Labcorp Holdings - Earnings Call - Q1 2017
April 25, 2017
Transcript
Operator (participant)
Good day, ladies and gentlemen, and thank you for standing by. Welcome to your Q1 2017 Labcorp earnings conference call. At this time, all participants are in a listen-only mode. Following management's prepared remarks, we will host a question-and-answer session, and our instructions will follow at that time. If during the conference you do need operator assistance, please press star then zero on your telephone keypad. As a reminder, this conference is being recorded for replay purposes. It is now my pleasure to hand the conference over to Mr. Scott Frommer, Vice President of Investor Relations. Sir, please proceed.
Scott Frommer (VP of Investor Relations)
Good morning and welcome to Labcorp's first quarter 2017 conference call. As detailed in today's press release, there will be a replay of this conference call available via telephone and internet. With me today are Dave King, Chairman and Chief Executive Officer; Glenn Eisenberg, Executive Vice President and Chief Financial Officer; and John Ratliff, CEO of Covance Drug Development. In addition to our press release, we also filed a Form 8K this morning that includes additional financial information. Both are available in the Investor Relations section of our website at www.labcorp.com and include a reconciliation of non-GAAP financial measures discussed during today's call to GAAP. Finally, we are making forward-looking statements during today's call. These forward-looking statements include, among others, statements about our expected financial results, the implementation of our business strategy, and the ongoing benefits from acquisitions.
These statements are based upon current expectations and are subject to change based upon various factors that could affect our financial results. Some of these factors are set forth in detail in our 2016 Form 10K. We have no obligation to provide any updates to these forward-looking statements, even if our expectations change. Now, I'll turn the call over to Dave King.
Dave King (Chairman and CEO)
Thank you, Scott, and good morning. Labcorp delivered another solid quarter to start 2017 with year-over-year revenue growth of 5%, adjusted EPS growth of 8%, and excellent free cash flow, and we returned $150 million to shareholders through share repurchases. We made strong progress on our enterprise-wide initiatives and turned in an outstanding performance in the diagnostics business. Customers continue to embrace our integrated solutions, as evidenced by two major health system partnerships, a record number of study wins based on combined data, and strong growth in companion diagnostics. In diagnostics, which represents 70% of our total revenue, we had excellent top-line growth with significant increases in total and organic volume and in revenue per requisition, leading to a 50 basis point expansion of our industry-leading margins.
Our diagnostics business is the backbone for our strong free cash flow, which we deployed judiciously in the quarter toward investing in the business, returning capital to shareholders, and growing through acquisitions. In drug development, our results were mixed. Although we are disappointed in our first quarter financial performance, we had some bright spots in the quarter, notably strong net orders, an improved book-to-bill, and better performance in the clinical business. These are all leading indicators that give us continuing optimism about the long-term growth characteristics of our company in 2018 and beyond. We continue to invest in the future of the drug development business. In the quarter, we again strengthened the leadership team and decided to expand Launch Pad to right-size the business in the near term and create a more scalable technology-enabled business for the future.
As I mentioned a moment ago, the strong growth in areas of strategic focus for the combined business demonstrates that customers are embracing our differentiated offering. I would like to update you on major developments during the quarter that highlight the unmatched value proposition of the combination of Labcorp Diagnostics and Covance Drug Development. We stated at the outset of the year that we are focused on the delivery of comprehensive integrated solutions to our customers' needs. Among the customers who need solutions in today's rapidly changing healthcare environment are health systems, and this quarter brought two important successes there. We announced an important transaction with Mount Sinai earlier this year that strengthens our position in the New York metro market, and we agreed on a significant partnership with PAML, a market-leading reference and outreach laboratory based in the Pacific Northwest.
Through PAML, we aligned ourselves with two innovative, fast-growing health systems and strengthened our relationships with over 10 community-based health systems across multiple states. Our offering to health systems and large provider groups is unique and extends beyond our multifaceted lab testing, operational, analytical, and clinical decision support expertise. The integration of our drug development solutions is a fundamental component of these relationships, enabling our partners to become research hubs. Patients gain greater access to high-quality care through clinical trials, providers will realize increased revenue tied to patient enrollment, and our biopharma customers will benefit from faster site activation and recruitment capabilities. The level of interest in our combined set of solutions from leading health systems has increased significantly, and we continue to be pleased at the very robust set of opportunities.
Another of our unique capabilities is the powerful combination of Labcorp Diagnostics' patients' data and Global Covance's physician investigator performance data. Through these proprietary data sets, we continue to provide unique insights that help us win orders. During the quarter, the use of Labcorp data played an important role in securing multiple awards with an aggregate value of more than $150 million, by far our strongest quarter to date. This brings our cumulative orders from the use of Labcorp data to more than $350 million, and I'll provide three concrete examples that highlight how we're using these capabilities to solve problems for our patients and customers. In the first example, we observed that approximately 18% of type 2 diabetes patients in our database had evidence of moderate kidney disease.
We worked with our client on the design of the study protocol, showing them that through minor changes in inclusion and exclusion criteria, we could safely increase the study-eligible patient population by over 50%. In the second example, we identified more than 30,000 patients in our database who were diagnosed in the past five years with myelofibrosis, a rare disease with few treatment options. Forty of these patients had opted in through the Labcorp patient portal to receive information about clinical trials, providing an opportunity for direct outreach to these consenting patients. The client cited this capability as a significant factor in the decision to choose Covance. The fusion of our combined capabilities spawns unique solutions at all stages of drug development, including real-world evidence. For example, we partnered with a large customer interested in certain biomarkers associated with use and non-use of a commercially available product.
Through this collaboration, Covance screens and enrolls subjects, distributes study kits to patients' homes, collects surveys, coordinates visits to Labcorp patient service centers for blood draws, runs laboratory tests, and makes reminder calls to subjects. These are but three of many examples of our customers' increasing desire to deploy our innovative solutions, only available through Labcorp, to solve their real-world problems. Finally, we continue to drive strong growth across the enterprise in companion diagnostics through additional customer partnerships, increased PD-L1 testing in Labcorp Diagnostics, collaboration on the development of tests tied to new immuno-oncology drugs and indications, as well as the expansion of our CDX offering to neurodegenerative disorders and rare endorphin diseases. As part of our investment in this business, we will open a dedicated companion diagnostics laboratory in North Carolina later this year to address rapidly growing demand.
The individual business units also had important successes in the quarter. After a comprehensive search, we announced the promotion of Gary Huff to the position of CEO of Labcorp Diagnostics. Gary has more than 25 years of commercial and operational expertise in the clinical laboratory industry. His last two roles before rejoining Labcorp were as Chief Operating Officer of a health system-affiliated outreach laboratory and as CEO of a JV between a commercial laboratory and an academic medical center. He brings deep experience with the requirements for success in forming laboratory partnerships with health systems and integrated delivery networks. Gary will join us beginning with our second quarter earnings call. I mentioned the success of our health system partnership strategy a few moments ago.
During the quarter, our diagnostics business formed a laboratory alliance with HCA in Virginia that will provide reference testing to four hospitals and more than 100 community physicians, optimize HCA's local lab footprint, maintain rapid results on staff testing, and establish a more streamlined lab results interface. In these settings, we are the provider of choice to provide high-quality patient care, integrate high-value IT and analytics tools, and reduce healthcare costs. We also continue developing our patient-facing capabilities, including improved online appointment scheduling and bill payment capabilities, self-service registration in patient service centers, and a completely revamped patient portal. These technologies enable direct communication with Labcorp patients, presenting valuable opportunities to grow our database of about 120,000 patients that have consented to be contacted about future clinical trials.
Through continued improvement of the patient portal user experience and refinement of the opt-in process, the rate of patients opting in has doubled, accelerating the value of this strategic differentiator. We are also implementing system-wide solutions to help patients make financial decisions related to our services. We can now check eligibility for services when the patient is in our facility, create a personalized estimate of the cost of services before a blood draw, and collect any balance due from the patient at the time of service. We also recently launched a web-based cost estimator for our non-invasive prenatal testing that allows consumers to estimate their cost for testing services based on their health insurance. In combination, these initiatives will improve the patient experience with Labcorp, increase our net promoter scores among our customers, and build customer and brand loyalty.
As part of our initiative to bring services closer to patients, we are exploring new business models to provide long-term growth opportunities, including piloting mobile phlebotomy, evaluating additional services that we can offer through our PSCs, and investing in innovative at-home collection devices. As you can see, we are driving innovation throughout our diagnostic offering on many fronts. Covance Drug Development is the only CRO providing the full spectrum of drug development capabilities, from research to real-world evidence studies, creating a commercial and scientific advantage for our partners. During the quarter, we entered into a contract for a full programmatic award of nine type 2 diabetes studies with a top-tier pharma partner. In this instance, our broad-based alliance involves the delivery of clinical, central lab, and early development solutions. We believe that this powerful end-to-end strategy will yield future cross-functional awards and help us accelerate long-term revenue and profit growth.
In addition, we continue to concentrate our sales efforts on higher-value therapeutic areas: oncology, CNS disorders, genetics, and rare endorphin diseases. Our combined company scientific expertise in these areas is significant and has driven an increase in the portion of our backlog tied to these therapeutic categories. These developments, combined with our improving orders and book-to-bill ratio, give us continued optimism about Covance's future. Nonetheless, there is more we can do to improve the delivery of services at Covance. We have therefore decided to expand our highly successful Launch Pad initiative to include Covance. Through Covance's Launch Pad, we will right-size the business, re-engineer our drug development systems and processes, and deploy technological advancements to improve service while maintaining the highest quality and sustainably reducing our cost base. Glenn will provide financial and other details on this initiative in a few moments.
In closing, we are in the early stages of capitalizing on multiple growth opportunities across our global markets. We are pleased with the success of our solutions-focused selling and our continued progress in repositioning ourselves to meet the needs of a rapidly changing healthcare system. Driven by the outstanding work of more than 50,000 colleagues around the world, we continue to create unique solutions to our customers' problems, improve the health and lives of patients worldwide, unlock profitable growth, and increase long-term shareholder value. Now, I'll turn the call over to Glenn.
Glenn Eisenberg (EVP and CFO)
Thank you, Dave. I'm going to start my comments with a review of our first quarter results, followed by a discussion of our Labcorp Diagnostics and Covance Drug Development segments, and conclude with an update on our 2017 guidance.
Revenue for the quarter was $2.4 billion, an increase of 4.9% over last year, due to solid organic growth in Labcorp Diagnostics and acquisitions, partially offset by unfavorable currency translation of 40 basis points. Organic revenue growth in the quarter on a constant currency basis was 2.7%. Operating income for the quarter was $333 million, or 13.8% of revenue, compared to $300 million, or 13% last year. Adjusted operating income, which excludes amortization, restructuring charges, and special items, was $391 million, or 16.2% of revenue, compared to $373 million, or 16.3% last year. The increase in adjusted operating income was primarily due to favorable price, mix, and acquisitions, partially offset by higher personnel costs in Covance Drug Development. The tax rate for the quarter was 31.2%, compared to 35.2% last year.
The adjusted tax rate, excluding special charges and amortization, was 31.5%, down from 34.8% last year, primarily due to the expected tax benefit from stock-based compensation. The increase in the tax benefit from stock-based comp was primarily driven by the increase in the company stock price when shares vested in the first quarter of this year, compared to the price when shares vested last year. This benefit was included in our prior full-year tax rate guidance, which we continue to expect to be approximately 34%. Net earnings for the quarter were $192 million, or $1.84 per diluted share. Adjusted EPS, which excludes amortization, restructuring charges, and other special items, were $2.22 in the quarter, up 8% over last year. Operating cash flow was $234 million in the quarter, compared to $128 million a year ago.
The increase of $106 million was primarily due to higher earnings and improved working capital management. Capital expenditures totaled $72 million, or 3% of revenue, compared to $71 million, or 3.1% last year. As a result, free cash flow was $162 million in the quarter, up from $56 million last year. At the end of the quarter, our cash balance was $366 million, down from $434 million at the end of 2016. During the quarter, we invested $152 million in acquisitions and repurchased $150 million of stock. As of March 31st, we had $590 million of authorization remaining under our share repurchase program. Total debt at quarter end was approximately $5.9 billion. The company's leverage at the end of the quarter was 3.1 times gross debt to last 12 months EBITDA, comparable to our leverage ratio at the end of 2016.
Now, I'll review our segment performance, beginning with Labcorp Diagnostics. Revenue for the quarter was $1.7 billion, an increase of 8% over last year. The increase in revenue was driven by acquisitions, price mix, and organic volume measured by requisitions. Revenue per requisition increased 3.8%, benefiting from price, mix, and the Sequenom acquisition. In addition, esoteric testing grew at a faster rate than core testing. Total volume increased 4.3%, of which organic volume was 1.8%. Acquisition volume was 2.5%, which was primarily driven by tuck-in acquisitions that have not yet annualized. Labcorp Diagnostics' adjusted operating income for the quarter was $341 million, or 19.9% of revenue, compared to $308 million, or 19.4% last year. The increase in operating income and 50 basis point margin improvement were primarily due to solid organic revenue growth, acquisitions, and the benefit from our Launch Pad initiative.
Labcorp Diagnostics remains on track to achieve its Launch Pad savings of $150 million over the three-year period ending this year. Now, I'll review the performance of Covance Drug Development. Revenue for the quarter was $690 million, a decline of $13 million, or 1.8% from last year. Excluding the impact from approximately 150 basis points of negative currency, revenue was roughly flat compared to last year. During the quarter, revenue increased in the clinical development business. This increase was offset by the decline in revenue in the early development and central lab businesses, primarily due to slower revenue conversion from the backlog and the previously discussed cancellation by sponsors of two large clinical studies in late 2016, for which we provided central lab services.
Execution of our strategy, which is focused on higher-value therapeutic areas such as oncology and CNS disorders, resulted in a higher percentage of our backlog tied to complex studies that continue to convert into revenue at a slower pace. Covance Drug Development's adjusted operating income was $83 million, or 12.1% of revenue, compared to $103 million, or 14.7% last year. The decline in operating income and margin was primarily due to higher personnel costs, including targeted strategic investments in the clinical business to support future growth, partially offset by cost synergies. We remain on track to achieve our target of $100 million in cost synergies through the three-year period ending this year, as we expect to complete the consolidation of our central lab facilities by the middle of the year. In addition, the company expanded its Launch Pad initiative to now include Covance Drug Development.
This initiative will be a three-year program for Covance that consists of two phases. We recently initiated the first phase to right-size Covance Drug Development's resources, primarily headcount and facility footprint. This phase is expected to generate pre-tax savings of approximately $20 million in 2017 and approximately $45 million on an annualized basis thereafter. The pre-tax cost to achieve these savings is estimated to be approximately $30 million in 2017, of which around $20 million is expected to be cash expenditures. The second phase will focus on re-engineering our systems and processes and improving productivity, which will contribute to sustained margin improvement over time. Planning for the second phase is underway, and we will provide additional details later this year. Covance Drug Development's net orders and net book-to-bill for the trailing 12 months were $3.2 billion and $1.15 billion, respectively, a sequential improvement over the 12-month period ending December 31, 2016.
Backlog at the end of the quarter was $5.2 billion, an increase of $300 million over year-end backlog, and we expect approximately $2.1 billion of this backlog to convert into revenue over the next 12 months. Now, I'll update our 2017 guidance, which assumes foreign exchange rates as of March 31 for the remainder of 2017 and includes the impact of the expansion of Launch Pad in Covance Drug Development, as well as anticipated capital allocation. We expect reported revenue growth of 3.5%-5.5% after adjusting for the negative impact from approximately 40 basis points of foreign currency translation. This is lower than our prior guidance by 100 basis points due to lower-than-expected revenue growth in Covance Drug Development, partially offset by higher-than-expected revenue growth in Labcorp Diagnostics.
We expect Labcorp Diagnostics' reported revenue growth of 5%-7% after adjusting for the negative impact from approximately 10 basis points of foreign currency translation. This is an increase from our prior guidance of 4.5%-6.5%, primarily due to better-than-expected organic volume growth. We expect Covance Drug Development reported revenue growth of 0%-2% after adjusting for the negative impact from approximately 130 basis points of foreign currency translation, which is lower than our prior guidance by 350 basis points. On a constant currency basis, we expect revenue growth of 1.3%-3.3%, which is also lower than our prior guidance, primarily due to our first quarter results, as well as the mix of contracted awards won during the quarter. Clinical development orders remain strong and typically take longer to convert into revenue.
In addition, our strategy to focus on high-value therapeutic areas, such as oncology, has resulted in a higher percentage of our backlog tied to complex studies that continue to convert into revenue at a slower pace. From a timing perspective, we expect Covance Drug Development's revenue and margins to sequentially increase throughout the year. However, we expect revenue and margins in the second quarter to be down year-on-year before showing favorable growth in the second half of 2017 compared to last year. Our 2017 adjusted EPS guidance is $9.20-$9.60, an increase of 4%-9% over 2016, and lower than our prior guidance of $9.35-$9.75 due to lower revenue growth expectations.
We expect a decline in our earnings outlook to primarily apply to our results in the second quarter due to the timing of revenue growth and the benefit from the expansion of our Launch Pad initiative in the second half of 2017. In addition, our second quarter results will also be negatively impacted by the timing of the Easter holiday, as well as the year-over-year comparison of leap year. We expect free cash flow to be between $925 million and $975 million, unchanged from our prior guidance. This concludes our formal remarks, and we'll now take questions. Operator.
Operator (participant)
Thank you. Thank you, sir. Ladies and gentlemen, at this time, if you would like to ask a question over the phone, please press star and then one on your telephone keypad. In the interest of time, we ask that everyone please limit themselves to one question, then rejoin the queue.
If your questions have been answered or you just wish to remove yourself from the queue, please press the pound key. Our first question will come from the line of Lisa Gill with JPMorgan. Please proceed.
Lisa Gill (MD and Head of Healthcare Services Research)
Thanks very much. And good morning. I just wanted to go quickly back to Glenn, your comment about favorable growth in margins in the second half. Is that primarily due to the Covance Launch Pad, or is there something else that's going to be driving that?
Glenn Eisenberg (EVP and CFO)
Yeah. No, a couple of things, Lisa. First, I think your reference of Covance. We expect to see sequentially improving revenues as we go throughout the year, even though for the second quarter, we expect revenues to be down year-on-year. The second half will be up in the third and fourth quarter. We expect year-over-year. So that's going to help drive the improvement.
To your point, in addition, with the Launch Pad initiative now moving to Covance, the bulk of the savings in 2017 will be recorded in the second half. Obviously, that will improve their margins in the third and fourth quarter, year-over-year as well.
Lisa Gill (MD and Head of Healthcare Services Research)
I apologize if you already went through this earlier, but I just want to better understand what is happening on the Covance side, especially on the organic side. I think when Dave, you gave guidance last quarter talking about the organic growth in this business and your expectations around the business. Can you maybe just give us a little more color as to what you're seeing in the marketplace? I know when we had a call a few weeks ago, we talked about the fact of insourcing, outsourcing, and you were not really seeing the impact there.
We already knew about some of the customer delays and cancellations. What else is happening in the market?
John Ratliff (CEO of Covance Drug Development)
Yeah. I'll take that on, Lisa. This is John. Inside the first quarter, we obviously saw a mix of contracted awards that were won and/or delayed. Clinical orders were strong, to give you color. That actually takes, obviously, longer to convert into revenue than our early development and/or even our central labs to a certain extent. Secondly, we saw within the backlog, we are increasingly raising our penetration within the oncology, CNS, rare endorphin, and this higher percentage of our backlog tied to those complex studies are also converting into revenue at a slightly slower pace. We did see delays in certain key customers' pipelines to the second quarter, third, and fourth.
Pleased, overall, with the net orders that we saw within the quarter. In terms of the long-term growth and specifically based on the data involved with the Labcorp and the Covance areas, we saw our largest quarter to date, about $150 million in the quarter, about $350 million of new awards cumulative due to the combination of the data sets and how that then drove wins within the quarter in terms of the aggregate book-to-bills.
Lisa Gill (MD and Head of Healthcare Services Research)
Okay. Thanks.
Operator (participant)
Thank you. Our next question will come from the line of Jack Meehan with Barclays. Please proceed.
Jack Meehan (Equity Research Analyst)
Hi. Thanks. Good morning. I wanted to follow up on the change in the view at Covance just over the past month. I'm surprised early development was cited as a weak area. Could you talk about the trends there? And then maybe just the magnitude of the weakness for central lab would also be helpful.
John Ratliff (CEO of Covance Drug Development)
Again, John, in terms of the early development in aggregate, strong area, but saw certain delays in terms of specific customer pipelines within lead optimization, etc. At the same time, saw strength in our backlog and book-to-bill. Did have a little bit of a mix of awards to clinical versus pure preclinical, and that drove a little bit of the delay in revenue conversion. Strong area looking at the pipeline of orders going forward and the opportunities that we see in terms of for the balance of the year. In terms of central labs, we did see a real shutdown in those two cancellations within the quarter, and central labs were affected by what I previously just mentioned, the penetration in oncology. They are seeing a stretch out in terms of the revenue conversion. Those are really the two areas that we saw affected.
I'll proactively address one last question. That is, if you look at our segment, clinical is growing above the actual total Covance revenue growth projected with the labs and early development below.
Jack Meehan (Equity Research Analyst)
That is helpful. Then, Glenn, I wanted to ask you about the volume growth in the quarter. As you've looked at the numbers, do you think the calendar was a headwind or a tailwind in the quarter? Or otherwise, what do you attribute to the step-up in the activity there?
Glenn Eisenberg (EVP and CFO)
Yeah. No, we did benefit, obviously, from the, call it the Easter holiday, falling in the second quarter. It obviously was a year-over-year improvement. The calendarization, interestingly enough, with leap year really impacts our second quarter much more than the first.
If you look at the first quarter, a slight tailwind, slight help to the organic volume, it's truly, call it an improvement in our volume as opposed to just the calendarization. As we look to the second quarter, you'll see a more substantial headwind for us. Between Easter falling into the second quarter, between the calendarization of how it matches up for us year-over-year, you're looking at a more substantial impact, probably around a point and a half, give or take, on our volume in the second quarter. For the first quarter of the 18, call it 30 basis points, we would consider being, call it calendarization/Easter.
Jack Meehan (Equity Research Analyst)
Very helpful. Thank you.
Operator (participant)
Thank you. Our next question will come from the line of Nicholas Jensen with Raymond James. Please proceed.
Hey, guys.
I just wanted to get an update on the contract negotiations that you're doing with United right now. How do we think about the timeline there? If there's anything of note in terms of relative size as they've grown quite nicely relative to the other managed care organizations over the last two to three years. Thanks.
Dave King (Chairman and CEO)
Morning. Nick, it's Dave. Obviously, as we've said, we've been engaged with United at the managed care team level for a significant period of time. They've been a terrific partner to us, and I think we've been a terrific partner to them. Over the last six months, we've become also significantly engaged at the senior executive level, involving a good deal of my time. I'm pleased with where we are. I think there's a recognition on both sides of the strength of the partnership and the value of the partnership.
We would like to get something done in 2017. I can't give you any further update other than I think both sides are committed to a fair resolution of the contract discussion and something that rewards us both for the value of the partnership over the now 10+ years.
Great. And then just quick follow-up in terms of the amount of M&A spent in the quarter. I think like $150 million or so of M&A activity. Can you maybe just walk us through your pipeline, how you're seeing that evolve over the last 6 to 12 months? Is the pending PAMA legislation driving increased interest from both health systems and others to perhaps look to you guys as an exit strategy? Just want to get your thoughts on M&A spend because that was a little bit bigger than we had thought in the quarter. Thanks.
I think the M&A pipeline continues to be very robust, and I attribute that to the not so much to PAMA because I think singling out any one factor is a little misleading. Just the general change in the healthcare environment. We're seeing a big push to value-based payment. We're seeing a big push to being able to procure services, the highest quality services at the most effective cost. As hospitals and smaller laboratories are recognizing that trend, I think a lot of them are relooking at, "Do we belong in this business? Is it a core competency? Are we bringing value to the patient?" I think when you add in the research hub capabilities that Covance brings us, we have a strong differentiated position in doing these really deep comprehensive hospital partnerships, health system partnerships.
You can expect us to continue to work on those. We are going to be opportunistic about what is available in the acquisition market and allocate our capital appropriately.
Thanks for the color.
Operator (participant)
Thank you. Our next question will come from the line of Amanda Murphy with William Blair. Please proceed.
Amanda Murphy (Partner of Life Sciences Tools and Diagnostics Senior Analyst)
Hi. Good morning. I just had a question, I guess, for John first to start off with. You had commented about some of the delays that you saw in terms of customer pipeline, I think you said both preclinical and clinical. I just was wondering if you could give some context there. Is there anything sort of macro that you could point to that might be driving that, or is that customer-specific?
John Ratliff (CEO of Covance Drug Development)
It is customer-specific and nothing macro. It is purely a pause in their very specific pipeline of activities that hit us in one to two areas.
Amanda Murphy (Partner of Life Sciences Tools and Diagnostics Senior Analyst)
Okay.
Got it. Dave, just a question for you on the hospital side. Obviously, you talked about developing deep partnerships. I was curious what your thoughts are around looking at some of the more lab management-type contracts going forward. Is that something that would be of interest to you moving into more of the inpatient, outpatient side of the business?
Dave King (Chairman and CEO)
Amanda, lab management can be a part of a comprehensive partnership with the health system. We are not opposed to lab management contracts. We have plenty of them in our business. What we are not out looking for is lab management contracts where essentially the value that we are bringing is rebadging employees and offering supply chain savings because in our view, that is not a high-margin business. It is well below our operating margins. It is an extremely high-touch business because of the nature of inpatient hospital services.
Pure lab management contracts alone are not particularly attractive to us. Our strategy has always been the lab management contract might be part of a comprehensive overall partnership that includes, obviously, our reference testing capabilities, our population health capabilities, our analytics capabilities, the Covance piece. Those are the types of partnerships we're doing. I think the announcements that you've seen in the quarter with Mount Sinai and with PAML, which are, again, you have three tremendously innovative market-leading health systems that are deciding that they want to associate themselves with Labcorp. I think that speaks volumes about the success of our hospital strategy.
Amanda Murphy (Partner of Life Sciences Tools and Diagnostics Senior Analyst)
Got it. Thank you very much.
Operator (participant)
Thank you. Our next question will come from the line of Ross Mukin with Evercore. Please proceed.
Hey, guys. It's Luke on for Ross today. I just start off on the CRO market.
Are you seeing any change to the contracts that are or the RFPs that are out there, specifically an increase in fee-for-service versus the strategic relationships?
John Ratliff (CEO of Covance Drug Development)
This is John. I think you're seeing a blend of that, a mix of that. There are certain of the strategics even that have moved to that more functional service provider, more for that fee-for-service that I think you're referencing even within their own mix. It's a vital part of our mix within the phase two, three, four. We see that playing out with a specific customer set. In terms of if you look across the portfolio, if you're asking, "Is there more of a shift to that?" I think we've seen that evolution over the last five years in terms of the use of that model. You're seeing that continue.
There has not been any radical within the last six months, "I'm going to shift to more of that FSP model than prior." You clearly have to have that in your repertoire in terms of addressing the different models of clinical.
Okay. Great. That's helpful. I guess, lastly, on the pricing market within the CRO business, are you guys seeing any bad behavior out there when these contracts are up?
No. Have not seen any individual going for share or in terms of low pricing. It's a pretty stable market.
Okay. Great. Thanks.
Operator (participant)
Thank you. Our next question will now come from the line of Dan Leonard with Deutsche Bank. Please proceed.
Dan Leonard (Equity Analyst)
Thanks. First question. Does the reduced outlook in Covance and the implementation of some Launch Pad initiatives there, does that impact at all your appetite to grow that business inorganically, or do you think that's unrelated?
Dave King (Chairman and CEO)
Dan and Dave. I just want to point out that the reduced outlook is 1% of a $10 billion revenue company. This is not a dramatic reduction either in our perspective on revenue or on earnings. It is not in any sense an indication that we are displeased with the Covance business. I would cite, again, what I referred to in my prepared remarks. You look at the ways in which the combined organizations are generating business that you do not hear anybody else talking about, the depth of the health system partnerships that we are doing, the use of the data and real examples of how the data is helping us to win, the companion diagnostics business. These are terrific success stories. We are two years into this. It was a major transformational acquisition.
We're very, very enthusiastic about the long-term opportunity here because the growth rate in the CRO industry has historically been higher than the lab industry because of the opportunity to expand our business on a more global scale. No, it does not in any way diminish our enthusiasm for continuing to grow the CRO business.
Dan Leonard (Equity Analyst)
That's helpful color. Thank you. Just a housekeeping question for Glenn. Glenn, is PAML in the new guidance for 2017, or are you waiting for those parts of the transaction to close before you include them in guidance?
Glenn Eisenberg (EVP and CFO)
Yeah. No. As we said earlier, just in general, we have capital allocation including in our guidance, including M&A. I think it's fair to say that obviously we announced two health system transactions that we expect both to close this year.
So it's fair to say that we have assumed those transactions would have an impact this year.
Dan Leonard (Equity Analyst)
Got it. Thank you.
Operator (participant)
Thank you. Our next question will come from the line of Steven Valiquette with Bank of America. Please proceed.
Steven Valiquette (MD and Equity Research Analyst)
Thanks. Good morning, everybody. I guess I'm just thinking about the current CRO results. Do you think that if you did have a more comprehensive service offering in the market, particularly with greater late-stage development infrastructure, would that help to lift the revenue and even results you're currently generating in the early-stage development and central lab components of your operations? Is that a big key to success here on the overall CRO apps if you do add more late-stage capabilities? Just curious to get more thoughts on that. Thanks.
John Ratliff (CEO of Covance Drug Development)
Again, John, I think we actually have very viable late-stage offering.
At the same time, we know organically we need to push through in certain therapeutic areas and internationally expansion and then even embracing some of the new models flowing through. We see obviously areas of the strategy that we're going to embrace. I also know within that post-marketing phase four area, we could have greater penetration. From our vantage point, having early preclinical development as well as then central labs does differentiate us from everyone else. I believe that, A, our leadership in labs and ED can bring our clinical business forward as well as strengthening clinical can then bring forward greater penetration within that early development as well. It works both ways. We know we got work to do on the expansion territories in that late-stage area. Those are what I just addressed.
Steven Valiquette (MD and Equity Research Analyst)
Okay.
I mean, you mentioned a new model in late-stage. I'm pretty sure I know what you're talking about. But maybe just to avoid any confusion, do you want to clarify what you're thinking about on new models in terms of servicing clients in late-stage?
John Ratliff (CEO of Covance Drug Development)
I think as you've seen, more and more we're moving to much more of a risk-based model. You're moving to more and more of a pricing based on value, based on outcomes, etc. That's one point of reference. There's different channels off of the FSP model that we were talking about before being addressed. These are at their infant state. At the same time, you need to be prepared for those and then move those forward within the scope of your total portfolio.
Steven Valiquette (MD and Equity Research Analyst)
Okay. Got it.
John Ratliff (CEO of Covance Drug Development)
Okay. Thanks.
Operator (participant)
Thank you.
Our next question will come from the line of Ralph Giacobbe with Citi. Please proceed.
Ralph Giacobbe (Head of US Health Care Research and MD)
Thanks. Good morning. Just on the Covance side, Ian mentioned higher personnel costs. I think you brought that up last quarter as well in terms of, I guess, increased Salesforce costs. Is there anything else maybe driving those pressures? If there is, where is that coming from? How do you combat that? More broadly, if you can give us maybe where you are thinking in terms of long-term margin profile at this point on the CRO side of the business. Thank you.
John Ratliff (CEO of Covance Drug Development)
From the standpoint of, yes, there were specifically strategic investments that were put through all of last year in terms of whether it's in the Salesforce, whether it's in certain of the therapeutic areas, whether it was on staffing clinical to the backlog.
At the same time, anytime you have those personnel on board and then you have now flat revenues within the first quarter, obviously you have to address that. In terms of your comment on combating that, that's the reference first phase of a Launch Pad, which is a $45 million annualized savings. At the same time, then around $20 million-$25 million in the second half of the year for 2017. Those are the majority being resources. Clearly what you're trying to do is align revenues with the resources. Longer term, I think from the vantage point of longer-term margins, we obviously see the business models of our competitors and know we have room to move on that. We'll obviously be addressing that in terms of, A, the Launch Pad, longer-term initiatives that we'll give more details on to the later part of this year.
Ralph Giacobbe (Head of US Health Care Research and MD)
Okay. Thanks. And then Dave, any updated thoughts on PAMA at this point, just given recent news there?
At the ACLA annual meeting, there was actually a presentation by CMS about data collection. We met with some CMS officials, industry representatives met with CMS officials to talk about we were continuing to have difficulty loading data. We requested a delay. That delay was granted, as you saw, to continue to put the data in. That is a positive. I continue to be, and I think our team continues to be, frustrated that the data collection process is not designed in a terribly efficient way. The amount of data that will be generated is going to be enormous.
Dave King (Chairman and CEO)
It raises the question of can the data be analyzed in a meaningful way between now and when CMS is supposed to put the proposed rule out? I think more fundamentally, Ralph, the issue continues to be the incorrect definition of applicable laboratories. The definition that the prior rule came up with is inconsistent with the legislative intent. It's inconsistent with, for colloquy. We supported that as we, the industry, supported PAMA as a way to bring market-based pricing to our industry. The way the rule has been generated, 95% of the hospitals are not going to be included, which means their commercial pricing, which is multiples above ours, is not going to be considered to be part of the "market." There's an irony there because when we talk about acquisitions, the hospital systems are considered to be part of the market.
When we talk about the PAMA pricing, hospital systems are not considered to be part of the market. We continue to push with CMS to revisit the definition. We are hopeful that they will do that and that we will, as a result, get a rule and an implementation of the legislation that is consistent with what Congress and the industry agreed that we wanted to do.
Ralph Giacobbe (Head of US Health Care Research and MD)
Okay. Helpful. Thank you.
Operator (participant)
Thank you. Our next question will come from the line of Bill Quirk with Piper Jaffray. Please proceed.
Alex Nowak (Assistant VP and Research Analyst)
Great. Good morning, everyone. This is Alex Nowak on for Bill today. This one is for John. I just want to be clear. You issued 2017 guidance at the end of February.
Should we read into that that you saw a number of more complex orders come in or a number of higher mix contracts come in that just took longer to convert over the timeframe, over the March timeframe? That is what's forcing you to lower your Covance guidance? I guess what I'm getting at is basically what happened today versus two months ago?
John Ratliff (CEO of Covance Drug Development)
The answer is we did see a higher level of clinical orders, which obviously take longer to convert. We did see a higher percentage of the actual orders going in that were oncology CNS-based, which are obviously converting into revenue at a slower pace. We had delays in the key customer pipelines that happened in that last 60 days that were more tactical-based. Those are the reasons why the reduced outlooks within the Covance revenue.
Dave King (Chairman and CEO)
It's Dave, I just want to add quickly because we want to be clear about this. It's not only the late-stage business that's affected by the mix of oncology CNS. If we have a central lab study that is doing oncology testing, then enrollment may be slower than it is for, for example, an infectious disease study or a diabetes study. The change in mix affects all of the segments of the business. It doesn't just affect the clinical late-stage business.
Alex Nowak (Assistant VP and Research Analyst)
Okay. That's helpful. Just a second question for you, Dave. Any update on BeaconLBS? Just curious, does your UnitedHealthcare and network contract, does that also include the BeaconLBS program?
Dave King (Chairman and CEO)
In terms of BeaconLBS, we're very focused on improving the features and function sets as we think about scaling BeaconLBS to new markets. The Texas situation remains the same.
That is, BeaconLBS is running there. But the "hard implementation where denials start" is not in effect. I didn't quite understand the second part of the question. Maybe you could just repeat that.
Alex Nowak (Assistant VP and Research Analyst)
Yeah. I was just
Dave King (Chairman and CEO)
Really quickly because five of and there's four people still waiting.
Alex Nowak (Assistant VP and Research Analyst)
Yep. Just curious, does the in-network contract that you have with UnitedHealthcare, does that also include BeaconLBS? I guess what I'm trying to read is if you don't re-sign with UnitedHealthcare for in-network, does that also inhibit you to run the BeaconLBS program?
Dave King (Chairman and CEO)
No. BeaconLBS is a separate company. And so it's not tied to the United contract. Obviously, United has been very supportive of BeaconLBS and has been very much engaged in its development and is our partner in its implementation. But it's not a part of the United contract.
Alex Nowak (Assistant VP and Research Analyst)
Great. Thank you.
Operator (participant)
Thank you. Our next question will come from the line of Gary Lieberman with Wells Fargo. Please proceed.
Gary Lieberman (Senior Healthcare Services Equity Research Analyst)
Good morning. Thanks for taking the question. I guess maybe just to go back to the Launch Pad initiative with respect to Covance and how we should think about that longer term. Obviously, with the near-term shortfall in the business, I can understand the need to reduce costs. I guess how should we think about that longer term and how that might impact your ability to thrive in that market?
Dave King (Chairman and CEO)
Gary, it's Dave, I am just going to point to the successes of Launch Pad in the Labcorp business and how it has improved our competitive position. We have redeployed resources towards customer-facing positions. We have reduced facilities and consolidated facilities in a way that has improved quality and service.
Our customer satisfaction scores among our provider community are at all-time highs even after two years of Launch Pad, which means it's improving the quality of the service we've delivered. It's not diminishing it in any way. The technology improvements in terms of patient self-service, the revenue cycle system, the bad debt improvement, all of these things are direct outgrowths of Launch Pad. Obviously, Propel has been a major innovation and improvement in quality and service. Launch Pad is not a program that just says, "We're going to rip costs out of the business." Launch Pad is a program that says, "Every dollar that we spend in the business, we're going to get a dollar and five of value in some way or another." I don't think you should think about Launch Pad as hurting our competitive positioning.
Launch Pad is going to improve our competitive positioning through right-sizing facilities, through getting the right employees facing the customer in the right place, through improvement of quality in service delivery, through better technology and tools. All of these things are going to be positive for the business in the long term. Frankly, we wouldn't invest in doing the Launch Pad project because it requires a lot of work from the team if we didn't believe in the business long term. I guess it just seems like it's a little bit more reactive here whereas it was a little bit more proactive in a diagnostics business. I don't agree with the characterization.
Gary Lieberman (Senior Healthcare Services Equity Research Analyst)
Okay. All right. Thank you very much.
Operator (participant)
Thank you. Our next question will come from the line of Ricky Goldwasser with Morgan Stanley. Please proceed.
Ricky Goldwasser (MD and Head of US Healthcare Services and Technology Research Team)
Yeah. Hi. Good morning. Thank you for taking my question.
The first question just on the clinical side, one of the questions we're getting from investors is whether the pharma companies are starting to do a lot more or more of insourcing, so bringing some of the trial business back in-house. We're also kind of seeing some anecdotal evidence from the tool companies that are actually seeing demand from pharma. We'd love to hear kind of your thoughts of what you think kind of the sponsors are doing and how they're thinking about insourcing versus outsourcing trial work.
John Ratliff (CEO of Covance Drug Development)
I think, and this is John again, I really haven't seen that, at least on our spectrum of customers. You'll always have, so I went to head of business of one pharma just recently where that rumble was that they were going to pull in insource resources ahead of the meeting.
It was the head of the business plus the head of procurement. Once I got into the meeting, it was not about that at all. They were consolidating the CROs who they work with. We were one of those that they were consolidating to. I do hear some rumble about that. I have not seen that with our customer set in terms of the insourcing "penetration" or backwards moving into pharma. I cannot talk to customers I am not at. You will have to ask the others of my brethren in terms of that. Right now, we have not seen that and still see an ever-increasing penetration, whether it is in the mid-tier or biotech or in that large pharma and as an industry trend.
Ricky Goldwasser (MD and Head of US Healthcare Services and Technology Research Team)
You are talking about the fact that it is taking longer to convert into revenues.
That is something that you guys have been talking about for over a year and a half now. If you can just give us some more context, is it taking longer to convert because you as a CRO and your CRO peers just are seeing more difficulty in recruiting patients? Is it taking longer to convert because of the customer side and the drug companies that are just kind of slowing their pace?
John Ratliff (CEO of Covance Drug Development)
No. I would say neither. It is more complex trials at the heart of it. More complex protocols within the oncology area, within the rare and orphan disease area. It also takes longer in terms of a phase three recruitment, yes, as opposed to infectious disease when you are looking at an oncology trial, etc. The orientation of the pipeline to those areas more and more gives you a longer revenue conversion.
Ricky Goldwasser (MD and Head of US Healthcare Services and Technology Research Team)
Okay.
Then the last question on that.
Dave King (Chairman and CEO)
That's it. Sorry, Ricky. We got two more people waiting. You had two. It's after 10:00. Let's move on, please. We'll take whatever you have offline.
Operator (participant)
Thank you. Our next question will come from the line of Brian Tanquilut with Jefferies. Please proceed.
Brian Tanquilut (Senior Equity Analyst)
Hey. Good morning. Thanks for taking the question. Just on the CRO side, we've heard a lot of discussion on certain assets that you guys probably would be interested in to bolster that business. As you prioritize international expansion, clinical capabilities, Asia being a perfect example, I mean, how would you rank what you're looking for in terms of what you see the need for the business to turn around and strengthen?
Dave King (Chairman and CEO)
Brian, it's Dave. Good morning. We've been talking about this quite a bit.
I'm not going to say anything that I haven't said multiple times. The clinical CRO business, we do need to be more sizable in Asia-Pac. That is one important consideration. It's only one. We want to acquire the asset that's going to fit us best from a strategic perspective. That involves financial returns. That involves cultural fit. That involves long-term opportunity where we see the business growing in therapeutic areas. There are multiple factors that we take into consideration. You're certainly correct that Asia-Pac is one of them.
Brian Tanquilut (Senior Equity Analyst)
Hey, Dave, what exactly about Asia stands out as driving that view?
Dave King (Chairman and CEO)
I think probably the biggest thing about Asia is there are a number of significant markets there that require data from their particular subjects. If we don't have the clinical presence in those markets, it's tough to win the studies.
It's mostly a function of large customers there in Japan and Korea, for example, large market opportunities, and regulatory environment in which they want to see. I should mention China as well, and regulatory environment in which they want to see specific data relating to their populations.
Brian Tanquilut (Senior Equity Analyst)
All right. Got it. Thanks, Dave.
Operator (participant)
Thank you. Our next question will come from the line of Isaac Ro with Goldman Sachs. Please proceed.
Isaac Ro (Head of US Medical Technology Team and Global Investment Research Division)
Good morning. Thanks, guys. Wanted to follow up on PAMA. You guys went through some of the things you're dealing with. I'm interested in your perspective regarding how you think the rest of the market, particularly the small independent labs and the hospital labs, are preparing for the implementation. Obviously, we don't know for sure, but hopefully next year.
I'm just curious as you think about just how you grade the preparedness among your competitors, what that means for you.
Dave King (Chairman and CEO)
I don't really have a good perspective on that, Isaac and Dave. I mean, I know what we hear when we go to ACLA. I think there's a surprising lack of awareness of the potential impact of PAMA, for example, is my perception in the hospital lab director environment. I think small labs, for the most part, at least the leaders of them that I talk to are aware of the potential outcomes. I don't know where they are in terms of preparedness or data submission. That's not something that we talk about with our peers.
Isaac Ro (Head of US Medical Technology Team and Global Investment Research Division)
Okay. And then just as a follow-up on the impact, we know the perspective walk on future reimbursement.
If we just think about maybe the first 12 months, if all goes according to your best expectations, do you think the net effect of incremental volume will be neutral or positive to your ASPs? Or is it too hard to say?
Dave King (Chairman and CEO)
I think we should be clear, and we've tried to be clear, that if PAMA is implemented based on the rule that's out there, there will be a reduction in the Medicare clinical lab fee schedule. It is very hard, no matter how much volume you get, to offset a price reduction in a book of business of that size. I would not expect, if PAMA gets implemented in January, that we will offset the financial impact of the fee schedule reduction with incremental volume.
Isaac Ro (Head of US Medical Technology Team and Global Investment Research Division)
Got it. Thank you.
Operator (participant)
Thank you. Ladies and gentlemen, this concludes our question-and-answer session for today.
It is now my pleasure to hand the conference over back to Dave King for closing comments and remarks. Sir.
Dave King (Chairman and CEO)
Thank you very much for joining us this morning. We appreciate your time and look forward to speaking to you on our second quarter earnings call.
Operator (participant)
Ladies and gentlemen, thank you for your participation on today's conference. This does conclude the program, and you may all disconnect. Everybody, have a wonderful day.