant to which Covance repatriated $103 million in accumulated foreignearnings in the fourth quarter of 2005, Covance intends to continue to leaveits unremitted foreign earnings invested indefinitely outside the United States.As a result, taxes have not been provided on any accumulated foreign unremittedearnings as of September 30, 2007.

 

**Comprehensive Income**

 

Covance’s total comprehensive income, which representsnet income plus the change in the cumulative translation adjustment equityaccount for the periods presented, was $54.0 million and $43.5 million for thethree months ended September 30, 2007 and 2006, respectively, and $135.8million and $121.9 million for the nine months ended September 30, 2007and 2006, respectively.

 

7

----

 

**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

**Reimbursable Out-of-Pocket Expenses**

** **

As discussed in Note 2 “Prepaid Expenses and OtherCurrent Assets”, Covance pays on behalf of its customers fees to investigators,volunteers and other out-of-pocket costs for which we are reimbursed at cost,without mark-up or profit. In connection with the requirements of FinancialAccounting 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 fromrevenue and expense in the consolidated statements of income fees paid toinvestigators and the associated reimbursement since Covance acts as an agenton behalf of the pharmaceutical company sponsors with regard to investigatorpayments, in accordance with the Financial Accounting Standards Board EmergingIssues Task Force Rule No. 99-19 (“EITF 99-19”), *Reporting Revenue Gross as a Principal versus Net asan Agent*.

 

**Stock-Based Compensation**

 

The Company sponsors severalstock-based compensation plans pursuant to which non-qualified stock optionsand restricted stock awards are granted to eligible employees. These plans aredescribed more fully in Note 7 herein and Note 10 to our audited consolidatedfinancial statements included in our Annual Report on Form 10-K for theyear ended December 31, 2006.

 

Effective January 1,2006, the Company adopted the fair value recognition provisions of Statement ofFinancial Accounting Standards No. 123R, *Share-BasedPayments*, (“SFAS 123R”) using the modified prospective transitionmethod. SFAS 123R revised Statement of Financial Accounting Standards No. 123,*Accounting for Stock-Based Compensation*,(“SFAS 123”) superseded Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*,(“APB 25”) and amended Statement of Financial Accounting Standards No. 95,*Statement of Cash Flows*. Under themodified prospective transition method, compensation expense is recognized inthe financial statements on a prospective basis for (a) all share-basedpayments granted prior to, but not vested as of January 1, 2006, basedupon the grant-date fair value estimated in accordance with the originalprovisions of SFAS 123, and (b) share-based payments granted on orsubsequent to January 1, 2006, based upon the grant-date fair valueestimated in accordance with the provisions of SFAS 123R. The grant-date fairvalue of awards expected to vest is expensed on a straight-line basis over thevesting period of the related awards. See Note 7.

 

**Earnings Per Share (“EPS”)**

** **

Basic EPS is computed by dividing net income availableto common stockholders by the weighted average number of shares outstandingduring the period. The computation of diluted EPS is similar to the computationof basic EPS, except that the denominator is increased to include the number ofadditional common shares that would have been outstanding if the dilutivepotential common shares had been issued; computed under the treasury stockmethod in accordance with the requirements of Statement of Financial AccountingStandards No. 128, *Earnings Per Share*.

 

In computing diluted earnings per share for the threemonths ended September 30, 2007 and 2006, the denominator was increased by1,016,625 shares and 1,137,825 shares, respectively, and for the nine monthsended September 30, 2007 and 2006, the denominator was increased by1,040,170 shares and 1,216,454 shares, respectively, representing the dilutiveeffect of stock options outstanding at September 30, 2007 and 2006 withexercise prices less than the average market price of Covance’s Common Stockduring each respective period. Excluded from the computation of diluted EPS forthe three months ended September 30, 2007 were options to purchase 1,200shares of common stock at prices ranging from $73.32 to $77.90 per sharebecause the exercise prices of such options were greater than the averagemarket price of Covance’s common stock during this period. Excluded from thecomputation of diluted EPS for the nine months ended September 30, 2007were options to purchase 10,789 shares of common stock at prices ranging from$66.55 to $77.90 per share because the exercise prices of such options weregreater than the average market price of Covance’s common stock during thisperiod. Excluded from the computation of diluted EPS for the three months endedSeptember 30, 2006 were options to purchase 2,155 shares of common stockat prices ranging from $63.79 to $66.38 per share because the exercise pricesof such options were greater than the average market price of Covance’s commonstock during this period. Excluded from the computation of diluted EPS for thenine months ended September 30, 2006 were options to purchase 7,634 sharesof common stock at prices ranging from $59.52 to $66.38 per share because theexercise prices of such options were greater than the average market price ofCovance’s common stock during this period.

 

8

----

 

**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

**Supplemental Cash Flow Information**

 

Cash paid for interest for the nine month periodsended September 30, 2007 and 2006 was $0.2 million and $0.1 million,respectively. Cash paid for income taxes for the nine month periods ended September 30,2007 and 2006 totaled $51.5 million and $33.0 million, respectively. The changein income taxes payable in the consolidated statement of cash flows for thenine month periods ended September 30, 2007 and 2006 includes as anoperating cash outflow the excess tax benefit received from the exercise ofnon-qualified stock options as measured under SFAS 123R of $4.3 million and$6.6 million, respectively (a corresponding cash inflow of $4.3 million and$6.6 million, respectively, has been included in financing cash flows).

 

**Recently Issued AccountingStandards**

 

In September 2006, the Financial AccountingStandards Board (the “FASB”) issued Statement of Financial Accounting StandardsNo. 158, *Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans, an amendment of FASBStatements No. 87, 88, 106 and 132(R)*, (“SFAS 158”). As of December 31,2006, Covance has adopted the recognition and disclosure provisions of SFAS158, which require an employer to recognize the over funded or under fundedstatus of its defined benefit postretirement plans – measured as the differencebetween the fair value of plan assets and the projected benefit obligation - asan asset or liability, respectively, in its balance sheet and to recognizechanges in the funded status of the plan in the year in which such changesoccur through other comprehensive income. SFAS 158 also requires, effective forfiscal years ending after December 15, 2008, that the measurement of theover funded or under funded status of a plan be made as of the employer’sfiscal year end and not as of an earlier measurement date. Covance will berequired to conform the measurement dates of its plans to December 31stfor its fiscal year ending December 31, 2008. Covance does not expect thischange in measurement dates to have a material impact on its consolidatedresults of operations or financial position.

 

In September 2006, the FASB issued Statement ofFinancial Accounting Standards No. 157, *FairValue Measurements,* (“SFAS 157”). SFAS 157, which applies wheneverother standards require (or permit) fair value measurement, defines fair valueand provides guidance for using fair value to measure assets and liabilities. SFAS157 also requires expanded disclosures about the extent to which companiesmeasure assets and liabilities at fair value, the information used in thosemeasurements and the effect of fair value measurements on earnings. Covancewill be required to adopt SFAS 157, which is effective for fiscal yearsbeginning after November 15, 2007, no later than the quarter beginning January 1,2008. Covance does not expect the adoption of SFAS 157 to have a materialimpact on its consolidated results of operations or financial position.

 

**3. Treasury Stock**

** **

In February 2007, the Covance Board of Directorsauthorized the repurchase of an additional 3.0 million shares under Covance’sstock repurchase program. At September 30, 2007, there are approximately2.3 million shares remaining for purchase under the 2007 authorization. Covancealso reacquires shares of its common stock in connection with certain employeebenefit plans when employees tender shares either in connection with reloadstock options or to satisfy income tax withholdings associated with the vestingof stock awards. The following table sets forth the treasury stock activityduring the nine month periods ended September 30, 2007 and 2006.

 

| ** **                             | ** ** | **Nine Months Ended September 30** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                             | ** ** | **2007**                                               | ** ** | **2006** | ** ** |
| **(amounts in thousands)**   | ** ** | **$**                                                  | ** ** | **# shares** | ** ** | **$** | ** ** | **# shares** | ** ** |
| Shares repurchased in connection with: |       |                                                   |       |   |   |   |   |   |   |
| Board approved buyback programs        |       | $                                                      | 59,628     |   | 977.0 |   | $ | 7,799 |   | 134.3 |   |
| Employee benefit plans                 |       | 1,934                                                  |       | 30.6 |   | 906 |   | 15.7 |   |
| Total                                  |       | $                                                      | 61,562     |   | 1,007.6 |   | $ | 8,705 |   | 150.0 |   |

 

9

----

 

**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

**4. Equity Method Investees**

** **

Covance has a 47% minority equity position in NoveprimLtd. (“Noveprim”), a supplier of research products, which was acquired in March 2004at a total 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 reflected in other assets on the consolidatedbalance sheet. During the three and nine month periods ended September 30,2007, Covance recognized $0.3 million and $1.4 million, respectively,representing its share of Noveprim’s earnings, less the elimination of profiton inventory purchased from Noveprim and still on hand at Covance at September 30,2007. During the three and nine month periods ended September 30, 2006,Covance recognized $0.2 million and $1.0 million, respectively, representingits share of Noveprim’s earnings, less the elimination of profit on inventorypurchased from Noveprim and still on hand at Covance at September 30, 2006.The carrying value of Covance’s investment in Noveprim at September 30,2007 and December 31, 2006 was $24.0 million and $23.0 million,respectively.

 

Covance has a minority equity position (approximately20% at September 30, 2007) in Bio-Imaging Technologies, Inc. (“BITI”).BITI uses proprietary medical imaging technologies to process and analyzemedical images, and also provides other services, including the data-basing andregulatory submission of medical images, quantitative data and text. During thethree and nine month periods ended September 30, 2007, Covance recognized$0.1 million and $0.3 million, respectively, representing its pro rata share ofBITI’s earnings. During the three and nine month periods ended September 30,2006, Covance recognized income of $0.02 million and a loss of $0.06 million,respectively, representing its pro rata share of BITI’s earnings (losses). Thecarrying value of Covance’s investment in BITI as of September 30, 2007and December 31, 2006 was $0.8 million and $0.5 million, respectively,while the fair market value was $16.7******million and $19.0 million, respectively.

 

**5. Acquisitions**

** **

In May 2006, Covance acquired the stock ofRadiant Research Inc. (“Radiant”) in a merger transaction for cash paymentsaggregating $66.6 million (including direct acquisition costs of $0.5 million).The Radiant acquisition included eight early development clinical sitesperforming Phase I/IIa clinical trial services. Results of operations forRadiant, which are 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 in June 2006.

 

In May 2006, Covance also acquired certain assetsand liabilities of Signet Laboratories, Inc. (“Signet”) for cash paymentstotaling $9.1 million (including direct acquisition costs of $0.2 million). Signetspecializes in the development of monoclonal antibodies and diagnostic assaysfor cancer, infectious diseases and neurodegenerative diseases. Results ofoperations for Signet, which are 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 beginningin June 2006.

 

The table below summarizes the purchase priceallocations for the Radiant and Signet acquisitions:

 
| ** **                                                                      | ** ** | **Radiant** | ** ** | **Signet** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|
| Estimated fair value of net tangible assets acquired                            |       | $           | 9,183      |       | $          | 352 |   |
| Fair value of intangible assets acquired (8 year  weighted average useful life) |       | 6,820       |       | 850        |       |
| Goodwill                                                                        |       | 50,567      |       | 7,896      |       |
| Net assets acquired                                                             |       | $           | 66,570     |       | $          | 9,098 |   |

 

The goodwill resulting from the Signet acquisition isdeductible for tax purposes, while the goodwill resulting from the merger withRadiant is not deductible for tax purposes.

 

10

----

 

**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

**6. Defined Benefit Plans**

** **

Covance sponsors various pension and otherpost-retirement benefit plans. As required by SFAS 158, Covance recognizes theover funded or under funded status of its defined benefit postretirement plans– measured as the difference between the fair value of plan assets and theprojected benefit obligation – as an asset or liability, respectively, in itsbalance sheet and recognizes changes in the funded status of the plan throughother comprehensive income (in the year such changes occur).

 

**Defined Benefit Pension Plans**

 

Covance sponsors two defined benefit pension plans forthe benefit of its employees at two United Kingdom subsidiaries and one definedbenefit pension plan for the benefit of its employees at a German subsidiary,all of which are legacy plans of previously acquired companies. Benefit amountsfor all three plans are based upon years of service and compensation. TheGerman plan is unfunded while the United Kingdom plans are funded. Covance’sfunding policy has been to contribute annually a fixed percentage of theeligible employee’s salary at least equal to the local statutory fundingrequirements. Pension plan assets are administered by the plans’ trustees andare principally invested in equity and debt securities. The components of netperiodic pension expense for these plans for the three and nine month periodsended September 30, 2007 and 2006 are as follows:

 
| ** **                                                | ** ** | **United Kingdom Plans**                      | ** ** | **German Plan**                                    | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                | ** ** | **Three Months Ended September 30** | ** ** | **Three Months Ended September 30** | ** ** |
| ** **                                                | ** ** | **2007**                                                | ** ** | **2006**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| Components of Net Periodic Pension Cost:                  |       |                                                    |       |                                                    |       |   |   |   |   |
| Service cost                                              |       | $                                                       | 1,495      |                                                    | $          | 1,520 |   | $ | 128 |   | $ | 102 |   |
| Interest cost                                             |       | 1,885                                                   |       | 1,627                                                   |       | 97 |   | 77 |   |
| Expected return on plan assets                            |       | (2,165                                                  | )          | (1,850                                                  | )          | — |   | — |   |
| Amortization of net actuarial loss                        |       | 358                                                     |       | 482                                                     |       | 16 |   | 13 |   |
| Participant contributions                                 |       | (565                                                    | )          | (586                                                    | )          | — |   | — |   |
| Net periodic pension cost                                 |       | $                                                       | 1,008      |                                                    | $          | 1,193 |   | $ | 241 |   | $ | 192 |   |
|                                                      |       |                                                    |       |                                                    |       |   |   |   |   |
| Assumptions Used to Determine Net Periodic Pension  Cost: |       |                                                    |       |                                                    |       |   |   |   |   |
| Discount rate                                             |       | 5.25                                                    | %          | 5.00                                                    | %          | 4.65 | % | 4.65 | % |
| 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** | ** ** |
| ** **                                                | ** ** | **2007**                                               | ** ** | **2006**                                               | ** ** | **2007** | ** ** | **2006** | ** ** |
| Components of Net Periodic Pension Cost:                  |       |                                                   |       |                                                   |       |   |   |   |   |
| Service cost                                              |       | $                                                      | 4,441      |                                                   | $          | 4,371 |   | $ | 373 |   | $ | 299 |   |
| Interest cost                                             |       | 5,595                                                  |       | 4,674                                                  |       | 278 |   | 223 |   |
| Expected return on plan assets                            |       | (6,427                                                 | )          | (5,314                                                 | )          | — |   | — |   |
| Amortization of net actuarial loss                        |       | 1,063                                                  |       | 1,384                                                  |       | 51 |   | 37 |   |
| Participant contributions                                 |       | (1,675                                                 | )          | (1,684                                                 | )          | — |   | — |   |
| Net periodic pension cost                                 |       | $                                                      | 2,997      |                                                   | $          | 3,431 |   | $ | 702 |   | $ | 559 |   |
|                                                      |       |                                                   |       |                                                   |       |   |   |   |   |
| Assumptions Used to Determine Net Periodic Pension  Cost: |       |                                                   |       |                                                   |       |   |   |   |   |
| Discount rate                                             |       | 5.25                                                   | %          | 5.00                                                   | %          | 4.65 | % | 4.65 | % |
| Expected rate of return on assets                         |       | 6.75                                                   | %          | 6.75                                                   | %          | n/a |   | n/a |   |
| Salary increases                                          |       | 4.00                                                   | %          | 4.00                                                   | %          | 2.50 | % | 2.50 | % |

 

11

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**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

## **Supplemental Executive Retirement Plan**

## ** **

In addition to these foreign defined benefit pensionplans, Covance also has a non-qualified Supplemental Executive Retirement Plan(“SERP”). The SERP, which is not funded, is intended to provide retirementbenefits for certain executive officers of Covance. Benefit amounts are basedupon years of service and compensation of the participating employees. Thecomponents of net periodic pension cost for the three and nine month periodsended September 30, 2007 and 2006 are as follows:

 
| ** **                                                | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Components of Net Periodic Pension Cost:                  |       |                                                |       |                                               |       |   |   |   |   |
| Service cost                                              |       | $                                                   | 271        |                                               | $          | 231 |   | $ | 814 |   | $ | 694 |   |
| Interest cost                                             |       | 193                                                 |       | 164                                                |       | 579 |   | 492 |   |
| Amortization of prior service cost                        |       | 19                                                  |       | 19                                                 |       | 57 |   | 57 |   |
| Amortization of net actuarial loss                        |       | 10                                                  |       | 8                                                  |       | 31 |   | 24 |   |
| Net periodic pension cost                                 |       | $                                                   | 493        |                                               | $          | 422 |   | $ | 1,481 |   | $ | 1,267 |   |
|                                                      |       |                                                |       |                                               |       |   |   |   |   |
| Assumptions Used to Determine Net Periodic Pension  Cost: |       |                                                |       |                                               |       |   |   |   |   |
| Discount rate                                             |       | 5.50                                                | %          | 5.50                                               | %          | 5.50 | % | 5.50 | % |
| Salary increases                                          |       | 4.00                                                | %          | 4.00                                               | %          | 4.00 | % | 4.00 | % |

 

#### **Post-Employment Retiree Health and Welfare Plan**

#### ** **

Covance also sponsors a post-employment retiree healthand welfare plan for the benefit of eligible employees at certain U.S.subsidiaries who retire after satisfying service and age requirements. Thisplan is funded on a pay-as-you-go basis and the cost of providing thesebenefits is shared with the retirees. The components of net periodicpost-retirement benefits cost for the three and nine month periods ended September 30,2007 and 2006 are as follows:

 
| ** **                                                                | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Components of Net Periodic Post-retirement Benefits  Cost:                |       |                                                |       |                                               |       |   |   |   |   |
| Service cost                                                              |       | $                                                   | 41         |                                               | $          | 44 |   | $ | 123 |   | $ | 132 |   |
| Interest cost                                                             |       | 70                                                  |       | 78                                                 |       | 210 |   | 234 |   |
| Amortization of net actuarial loss                                        |       | —                                              |       | 13                                                 |       | — |   | 39 |   |
| Net periodic post-retirement benefits cost                                |       | $                                                   | 111        |                                               | $          | 135 |   | $ | 333 |   | $ | 405 |   |
|                                                                      |       |                                                |       |                                               |       |   |   |   |   |
| Assumptions Used to Determine Net Periodic  Post-retirement Benefit Cost: |       |                                                |       |                                               |       |   |   |   |   |
| Discount rate                                                             |       | 5.50                                                | %          | 5.50                                               | %          | 5.50 | % | 5.50 | % |
| Health care cost trend rate                                               |       | 9.00                                                | %(a)       | 9.00                                               | %(a)       | 9.00 | %(a) | 9.00 | %(a) |

 

----

(a) decreasing to ultimate trend of 5.00% in 2011

 

12

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**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

**7. Stock-BasedCompensation Plans**

** **

Covance sponsors several employee stock-basedcompensation plans which are described more fully in Note 10 to our auditedconsolidated financial statements included in our Annual Report on Form 10-Kfor the year ended December 31, 2006.

 

In May 2007, Covance’s shareholders approved the2007 Employee Equity Participation Plan (the “2007 EEPP”) in replacement of the2002 Employee Equity Participation Plan (the “2002 EEPP”). Effective uponapproval of the 2007 EEPP, no further grants or awards were permitted under the2002 EEPP. Shares remaining for grant under the 2002 EEPP will be available forgrant under the 2007 EEPP. In addition, the Covance Board of Directors directedthat, effective May 3, 2007, no further grants would be permitted underthe 2002 Employee Stock Option Plan (the “2002 ESOP”) and, unlike the 2002EEPP, shares remaining for grant under the 2002 ESOP would not be available forgrant under the 2007 EEPP. The 2007 EEPP became effective on May 3, 2007and will expire on May 2, 2017. The 2007 EEPP authorizes the Compensationand Organization Committee of the Board of Directors (the “CompensationCommittee”), or such committee as is appointed by the Covance Board ofDirectors, to administer the 2007 EEPP, to grant awards to employees andconsultants of Covance or entities in which Covance has a controlling orsignificant equity interest. The 2007 EEPP authorizes the CompensationCommittee to grant the following awards to eligible employees: options topurchase common stock; stock appreciation rights; and other stock awards eithersingly or in combination. The exercise period for stock options granted underthe 2007 EEPP is determined by the Compensation Committee at the time of grant,and is generally ten years from the date of grant. The vesting period for stockoptions and stock awards granted under the 2007 EEPP is determined by theCompensation Committee at the time of grant. Generally, options vest over athree year period for senior executives and over a two year period for allother optionees. Stock awards generally vest over a three year period for allemployees. The number of shares of Covance common stock initially available forgrant under the 2007 EEPP totaled approximately 1.6 million plus approximately3.3 million shares remaining available under the 2002 EEPP at the time the 2007EEPP was approved. All stock option grants under the 2002 EEPP remainingoutstanding are now administered in accordance with the provisions of the 2002EEPP out of shares issuable under the 2007 EEPP. The Company issues authorizedbut previously unissued shares when options are exercised or for stock awards. AtSeptember 30, 2007 there were approximately 4.9 million shares remainingavailable for grants or awards under the 2007 EEPP. No stock appreciationrights have been granted under the 2002 ESOP, the 2002 EEPP or the 2007 EEPP.

 

The grant-date fair value of stock option awards isestimated using an option pricing model as more fully described in Note 10 toour audited consolidated financial statements included in our Annual Report on Form 10-Kfor the year ended December 31, 2006. The grant-date fair value of optionsexpected to vest is expensed on a straight-line basis over the vesting periodof the related awards.

 

The following table setsforth the weighted-average assumptions used to calculate the fair value ofoptions granted for the three and nine month periods ended September 30,2007 and 2006:

 
| ** **                       | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|----------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected stock price volatility  |       | 42%                                                 |       | 44%                                                |       | 42% |   | 44% |   |
| Risk free interest rate(s)       |       | 4.7% - 5.1%                                         |       | 3.9% - 4.5%                                        |       | 4.7% - 5.1% |   | 3.9% - 4.5% |   |
| Expected life of options (years) |       | 4.3                                                 |       | 4.3                                                |       | 4.3 |   | 4.3 |   |

 

Restricted stock awards aregranted subject to certain restrictions, including in some cases serviceconditions and in other cases service and performance conditions. Thegrant-date fair value of restricted stock awards expected to vest, which hasbeen determined based upon the market value of Covance’s shares on the grantdate, is expensed on a straight-line basis over the vesting period of therelated awards.

 

Covance also has an employeestock purchase plan (“ESPP”) pursuant to which Covance may make availablefor sale to its employees shares of its common stock at a price equal to 85% ofthe lower of the market value on the first or last day of each calendar quarter.The ESPP is intended to give Covance employees the opportunity to purchaseshares of Covance common stock through payroll deductions.

 

13

----

 

**COVANCE INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(UNAUDITED)**

**September 30, 2007 and 2006**

**(dollars in thousands, unless otherwise indicated)**

 

Results of operations forthe three month period ended September 30, 2007 include total stock-basedcompensation expense of $5.7 million ($3.8 million net of tax benefit of $1.9million), $1.9 million of which has been included in cost of revenue and $3.8million of which has been included in selling, general and administrativeexpenses. Results of operations for the nine month period ended September 30,2007 include total stock-based compensation expense of $16.8 million ($11.3million net of tax benefit of $5.5 million), $5.8 million of which has beenincluded in cost of revenue and $11.0 million of which has been included inselling, general and administrative expenses. Results of operations for thethree month period ended September 30, 2006 include total stock-basedcompensation expense of $5.8 million ($3.9 million net of tax benefit of $1.9million), $1.7 million of which has been included in cost of revenue and $4.1million of which has been included in selling, general and administrativeexpenses. Results of operations for the nine month period ended September 30,2006 include total stock-based compensation expense of $15.2 million ($10.3million net of tax benefit of $4.9 million), $5.2 million of which has beenincluded in cost of revenue and $10.0 million of which has been included inselling, general and administrative expenses.

 

**8. Segment Information**

** **

Covance has two reportable segments: early developmentand late-stage development. Early development services, which includes Covance’spreclinical and clinical pharmacology service capabilities, involve evaluatinga new compound for safety and early effectiveness as well as evaluating theabsorption, distribution, metabolism and excretion of the compound in the humanbody. It is at this stage that a pharmaceutical company, based on availabledata, will generally decide whether to continue further development of a drug. Late-stagedevelopment services, which include Covance’s central laboratory, clinicaldevelopment, cardiac safety services, periapproval 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 accounting policies of the reportablesegments are the same as those described in Note 2.

 

Segment net revenues, operating income and totalassets for the three and nine month periods ended September 30, 2007 and2006 are as follows:

 

| ** **                                        | ** ** | **Early  Development** | ** ** | **Late-Stage  Development** | ** ** | **Other  Reconciling Items** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|-----------------------------|------------|-----------------------------------|------------|-----------|------------|
| ***Three months ended September 30,  2007*** |       |                   |       |                        |       |                              |       |      |       |
| Total revenues from external customers            |       | $                      | 199,486    |                        | $          | 196,503                           |       | $         | 18,712     | (a) | $ | 414,701 |   |
| Operating income                                  |       | $                      | 51,777     |                        | $          | 34,426                            |       | $         | (26,105    | )(b) | $ | 60,098 |   |
| Total assets                                      |       | $                      | 871,099    |                        | $          | 472,472                           |       | $         | 116,356    | (c) | $ | 1,459,927 |   |
|                                              |       |                   |       |                        |       |                              |       |      |       |
| ***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 |   |
|                                              |       |                   |       |                        |       |                              |       |      |       |
| ***Nine months ended September 30,  2007***  |       |                   |       |                        |       |                              |       |      |       |
| Total revenues from external customers            |       | $                      | 569,804    |                        | $          | 565,649                           |       | $         | 60,361     | (a) | $ | 1,195,814 |   |
| Operating income                                  |       | $                      | 144,450    |                        | $          | 95,536                            |       | $         | (72,332    | )(b) | $ | 167,654 |   |
| Total assets                                      |       | $                      | 871,099    |                        | $          | 472,472                           |       | $         | 116,356    | (c) | $ | 1,459,927 |   |
|                                              |       |                   |       |                        |       |                              |       |      |       |
| ***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 |   |

 

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| (a) |   | Represents revenues associated with reimbursable  out-of-pocket expenses.                                                                                            |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (b) |   | Represents corporate expenses (primarily information  technology, marketing, communications, human resources, finance, legal and  stock-based compensation expense). |
| (c) |   | Represents corporate assets.                                                                                                                                         |

 

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**Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

You should read the following discussion together withthe unaudited Covance consolidated financial statements and the accompanyingnotes included in this Quarterly Report on Form 10-Q for the quarter endedSeptember 30, 2007.

 

**Overview**

 

Covance is a leading drug development services companyproviding a wide range of early-stage and late-stage product developmentservices on a worldwide basis primarily to the pharmaceutical, biotechnologyand 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, cardiac safety services,periapproval and market access services. Although each segment has separateservices within it, they can be combined in joint service offerings and webelieve clients increasingly are interested in opportunities for such combinedservices. Covance believes it is one of the largest drug development servicescompanies, based on annual net revenues, and one of a few that is capable ofproviding comprehensive global product development services. Covance offers itsclients high quality services designed to provide data to clients as rapidly aspossible and reduce product development time. 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’s consolidated financial statements areprepared in accordance with U.S. generally accepted accounting principles (“GAAP”),which require management to make estimates and assumptions about future eventsthat affect the amounts reported in the financial statements and theaccompanying notes. Actual results could differ from these estimates. Thefollowing discussion highlights what we believe to be the critical accountingpolicies and judgments made in the preparation of these consolidated financialstatements.

 

***Revenue Recognition.***Covancerecognizes revenue either as services are performed or products are delivered,depending upon the nature of the work contracted. Historically, a majority ofCovance’s net revenues have been earned under contracts which range in durationfrom a few months to two years, but can extend in duration up to five years orlonger. Service contracts generally take the form of fee-for-service orfixed-price arrangements. In the case of fee-for-service contracts, revenue isrecognized as services are performed, based upon, for example, hours worked orsamples tested. 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 uponthe achievement of performance-based milestones over the contract duration. Mostcontracts are terminable by the client either immediately or upon notice. Thesecontracts typically require payment to Covance of expenses to wind down thestudy, fees earned to date and, in some cases, a termination fee or a paymentto Covance of some portion of the fees or profits that could have been earnedby Covance under the contract if it had not been terminated early. Terminationfees are 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 aprovision for doubtful accounts relating to amounts due that may not becollected. This bad debt provision is monitored on a monthly basis and adjustedas circumstances warrant. Since the recorded bad debt provision is based uponmanagement’s judgment, actual bad debt write-offs may be greater or lessthan the amount recorded. Historically bad debt write-offs have not beenmaterial.

 

15

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***Taxes on Income.***Since Covance conductsoperations on a global basis, its effective tax rate has and will continue todepend upon the geographic distribution of its pre-tax earnings among locationswith varying tax rates. Covance’s profits are further impacted by changes inthe tax rates of the various jurisdictions in which Covance operates. Inaddition, Covance maintains a reserve for uncertain income tax positions,changes in which also impact Covance’s effective tax rate in the period inwhich such changes are made.

 

Effective January 1, 2007, the Company adopted the provisions ofFinancial Accounting Standards Board Interpretation No. 48, *Accounting for Uncertainty in Income Taxes – anInterpretation of FASB Statement No. 109* (“FIN 48”). This authoritativeinterpretation clarified and standardized the manner by which companies arerequired to account for uncertain income tax positions. Under the guidance ofFIN 48, the Company may recognize the tax benefit from an uncertain taxposition only if it is more likely than not to be sustained upon examinationbased on the technical merits of the position. The amount of the accrual forwhich an exposure exists is measured as the largest amount of benefitdetermined on a cumulative probability basis that the Company believes is morelikely than not to be realized upon ultimate settlement of the position. OnJanuary 1, 2007, the Company recognized a $0.6 million increase its liabilityfor uncertain income tax positions, which was accounted for as a reduction to retainedearnings, for the cumulative effect change of adopting FIN 48. The reserve foruncertain income tax positions at January 1, 2007, as calculated under themeasurement provisions of FIN 48, was $9.1 million. Components of the reserveare classified as either a current or long-term liability in the consolidatedbalance sheet based on when the Company expects each of the items to besettled. Accordingly, the Company recorded a current liability of $3.5 millionin accrued expenses and other current liabilities and a long-term liability of$5.6 million in other liabilities on its balance sheet at January 1, 2007,including accrued interest of approximately $1.3 million. Consistent withhistorical practice, Covance records interest and penalties accrued in relationto uncertain income tax positions as a component of income tax expense.

 

Anychanges in the liability for uncertain tax positions would impact the effectivetax rate of Covance. Over the next twelve months, it is reasonably possiblethat the uncertainty surrounding a portion of the reserve for uncertain incometax positions, related to certain foreign tax withholding and income taxes,dividend income, transfer pricing and state tax issues, will be resolved as aresult of the expiration of the statute of limitations or the conclusion ofvarious state and foreign tax audits. If such resolutions are favorable,Covance would reduce the carrying value of its reserve for these items by up to$0.7 million. The following tax years remain open to investigation as ofJanuary 1, 2007 for the Company’s major tax jurisdictions:

 
| **Tax Jurisdiction** | ** ** | **Years** |
|---------------------------|------------|-----------|
| US  Federal and State     |       | 2002-2006 |
| United Kingdom            |       | 2004-2006 |
| Switzerland               |       | 2002-2006 |
| Germany                   |       | 2006      |

 

As ofSeptember 30, 2007, the balance of the reserve for uncertain income taxpositions is $8.2 million, of which $2.0 million is recorded as a currentliability in accrued expenses and other current liabilities, and $6.2 millionis recorded as a long-term liability in other liabilities on the consolidatedbalance sheet, including accrued interest of $1.3 million. During the threemonth period ended September 30, 2007, the balance of the reserve for uncertainincome tax positions decreased by $0.9 million due to the settlement of a USState audit of $0.5 million and the release of a $0.6 million reserve forpreviously unrecognized tax benefits in jurisdictions where the statute oflimitations had lapsed, partially offset by a $0.2 million increase in accruedinterest.

 

TheCompany also maintains a tax reserve related to exposures for non-income taxmatters such as value-added tax and state sales and use and other taxes, whichare accounted for in accordance with Statement of Financial AccountingStandards No. 5, *Accounting forContingencies*. The balance of this reserve at September 30, 2007 is$1.0 million and is recorded as a current liability in accrued expenses andother current liabilities on the consolidated balance sheet.

 

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. It is also possible that changes in factsand circumstances could cause Covance to either materially increase or reducethe carrying amount of its tax reserve.

 

Covance’s policy is to provide income taxes onearnings of foreign subsidiaries only to the extent those earnings are taxableor are expected to be remitted. Covance’s historical policy has been to leaveits unremitted foreign earnings invested indefinitely outside the UnitedStates. Except for the amounts repatriated in the fourth quarter of 2005 underthe American Jobs

 

16

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Creation Act of 2004, Covance intends to continue toleave its unremitted foreign earnings invested indefinitely outside the UnitedStates. As a result, taxes have not been provided on any accumulated foreignunremitted earnings as of September 30, 2007.

 

***Stock-Based Compensation.***The Company sponsorsseveral stock-based compensation plans pursuant to which non-qualified stockoptions and restricted stock awards are granted to eligible employees. Theseplans are described more fully in Note 10 to our audited financial statementsincluded in our Annual Report on Form 10-K for the year ended December 31, 2006and Note 7 to our consolidated financial statements in our Quarterly Report onForm 10-Q for the quarter ended September 30, 2007 included elsewhere herein.

 

Thegrant-date fair value of stock awards is based upon the underlying price of thestock on the date of grant. The grant-date fair value of stock option awardsmust be determined using an option pricing model. Option pricing models requirethe use of estimates and assumptions as to (a) the expected term of the option,(b) the expected volatility of the price of the underlying stock, (c) therisk-free interest rate for the expected term of the option and (d) pre-vestingforfeiture rates. For stock options granted prior to January 1, 2006, theCompany used the Black-Scholes-Merton option pricing formula for determiningthe grant-date fair value of such awards. 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 Companychanged to the Lattice-Binomial option pricing formula as it believes suchformula may result in a better estimate of fair value than theBlack-Scholes-Merton formula.

 

Theexpected term of the option is based upon the contractual term and expectedemployee exercise and expected post-vesting employment termination behavior. Theexpected volatility of the price of the underlying stock is based upon thehistorical volatility of the Company’s stock computed over a period of timeequal to the expected term of the option. The risk free interest rate is basedupon the implied yields currently available from the U.S. Treasury zero-couponyield curve for issues with a remaining duration equal to the expected term ofthe option. Pre-vesting forfeiture rates are estimated based upon pastvoluntary termination behavior and past option forfeitures.

 

The following table sets forth the weighted-averageassumptions used to calculate the fair value of options granted for the threeand nine month periods ended September 30, 2007 and 2006:

 
| ** **                        | ** ** | **Three Months Ended September 30** | ** ** | **Nine Months Ended September 30** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                                | ** ** | **2006**                                               | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected stock price  volatility  |       | 42%                                                     |       | 44%                                                    |       | 42% |   | 44% |   |
| Risk free interest  rate(s)       |       | 4.7% - 5.1%                                             |       | 3.9% - 4.5%                                            |       | 4.7% - 5.1% |   | 3.9% - 4.5% |   |
| Expected life of  options (years) |       | 4.3                                                     |       | 4.3                                                    |       | 4.3 |   | 4.3 |   |

 

Changesin any of these assumptions could impact, potentially materially, the amount ofexpense recorded in future periods related to stock-based awards.

 

***Impairment of Assets.***Covancereviews its long-lived assets other than goodwill and other indefinite livedintangible assets for impairment, when events or changes in circumstances occurthat indicate that the carrying value of 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 future cash flows may be greater or less thanestimated.

 

Covance performs an annual test for impairment ofgoodwill and other indefinite lived intangible assets during the fourth quarter.This test is performed by comparing, at the reporting unit level, the carryingvalue of the reporting unit to its fair value. Covance assesses fair valuebased upon its best estimate of the present value of the future cash flows thatit expects to be generated by the reporting unit. The most recent test forimpairment performed for 2006 did not identify any instances of impairment andthere were no events through September 30, 2007 that warranted areconsideration of our impairment test results. However, changes in expectationsas to the present value of the reporting unit’s future cash flows might impactsubsequent years’ assessments of impairment.

 

***Defined Benefit Pension Plans******.***Covance sponsors defined benefitpension plans for the benefit of its employees at three foreign subsidiaries,as well as a non-qualified supplemental executive retirement plan and apost-employment retiree health and welfare plan for the benefit of eligibleemployees at certain U.S. subsidiaries. The measurement of the related benefitobligation and net periodic benefit cost recorded each year is based uponactuarial computations, which require the use of judgment as to certain

 

17

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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 (suchas the return on plan assets, future rate of salary increases and planparticipation rates) will likely differ from the assumptions used. Thosedifferences, along with changes that may be made in the assumptions used fromperiod to period, will impact the amounts reported in the financial statementsand footnote disclosures.

 

Set forth below is a discussion of the impact that (a)differences between assumed results and actual results and (b) assumptionchanges have had on our results of operations for the years ended December 31,2006, 2005 and 2004 and on the financial position of the plans as of December31, 2006 and 2005 for our United Kingdom defined benefit pension plans (thelargest of our defined benefit-type pension plans).

 
| ** **                                                                 | ** ** | **United Kingdom Plans** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------|------------|
| **(amounts in millions)**                                        | ** ** | **2006**                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net periodic pension  cost                                                 |       | $                                  | 4.6        |   | $ | 4.1 |   | $ | 4.3 |   | $ | 4.1 |   |
|                                                                       |       |                               |       |   |   |   |   |   |   |
| Weighted average  assumptions used to determine net periodic pension cost: |       |                               |       |   |   |   |   |   |   |
| Discount rate                                                              |       | 5.00                               | %          | 5.75 | % | 6.00 | % | 6.00 | % |
| Expected rate of return  on assets                                         |       | 6.75                               | %          | 6.75 | % | 6.00 | % | 6.00 | % |
| Salary increases                                                           |       | 4.00                               | %          | 4.00 | % | 3.50 | % | 3.50 | % |
|                                                                            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |

 

The increase (decrease) in the net periodic benefitcost from period to period is attributable to the following:

 
| ** **                                                                   | ** ** | **United Kingdom Plans** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------|------------|
| **(amounts in millions)**                                          | ** ** | **2005 to 2006**         | ** ** | **2004 to 2005** | ** ** | **2003 to 2004** | ** ** |
| Change in discount rate                                                      |       | $                                  | 2.4        |   | $ | 0.4 |   | — |   |
| Change in expected rate  of return on assets                                 |       | —                             |       | (0.6 | ) | — |   |
| Change in rate of  salary increases                                          |       | —                             |       | 0.4 |   | — |   |
| Other, including  differences between actual experience and assumptions used |       | (1.9                               | )          | (0.4 | ) | $ | (0.3 | ) |
| Foreign currency  exchange rate changes                                      |       | —                             |       | — |   | 0.5 |   |
| Net change in periodic  benefit cost                                         |       | $                                  | 0.5        |   | $ | (0.2 | ) | $ | 0.2 |   |
|                                                                         |       |                               |       |   |   |   |   |
|                                                                         |       |                               |       |   |   |   |   |
|                                                                         |       | **United Kingdom Plans** |       |
|                                                                         |       | **2006**                           | ** ** | **2005** | ** ** | **2004** |   |
| Weighted average assumptions  used to determine benefit obligation:          |       |                               |       |   |   |   |   |
| Discount rate                                                                |       | 5.25                               | %          | 5.00 | % | 5.75 | % |
| Salary increases                                                             |       | 4.00                               | %          | 4.00 | % | 4.00 | % |
|                                                                              |            |                                    |            |  |  |  |  |  |  |  |  |  |  |

 

The change in the projected benefit obligation fromperiod to period is attributable to the following:

 
| ** **                                                                   | ** ** | **United Kingdom Plans** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------|------------|
| **(amounts in millions)**                                          | ** ** | **2005 to 2006**         | ** ** | **2004 to 2005** | ** ** |
| Projected benefit  obligation, beginning of year                             |       | $                                  | 119.8      |   | $ | 103.3 |   |
| Service/interest cost  components of net periodic benefit cost in year       |       | 12.2                               |       | 10.5 |   |
| Benefits paid                                                                |       | (1.3                               | )          | (1.2 | ) |
| (Increase)/reduction in  discount rate                                       |       | (8.6                               | )          | 18.6 |   |
| Other, including  differences between actual experience and assumptions used |       | 3.9                                |       | (0.5 | ) |
| Foreign currency  exchange rate changes                                      |       | 15.3                               |       | (10.9 | ) |
| Projected benefit  obligation, end of year                                   |       | $                                  | 141.3      |   | $ | 119.8 |   |

 

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**Foreign Currency Risks**

 

SinceCovance operates on a global basis, it is exposed to various foreign currencyrisks. Two specific risks arise from the nature of the contracts Covanceexecutes with its customers since from time to time contracts are denominatedin a currency different than the particular Covance subsidiary’s localcurrency. These risks are generally applicable only to a portion of thecontracts executed by Covance’s subsidiaries providing clinical services. Thefirst risk occurs when revenue recognized for services rendered is denominatedin a currency different from the currency in which the subsidiary’s expensesare incurred. As a result, the subsidiary’s net revenues and resultant earningscan be affected by fluctuations in exchange rates. Historically, fluctuationsin exchange rates from those in effect at the time contracts were executed havenot had a material effect upon Covance’s consolidated financial results. See “RiskFactors”.

 

The secondrisk results from the passage of time between the invoicing of customers underthese contracts and the ultimate collection of customer payments against suchinvoices. 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 currency transactiongain or loss, as applicable, and is reported in other expense (income) inCovance’s consolidated statements of income.

 

Finally,Covance’s consolidated financial statements are denominated in U.S. dollars.Accordingly, changes in exchange rates between the applicable foreign currencyand the U.S. dollar will affect the translation of each foreign subsidiary’sfinancial results into U.S. dollars for purposes of reporting Covance’sconsolidated financial results. The process by which each foreign subsidiary’sfinancial results are translated into U.S. dollars is as follows: incomestatement accounts are translated at average exchange rates for the period;balance sheet asset and liability accounts are translated at end of periodexchange rates; and equity accounts are translated at historical exchangerates. Translation of the balance sheet in this manner affects the stockholders’equity account, referred to as the cumulative translation adjustment account.This account exists only in the foreign subsidiary’s U.S. dollar balance sheetand is necessary to keep the foreign balance sheet stated in U.S. dollars inbalance. At September 30, 2007, accumulated other comprehensive income on theconsolidated balance sheet includes the cumulative translation account balanceof $45.9 million.

 

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

 

Covancesegregates its recurring operating expenses among four categories: cost ofrevenue; reimbursed out-of-pocket expenses; selling, general and administrativeexpenses; and depreciation and amortization. Cost of revenue includes directlabor and related benefits, other direct costs, shipping and handling fees, andan allocation of facility charges and information technology costs, andexcludes depreciation and amortization. Cost of revenue, as a percentage of netrevenues, tends and is expected to fluctuate from one period to another, as aresult of changes in labor utilization and the mix of service offeringsinvolving hundreds of studies conducted during any period of time. Selling,general and administrative expenses consist primarily of administrative payrolland related benefit charges, advertising and promotional expenses,administrative travel and an allocation of facility charges and informationtechnology costs, and excludes depreciation and amortization.

 

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.

 

**Quarterly Results**

** **

Covance’squarterly operating results are subject to variation, and are expected tocontinue to be subject to variation, as a result of factors such as (1) delaysin initiating or completing significant drug development trials, (2)termination or reduction in size of drug development trials, (3) acquisitionsand divestitures, (4) changes in the mix of our services, and (5) exchange ratefluctuations. Delays and terminations of trials are often the result of actionstaken by Covance’s customers or regulatory authorities and are not typicallycontrollable by Covance. Since a large amount of Covance’s operating costs arerelatively fixed while revenue is subject to fluctuation, moderate variationsin the commencement, progress or completion of drug development trials maycause significant variations in quarterly results.

 

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**Resultsof Operations**

** **

***Three Months Ended September 30, 2007 Compared with Three Months EndedSeptember 30, 2006.***Net revenues increased 16.0% to$396.0 million for the three months ended September 30, 2007 from $341.5million for the corresponding 2006 period. Excluding the impact of foreignexchange rate variances between both periods net revenues increased 13.7% ascompared to the corresponding 2006 period. Net revenues from Covance’s earlydevelopment segment grew 19.2%, or 16.5% excluding the impact of foreignexchange rate variances between both periods, driven by strength in toxicology,chemistry and clinical pharmacology services. Net revenues from Covance’slate-stage development segment grew 12.9%, or 11.1% excluding the impact offoreign exchange rate variances between both periods, driven by strength inclinical development and improved results in central laboratory services.

 

Costof revenue increased 15.5% to $258.4 million or 65.2% of net revenues for thethree months ended September 30, 2007 as compared to $223.7 million or 65.5% ofnet revenues for the corresponding 2006 period. Gross margins increased by 30basis points to 34.8% for the three months ended September 30, 2007 from 34.5%for the corresponding 2006 period.

 

Overall,selling, general and administrative expenses increased 12.7% to $61.1 millionfor the three months ended September 30, 2007 from $54.2 million for thecorresponding 2006 period. As a percentage of net revenues, selling, generaland administrative expenses decreased 50 basis points to 15.4% for the threemonth period ended September 30, 2007 from 15.9% for the corresponding 2006period.

 

Depreciationand amortization increased 12.8% to $16.4 million or 4.2% of net revenues forthe three months ended September 30, 2007 from $14.6 million or 4.3% of netrevenues for the corresponding 2006 period primarily as a result of higherlevels of capital spending over the last eighteen months.

 

Incomefrom operations increased 22.6% to $60.1 million or 15.2% of net revenues forthe three months ended September 30, 2007 from $49.0 million or 14.4% of netrevenues for the corresponding 2006 period. Income from operations from Covance’searly development segment increased $11.4 million or 28.4% to $51.8 million or26.0% of net revenues for the three months ended September 30, 2007 from $40.3million or 24.1% of net revenues for the corresponding 2006 period. Theexpansion in early development operating margin was driven by toxicology,chemistry and clinical pharmacology services. Income from operations fromCovance’s late-stage development segment increased $4.0 million or 13.1% to$34.4 million or 17.5% of net revenues for the three months ended September 30,2007 from $30.4 million or 17.5% of net revenues for the corresponding 2006period. Improvements in clinical development and increased central laboratoryservices operating margin were offset by a decline in operating margin inmarket access services primarily due to fewer new biological service launches.Corporate expense increased $4.4 million to $26.1 million or 6.6% of netrevenues for the three months ended September 30, 2007 from $21.7 million or6.4% of net revenues for the three months ended September 30, 2006. Included inCorporate expense is stock-based compensation expense of $5.7 million or 1.4%of net revenues for the three months ended September 30, 2007, as compared to$5.8 million or 1.7% of net revenues for the corresponding 2006 period. Thehigher level of Corporate expenses for the three months ended September 30,2007 as compared to the corresponding 2006 period reflects an increase incompensation-related expenses and investments in infrastructure to supporthigher levels of current and expected future growth.

 

Otherincome, net increased $0.8******million to $2.6 million for the three months ended September 30,2007 from $1.8 million for the corresponding 2006 period primarily as a resultof a $0.6******millionincrease in net interest income due to higher average invested cash balances inthe third quarter of 2007 and higher average interest rates earned on thosebalances.

 

Covance’seffective tax rate for the three months ended September 30, 2007 was 29.5%compared to 25.0% for the corresponding 2006 period. The effective tax rate forthe three months ended September 30, 2006 included the impact of a $2.5 millionreduction in income tax reserves resulting from several favorable income taxdevelopments arising in the third quarter of 2006. These developments includeda matter as to which closure was reached with a foreign tax authority relatingto research and development tax credits totaling $1.8 million as well asexposures as to which it was no longer probable that a liability existsrelating primarily to transfer pricing matters aggregating $0.7 million. Excludingthe impact of the 2006 tax reserve adjustment, Covance’s effective tax rate forthe three months ended September 30, 2006 would have been 29.9% as compared to29.5% for the three months ended September 30, 2007. The 40 basis point yearover year reduction in Covance’s effective tax rate is attributable to a numberof factors, including the mix of our pre-tax earnings across various taxjurisdictions and other planning initiatives.

 

Covancehas a minority equity position (approximately 20% at September 30, 2007) inBio-Imaging Technologies, Inc. (“BITI”). BITI uses proprietary medical imagingtechnologies to process and analyze medical images, and also provides other

 

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services, including the data-basing and regulatory submissionof medical images, quantitative data and text. For the three month periodsended September 30, 2007 and 2006, Covance recognized income of $0.1 millionand $0.02 million, respectively, representing its pro rata share of BITI’searnings.

 

Covancehas a 47% minority equity position in Noveprim Limited (“Noveprim”), a supplierof research products. For the three month periods ended September 30, 2007 and2006, Covance recognized $0.3 million and $0.2 million, respectively,representing its share of Noveprim’s earnings, less the elimination of profiton inventory purchased from Noveprim and still on hand at Covance at September30, 2007 and 2006.

 

Netincome of $44.6 million for the three months ended September 30, 2007 increased$6.3 million or 16.6% as compared to $38.3 million for the corresponding 2006period.

 

***Nine Months Ended September 30, 2007 Compared with Nine Months EndedSeptember 30, 2006.***Net revenues increased 13.9% to $1.14billion for the nine months ended September 30, 2007 from $997.2 million forthe corresponding 2006 period. Excluding the impact of foreign exchange ratevariances between both periods, net revenues increased 11.3% as compared to thecorresponding 2006 period. Net revenues from Covance’s early developmentsegment grew 22.4%, or 19.5% excluding the impact of foreign exchange ratevariances between both periods, driven primarily by strength in toxicology,chemistry and clinical pharmacology services. Net revenues from Covance’slate-stage development segment increased 6.4%, or 4.5% excluding the impact offoreign exchange rate variances between both periods. Strength in clinicaldevelopment more than offset softness in (1) commercialization services, dueprimarily to fewer new biological service launches; (2) cardiac safetyservices, due to low orders; and (3) central laboratory services, due to delaysin enrollment and longer trial durations and a shift in mix of studies.

 

Costof revenue increased 12.7% to $743.8 million or 65.5% of net revenues for thenine months ended September 30, 2007 as compared to $660.0 million or 66.2% ofnet revenues for the corresponding 2006 period. Gross margins increased by 70basis points to 34.5% for the nine months ended September 30, 2007 from 33.8%for the corresponding 2006 period.

 

Overall,selling, general and administrative expenses increased 13.8% to $175.0 millionfor the nine months ended September 30, 2007 from $153.8 million for thecorresponding 2006 period. Selling, general and administrative expenses as apercentage of revenues were 15.4% for each of the nine month periods endedSeptember 30, 2007 and 2006.

 

Depreciationand amortization increased 18.2% to $49.0 million or 4.3% of net revenues forthe nine months ended September 30, 2007 from $41.5 million or 4.2% of netrevenues for the corresponding 2006 period primarily as a result of higherlevels of capital spending over the last eighteen months.

 

Incomefrom operations increased 18.1% to $167.7 million or 14.8% of net revenues forthe nine months ended September 30, 2007 from $141.9 million or 14.2% of netrevenues for the corresponding 2006 period. Income from operations from Covance’searly development segment increased $29.5 million or 25.6% to $144.4 million or25.4% of net revenues for the nine months ended September 30, 2007 from $115.0million or 24.7% of net revenues for the corresponding 2006 period. Theexpansion in early development operating margin was driven primarily bytoxicology, chemistry and clinical pharmacology services. Income fromoperations from Covance’s late-stage development segment increased $4.6 millionor 5.0% to $95.5 million for the nine months ended September 30, 2007 from$90.9 million for the corresponding 2006 period. Income from operations as apercentage of net revenues decreased to 16.9% for the nine months endedSeptember 30, 2007 from 17.1% for the corresponding 2006 period. Strength inclinical development operating margin was offset by the operating margin impactof revenue softness in central laboratories, market access services and cardiacsafety services. Corporate expense increased $8.3 million to $72.3 million or6.4% of net revenues for the nine months ended September 30, 2007 from $64.0million or 6.4% of net revenues for the nine months ended September 30, 2006. Includedin Corporate expense is stock-based compensation expense of $16.8 million or1.5% of net revenues for the nine months ended September 30, 2007, as comparedto $15.2 million or 2.3% of net revenues for the corresponding 2006 period. Thehigher level of Corporate expenses for the nine months ended September 30, 2007as compared to the corresponding 2006 period also reflects an increase incompensation-related expenses and investments in infrastructure to supporthigher levels of current and expected future growth.

 

Otherincome, net increased $1.8 million to $7.0 million for the nine months endedSeptember 30, 2007 from $5.2 million for the corresponding 2006 period,primarily as a result of a $1.6 million increase in net interest income due tohigher average invested cash balances in the first nine months of 2007 andhigher average interest rates earned on those balances.

 

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Covance’seffective tax rate for the nine months ended September 30, 2007 was 29.4%compared to 28.1% for the corresponding 2006 period. The effective tax rate forthe nine months ended September 30, 2006 included the impact of a $2.5 millionreduction in income tax reserves resulting from several favorable income taxdevelopments arising in the third quarter of 2006. These developments includeda matter as to which closure was reached with a foreign tax authority relatingto research and development tax credits totaling $1.8 million as well asexposures as to which it was no longer probable that a liability existsrelating primarily to transfer pricing matters aggregating $0.7 million. Excludingthe impact of the 2006 tax reserve adjustment, Covance’s effective tax rate forthe nine months ended September 30, 2006 would have been 29.8% as compared to29.4% for the nine months ended September 30, 2007. The 40 basis point yearover year reduction in Covance’s effective tax rate is attributable to a numberof factors, including the mix of our pre-tax earnings across various taxjurisdictions and other planning initiatives.

 

Covancehas a minority equity position (approximately 20% at September 30, 2007) inBio-Imaging Technologies, Inc. (“BITI”). BITI uses proprietary medical imagingtechnologies to process and analyze medical images, and also provides otherservices, including the data-basing and regulatory submission of medicalimages, quantitative data and text. During the nine month periods endedSeptember 30, 2007 and 2006, Covance recognized income of $0.3 million andlosses of $0.1 million, respectively, representing its pro rata share of BITI’searnings (losses).

 

Covancehas a 47% minority equity position in Noveprim Limited (“Noveprim”), a supplierof research products. For the nine month periods ended September 30, 2007 and2006, Covance recognized $1.4 million and $1.0 million, respectively,representing its share of Noveprim’s earnings, less the elimination of profiton inventory purchased from Noveprim and still on hand at Covance at September30, 2007 and 2006.

 

Netincome of $125.0 million for the nine months ended September 30, 2007 increased$18.3 million or 17.2% as compared to $106.7 million for the corresponding 2006period.

 

**Liquidityand Capital Resources**

** **

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 June 2009 and may be expanded to $125.0million at Covance’s election. Covance believes cash from operations willprovide sufficient liquidity for the foreseeable future. At September 30, 2007,there were no outstanding borrowings and $1.1 million of outstanding letters ofcredit under the Credit Facility. Interest on all outstanding borrowings underthe Credit Facility is based upon the London Interbank Offered Rate (“LIBOR”)plus a 75 basis point margin. The Credit Facility contains various financialand other covenants. At September 30, 2007, Covance was in compliance with theterms of the Credit Facility. The Credit Facility is collateralized byguarantees of certain of Covance’s domestic subsidiaries and a pledge of 65percent of the capital stock of certain of Covance’s foreign subsidiaries.

 

Duringthe nine months ended September 30, 2007, Covance’s operations provided netcash of $176.1 million, an increase of $10.8 million from the corresponding2006 period. The change in net operating assets used $13.5 million in cashduring the nine months ended September 30, 2007, primarily due to an increasein accounts receivable, unbilled services and other current assets, partiallyoffset by an increase in accrued expenses and unearned revenue, while this netchange used $3.0 million in cash during the nine months ended September 30,2006, primarily due to an increase in prepaid expenses and other current assetsand unbilled services, partially offset by an increase in accrued expenses and incometaxes payable. Covance’s ratio of current assets to current liabilities was2.26 at September 30, 2007 and 2.21 at December 31, 2006.

 

Investingactivities for the nine months ended September 30, 2007 used $104.7 million,compared to using $145.6 million for the corresponding 2006 period. Capitalspending for the first nine months of 2007 totaled $104.8 million, and wasprimarily for the expansion of our preclinical facilities in North America andEurope, outfitting of new facilities, upgrade of existing equipment, and thepurchase of new equipment, hardware and software for newly hired employees. Capitalspending for the corresponding 2006 period totaled $71.8 million, and wasprimarily for the expansion of our Madison, WI and Harrogate, UK facilities,outfitting of new facilities, upgrade of existing equipment, and the purchaseof new equipment and software for newly hired employees. Investment activitiesfor the nine months ended September 30, 2006 included cash payments totaling$74.6 million for the acquisitions of Radiant Research Inc. and SignetLaboratories, Inc.

 

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Financingactivities for the nine months ended September 30, 2007 used $35.6 million andwas primarily comprised of the purchase into treasury of 977,000 shares ofcommon stock under the share buyback program authorized by Covance’s Board ofDirectors, and the purchase into treasury of 30,573 shares of common stock inconnection with employee benefit plans, for an aggregate cost of $61.6 million,partially offset by proceeds from the exercise of stock options of $17.7million, excess tax benefits realized on the exercise of stock options of $4.3million and employee contributions to Covance’s employee stock purchase plan of$4.0 million. Financing activities for the nine months ended September 30, 2006provided $26.2 million and was primarily comprised of proceeds from theexercise of stock options of $25.0 million, excess tax benefits realized on theexercise of stock options of $6.6 million and employee contributions to Covance’semployee stock purchase plan of $3.3 million, partially offset by the purchaseinto treasury of 150,017 shares for an aggregate cost of $8.7 million,primarily in connection with the share buyback program authorized by Covance’sBoard of Directors.

 

**Inflation**

** **

Whilemost of Covance’s net revenues are earned under contracts, the long-termcontracts (those in excess of one year) generally include an inflation or costof living adjustment for the portion of the services to be performed beyond oneyear from the contract date. As a result, Covance believes that the effects ofinflation generally do not have a material adverse effect on its operations orfinancial condition.

 

**Recently Issued Accounting Standards**

 

InSeptember 2006, the Financial Accounting Standards Board (the “FASB”) issuedStatement of Financial Accounting Standards No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and132(R),* (“SFAS 158”). As of December 31, 2006, Covance adopted therecognition and disclosure provisions of SFAS 158, which require an employer torecognize the over funded or under funded status of its defined benefitpostretirement plans – measured as the difference between the fair value ofplan assets and the projected benefit obligation - as an asset or liability,respectively, in its balance sheet and to recognize changes in the fundedstatus of the plan in the year in which such changes occur through othercomprehensive income. SFAS 158 also requires, effective for fiscal years endingafter December 15, 2008, that the measurement of the over funded or underfunded status of a plan be made as of the employer’s fiscal year end and not asof an earlier measurement date. Covance will be required to conform themeasurement dates of its plans to December 31st for its fiscal yearending December 31, 2008. Covance does not expect this change in measurementdates to have a material impact on its consolidated results of operations orfinancial position.

 

InSeptember 2006, the FASB issued Statement of Financial Accounting Standards No.157, *Fair Value Measurements,* (“SFAS157”). SFAS 157, which applies whenever other standards require (or permit)fair value measurement, defines fair value and provides guidance for using fairvalue to measure assets and liabilities. SFAS 157 also requires expandeddisclosures about the extent to which companies measure assets and liabilitiesat fair value, the information used in those measurements and the effect offair value measurements on earnings. Covance will be required to adopt SFAS157, which is effective for fiscal years beginning after November 15, 2007, nolater than the quarter beginning January 1, 2008. Covance does not expect theadoption of SFAS 157 to have a material impact on its consolidated results ofoperations or financial position.

 

***Forward Looking Statements.****Statements in this Management’s Discussion and Analysis of FinancialCondition and Results of Operations, as well as in certain other parts of thisQuarterly Report on Form 10-Q that look forward in time, are forward lookingstatements made pursuant to the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. Forward looking statements includestatements concerning plans, objectives, goals, strategies, future events orperformance, expectations, predictions, and assumptions and other statementswhich are other than statements of historical facts. All such forward lookingstatements are based on the current expectations of management and are subjectto, and are qualified by, risks and uncertainties that could cause actualresults to differ materially from those expressed or implied by thosestatements. These risks and uncertainties include, without limitation,competitive factors, outsourcing trends in the pharmaceutical industry, levelsof industry research and development spending, the Company’s ability tocontinue to attract and retain qualified personnel, the fixed price nature ofcontracts or the loss of large contracts, risks associated with acquisitionsand investments, the Company’s ability to increase order volume, the pace oftranslation of orders into revenue in late-stage development services, andother factors described in Covance’s filings with the Securities and ExchangeCommission, including its Annual Report on Form 10-K.*

 

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**Item 3. Quantitative and Qualitative DisclosureAbout Market Risk**

 

For the nine months ended September 30, 2007,approximately 37% of our net revenues were derived from our operations outsidethe United States. We do not engage in derivative or hedging activities relatedto our potential foreign exchange exposures. See “Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Foreign CurrencyRisks” for a more detailed discussion of our foreign currency risks andexposures.

 

**Item 4. Controls and Procedures**

 

Disclosure controls and procedures. The Company’sPrincipal Executive Officer and Principal Financial Officer have reviewed andevaluated the effectiveness of the Company’s disclosure controls and proceduresas of the end of the period covered in this report. Based on that evaluation,the Principal Executive Officer and the Principal Financial Officer haveconcluded that the Company’s current disclosure controls and procedures areeffective. There have been no significant changes in the Company’s internalcontrols or in the other factors that significantly affect those controls.

 

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**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 outlined below were to occur individually or in theaggregate, our business, results of operations, financial condition, and cashflows could be materially adversely affected.

 

**Changesin government regulation or in practices relating to the pharmaceuticalindustry could decrease the need for the services we provide.**

** **

Governmental agenciesthroughout the world, but particularly in the United States, strictly regulatethe drug development process. Our business involves helping pharmaceutical andbiotechnology companies navigate the regulatory drug approval process. Changesin regulation, such as a relaxation in regulatory requirements or theintroduction 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 government increases efforts to contain drug costsand pharmaceutical and biotechnology company profits from new drugs, our customersmay spend less, or reduce their growth in spending on research and development.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.

 

**Failureto comply with existing regulations could result in a loss of revenue orearnings or in increased costs.**

 

Any failure on our partto 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 to fail to properly monitor compliance byclinical trial investigators with study protocols, the data collected from thattrial could be disqualified. If this were to happen, we could be contractuallyrequired to repeat the trial at no further cost to our customer, but atsubstantial 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 contractsprovide for services on a fixed price or fee-for-service with a cap basis andthey may be terminated or reduced in scope either immediately or upon notice. Cancellationsmay occur for a variety of reasons, including:

 

•                  thefailure of products to satisfy safety requirements;

•                  unexpectedor undesired results of the products;

•                  insufficient patientenrollment;

•                  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 inscope or delay of a large contract or the loss or delay of multiple contractscould materially adversely affect our business, although our contractsfrequently entitle us to receive the costs of winding down the terminatedprojects, as well as all fees earned by us up to the time of termination. Somecontracts also entitle us to a termination fee.

 

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

 

Since our contracts areoften structured as fixed price or fee-for-service with a cap, we bear thefinancial risk if we initially under price our contracts or otherwise overrunour cost estimates. Such under pricing or significant cost overruns could havea material adverse effect on our business, results of operations, financialcondition, and cash flows.

 

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

 

We may seek to developand market new services that complement or expand our existing business orexpand our service offerings through acquisition. If we are unable to developnew services and/or create demand for those newly developed services, or expandour service offerings through acquisition, our future business, results ofoperations, financial condition, and cash flows could be adversely affected.

 

**Ourquarterly operating results may 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

•                  changesin the mix of our services.

 

We believe that operatingresults for any particular quarter are not necessarily a meaningful indicationof future results. While fluctuations in our quarterly operating results couldnegatively or positively affect the market price of our common stock, thesefluctuations may not be related to our future overall operating performance.

 

**We dependon the pharmaceutical and biotechnology industries**.

 

Our revenues dependgreatly on the expenditures made by the pharmaceutical and biotechnologyindustries in research and development. Accordingly, economic factors andindustry trends that affect our clients in these industries also affect ourbusiness. If companies in these industries were to reduce the number ofresearch and development projects they outsource, our business could bematerially adversely affected.

 

**Weoperate in a highly competitive industry.**

 

Competitors in the contract research organizationindustry range from small, limited-service providers to full service globalcontract research organizations. Our main competition consists of in-housedepartments of pharmaceutical companies, full-service and functional contractresearch organizations**,** anduniversities and teaching hospitals, although to a lesser degree. We compete ona variety of factors, including:

 

•                  reputation for on-time qualityperformance and regulatory compliance;

•                  expertise and experience in specificareas;

•                  scope of service offerings;

•                  strengths in various geographicmarkets;

•                  price;

•                  technological expertise and efficientdrug development processes;

•                  quality of facilities;

•                  ability to acquire, process, analyzeand report data in an accurate manner;

•                  ability to manage large-scaleclinical trials both domestically and internationally;

•                  expertise and experience in marketaccess services; 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 entitiesconsidering entering the contract research organization industry will find fewbarriers to entry, thus further increasing possible competition. Thesecompetitive pressures may affect the attractiveness of our services and couldadversely affect our financial results.

 

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**We mayexpand our business through acquisitions.**

 

We review manyacquisition candidates and, in addition to acquisitions which we have alreadymade, we are continually evaluating new acquisition opportunities. Factorswhich may affect our ability to grow successfully through acquisitions include:

 

•                  difficultiesand expenses in connection with integrating the acquired companies andachieving the expected benefits;

•                  diversionof management’s attention from current operations;

•                  thepossibility that we may be adversely affected by risk factors facing theacquired companies;

•                  acquisitionscould be dilutive to earnings, or in the event of acquisitions made through theissuance of our common stock to the shareholders of the acquired company,dilutive to the percentage of ownership of our existing stockholders;

•                  potentiallosses resulting from undiscovered liabilities of acquired companies notcovered by the indemnification we may obtain from the seller;

•                  risksof not being able to overcome differences in foreign business practices,language and other cultural barriers in connection with the acquisition offoreign companies; and

•                  lossof key employees of the acquired companies.

 

**We may beaffected by potential health care reform.**

 

In recent years theUnited States Congress and state legislatures have considered various types ofhealth care reform in order to control growing health care costs. We are unableto predict what legislative proposals will be adopted in the future, if any. Similarreform movements have occurred in Europe and Asia.

 

Implementation of healthcare reform legislation that contain costs could limit the profits that can bemade from the development of new drugs. This could adversely affect researchand 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 relyon third parties for important services.**

 

Wedepend on third parties to provide us with services critical to our business. Forinstance, we have entered into an agreement with IBM to manage certain aspectsof our information technology infrastructure. The failure of any of these thirdparties to adequately provide the needed services could have a material adverseeffect on our business.

 

**Ourrevenues and earnings are exposed to exchange rate fluctuations**.

 

We derive a large portionof our net revenues from international operations. For the nine month periodended September 30, 2007, we derived approximately 37% of our net revenues fromoutside the United States. Our financial statements are denominated in U.S.dollars. In addition, in certain circumstances, we may incur costs in onecurrency related to our services or products for which we are paid in adifferent currency. As a result, factors associated with internationaloperations, including changes in foreign currency exchange rates, could significantlyaffect our results of operations, financial condition and cash flows.

 

**The lossof our key personnel could 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 the nature of our business, our success isdependent upon our ability to attract and retain technologically qualifiedpersonnel. 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.

 

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**Contract research services create a risk ofliability**.

 

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

•                  errorsand omissions during a trial that may undermine the usefulness of a trial ordata from the trial.

 

Wealso contract with physicians, also referred to as investigators, to conductthe clinical trials to test new drugs on human volunteers. These tests cancreate a risk of liability for personal injury or death to volunteers,resulting from negative reactions to the drugs administered or fromprofessional malpractice by third party investigators. We believe that ourrisks in this area are generally reduced by the following:

 

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

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

•                  ourefforts to comply with various regulatory requirements we must follow inconnection with our business.

 

Contractualindemnifications generally do not protect us against liability arising from certainof our own actions, such as negligence or misconduct. We could be materiallyand adversely affected if we were required to pay damages or bear the costs ofdefending any claim which is not covered by a contractual indemnificationprovision or in the event that a party who must indemnify us does not fulfillits indemnification obligations or which is beyond the level of our insurancecoverage. There can be no assurance that we will be able to maintain suchinsurance coverage on terms acceptable to us.

 

**Reliance on air transportation**.

 

Ourcentral laboratories and certain of our other businesses are heavily reliant onair travel for transport of clinical trial kits and other material, productsand people, and a significant disruption to the air travel system, or ouraccess to it, could have a material adverse effect on our business.

 

**Certain service offerings andresearch products are dependent on limited sources of supply of services orproducts which if interrupted could affect our business.**

 

We depend on a limited number of suppliers for certainservices and for certain animal populations. Disruptions to the continuedsupply of these services or products may arise from export import restrictionsor embargoes, foreign political or economic instability, or otherwise.Disruption of supply could have a material adverse effect on our business.

 

**Actions of animal rights extremists may affect ourbusiness**.

 

Ourearly development services utilize animals in preclinical testing of the safetyand efficacy of drugs and also breed and sell animals for biomedical research. Suchactivities are required for the development of new medicines and medicaldevices under regulatory regimes in the United States, Europe, Japan and othercountries. Acts of vandalism and other acts by animal rights extremists whoobject to the use of animals in drug development could have a material adverseeffect on our business.

 

**Our animal populations may suffer diseases thatcan damage our inventory, harm our reputation, result in decreased sales ofresearch products or result in other liability to us.**

 

It is important that our research products be free ofdiseases, including infectious diseases. The presence of diseases can distortor compromise the quality of research results, can cause loss of animals in ourinventory, can result in harm to humans or outside animal populations if thedisease is not contained to animals in inventory, or can result in other losses.Such results could harm our reputation or have a material adverse effect on ourfinancial condition, results of operations, and cash flows.

 

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**Item 6. 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.*** |

 

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**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:  October 26, 2007 |   | 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                               |       |                                      |       |             |   |
|       Joseph  L. Herring    |       | Chairman  of the Board and                |       | October 26, 2007 |
|                                                      |       | Chief  Executive Officer                  |       |             |
|                                                      |       | (Principal Executive  Officer)            |       |             |
|                                                      |       |                                      |       |             |
| /s/  William E. Klitgaard                            |       |                                      |       |             |   |
|       William  E. Klitgaard |       | Corporate Senior  Vice President and      |       | October 26, 2007 |
|                                                      |       | Chief Financial  Officer                  |       |             |
|                                                      |       | (Principal  Financial Officer)            |       |             |
|                                                      |       |                                      |       |             |
| /s/  Michele A. Kennedy                              |       |                                      |       |             |   |
|       Michele  A. Kennedy   |       | Corporate Vice  President, Controller and |       | October 26, 2007 |
|                                                      |       | Chief Accounting  Officer                 |       |             |
|                                                      |       | (Principal  Accounting Officer)           |       |             |

 

30

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**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.*** |

 

31

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