Labcorp Holdings - Earnings Call - Q3 2014

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the third-quarter 2014 Labcorp Holdings earnings conference call. My name is Shawn Tulay, and I will be your facilitator for today’s call. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session toward the end of this conference, at which time you may press star one to participate. If at any time during the call you require operator assistance, please press star zero, and an operator will be happy to assist you. As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Steve Anderson. Please proceed, sir.

Steve Anderson (VP of Investor Relations)

Good morning, and welcome to Labcorp’s third-quarter 2014 conference call. I’m Steve Anderson, Vice President of Investor Relations, and with me today are Dave King, Chairman and Chief Executive Officer; Glenn Eisenberg, Executive Vice President and Chief Financial Officer; and Ed Dodson, Senior Vice President and Chief Accounting Officer. This morning, we will highlight our progress on our five-pillar strategy, discuss our third-quarter 2014 financial results, and update our 2014 guidance. Before we get started, I would like to point out that there will be a replay of this conference call available via telephone and internet. Please refer to today’s press release for replay information. This morning, the company filed a Form 8-K that included additional information on our business and operations. This information is also available on our website. Analysts and investors are directed to this 8-K and our website to review this supplemental information.

Additionally, we refer you to today’s press release, which is available on our website for a reconciliation of non-GAAP financial measures discussed during today’s call to GAAP. These non-GAAP measures include adjusted EPS, free cash flow, and adjusted operating income. I would also like to point out that we are making forward-looking statements during this conference 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 the company’s financial results. Some of these factors are set forth in detail in our 2013 10-K and will be included in subsequent filings with the SEC. The company has 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, Steve. Good morning. We are pleased with the strong revenue and volume growth that we have generated this year and believe that the long-term growth prospects for our business and industry remain great. We employ our five-pillar strategy to capitalize on these opportunities, and I would now like to highlight our key initiatives within this strategy. With respect to Pillar One, we deploy our capital to investments that enhance our business and return capital to shareholders. Last month, we announced our acquisition of LipoScience, a premier esoteric laboratory focused on personalized diagnostics for cardiovascular and metabolic disorders. The NMR LipoProfile test is the only FDA-cleared test for measuring LDL particle numbers, offering actionable information for physicians and patients in the management of cardiovascular disease. Hence, this acquisition will enhance our innovative clinical decision support programs, allowing us to provide broader, differentiated knowledge services to physicians and patients.

Furthermore, the novel application of nuclear magnetic resonance technology furthers our leadership in scientific innovation. This transaction is expected to be accretive to Labcorp’s earnings in year one and to earn its cost of capital by year three. Earlier this month, the Federal Trade Commission granted early termination of the HSR waiting period for this acquisition, and we expect it to close during the fourth quarter. During the quarter, we repurchased approximately $66 million of our shares, bringing our year-to-date total to $228 million. Our cash balance at the end of the third quarter was $576 million, but this cash balance does not reflect any change in our capital allocation philosophy. We anticipate reducing this cash balance in future quarters, continuing to make strategic acquisitions as well as returning capital to our shareholders. Under Pillar Two, we aim to enhance our IT capabilities to improve the physician and patient experience.

We continue to improve our tools that assist physicians and patients in interpreting test results and optimizing decision-making. To this end, we are partnering with Wolters Kluwer to develop UpToDate Advisor for Labs, a decision-support resource for clinicians interpreting test results. This partnership equips clinicians with real-time contextual laboratory decision-support content delivered while the clinician is reviewing results. Similar content will be made available to patients, which will help them to review and understand their lab results. That content will be available through our patient portal, where registrations now exceed 625,000 patients, and these patients currently review over 120,000 reports via the portal each month. We believe that providing patients with tools that help them understand their health is fundamental to reducing costs and improving outcomes. With respect to Pillar Three, we continue to improve efficiency to offer the most compelling value in laboratory services.

Our Propel robots in our Burlington and Tampa laboratories continue to drive expense reduction through improvements in throughput and accuracy and to enhance service levels. We remain on schedule to begin the installation of Propel in our Dublin, Ohio facility at the end of this year, and we plan to install Propel in five additional facilities over the next two years. We continue to streamline our operations and reduce expenses through facility rationalization. The consolidations of our facilities in Mitchell Field, New York, and Monrovia, California, into our Connecticut and Santa Fe laboratories, respectively, are now complete. Also, we continue to consolidate services, expand our test offerings, and leverage increased capacity in our Center for Specialty and Clinical Testing, located in Phoenix, Arizona. We are building significant momentum on our enterprise-wide business process improvement initiative, and we have initiated several projects that will begin to bear fruit in 2015.

We are re-engineering our business to provide a better operating platform, sustainable long-term savings, and a world-class customer experience. We plan to discuss this initiative in detail when we report our year-end results and provide our 2015 guidance in February. Under Pillar Four, we continue our scientific innovation at reasonable and appropriate pricing. We recently launched our InformaSeq prenatal test, an advanced non-invasive next-generation prenatal screening assay that assesses risk for multiple fetal chromosomal abnormalities from a single maternal blood draw. There are testing options for several additional common sex-related abnormalities as part of InformaSeq. We have also recently launched our BRCA next-generation sequencing assay, which provides complete gene sequence analysis of BRCA1 and BRCA2.

In combination with our care coordination pre-authorization service, Labcorp offers an end-to-end program that includes compliance with insurance requirements, comprehensive testing, and expert interpretation from our licensed directors and our team of 123 board-certified genetic counselors and nine medical geneticists. We also continue to see growth in our companion diagnostic assays that help physicians guide targeted drug therapy. For example, our HCV GeneAssure NS3 4A assay is the first commercially available test to provide drug-resistance data for new HCV antivirals. With respect to Pillar Five, we continue our progress in developing knowledge services. Last month, we announced the launch of Enlighten Health Genomics, and later this quarter, Enlighten Health Genomics will introduce Exome Reveal, a whole exome sequencing testing service. Exome Reveal will provide genome-wide interpretation for children with serious genetic diseases, as well as additional diagnostic information for patients of any age.

Because evidence increasingly suggests that early genetic diagnosis can improve clinical outcomes, patients with serious genetic conditions require a thorough interpretation of their genome. We will offer innovative and affordable diagnostic solutions that make genomic testing accessible to support critical clinical diagnoses. We continue to develop all aspects of our Enlighten Health initiative: our decision-support programs, our care intelligence data analytics programs, and our clinical trials business. Our data and analytics tools help physicians understand their metrics of care delivery and improve compliance with pay-for-performance and population health metrics. Our disease-specific expertise in kidney stone disease, chronic kidney disease, cardiovascular disease, and coagulation helps physicians tailor specific treatment programs for their patients. Finally, our clinical trial central lab business serves physicians and patients by working with pharmaceutical companies to create vertical alignment—from drug design to identification of unique patient populations that will respond to therapy.

As discussed on our last earnings call, we invested in Beacon LBS in 2011 because we understood that providers need assistance in selecting the right test for their patients, and payers need help in appropriately managing the utilization of laboratory testing. After extensive market analysis and an enormous amount of hard work, we invented a tool that helps physicians choose the right test at the right time and helps payers improve quality of care and thoughtfully address concerns about unit cost and trend. UnitedHealthcare launched the innovative laboratory benefit management program with Beacon LBS in Florida on October 1st, and we are pleased with the rollout thus far. We have positioned Labcorp to grow through the era of healthcare reform, a time in which quality, efficiency, scale, and a central role in improving care delivery and patient outcomes will be the key measures of success.

Our five-pillar strategy will enable us to excel in all of these areas, generating shareholder value for years to come. Now, I’ll turn the call over to Glenn to review our financial results.

Steve Anderson (VP of Investor Relations)

Thank you, Dave. Sales for the quarter were $1.6 billion, an increase of 6.1% over last year. The increase in sales was the result of strong volume measured by requisitions and acquisitions, which was partially offset by price, mix, and currency. Total volume increased 6.9% over last year, with most of the growth coming organically. Revenue per requisition decreased 0.7%, of which 0.3% was due to foreign currency translation. Top-line growth was spread evenly across our core and esoteric businesses. From a payer perspective, managed care revenue increased the most at roughly 10%, while pricing remained relatively flat. The increase in managed care revenue was driven in part by the Affordable Care Act. Gross profit for the quarter was $571 million, or 36.8% of sales. This compares to gross profit of $548 million, or 37.5% of sales last year.

The increase in gross profit was due to volume and productivity, which was partially offset by price, mix, personnel costs, and depreciation. SG&A for the quarter was $306 million, or 19.7% of sales, compared to $279 million, or 19.1% last year. During the quarter, we incurred $5 million of special charges, primarily related to our business process improvement initiative. The remainder of the increase was due to personnel costs, acquisitions, and an increase in bad debt expense. While the bad debt rate was higher than last year, it was down from last quarter, and we expect to continue to make progress on lowering this rate in the future. During the quarter, we had $6 million of restructuring and special items, primarily due to facility closures and related severance, compared to $4 million last year.

Operating income was $241 million, or 15.6% of sales, compared to $245 million, or 16.7% of sales last year.

As a result, net income for the quarter was $137 million, or $1.59 per diluted share. This compares to $148 million, or $1.63 per diluted share last year. Excluding amortization, restructuring, and other special items, adjusted EPS was $1.80, unchanged from last year. We continue to generate strong cash flow. During the quarter, operating cash flow was $176 million, compared to $234 million last year, as we used working capital to support strong top-line growth. Capital expenditures totaled $53 million, which was essentially unchanged from last year. As a result, free cash flow — or cash from operating activities after capital expenditures — was $123 million, compared to $182 million last year. As Dave mentioned, during the third quarter, we repurchased $66 million of our stock, bringing our year-to-date share repurchases to $228 million. We ended the quarter with approximately $824 million remaining under our board-authorized share repurchase program.

Our full-year guidance for 2014 is for sales growth of approximately 3%. Given our performance in the third quarter and outlook for the year, we have increased our 2014 adjusted EPS guidance to $6.70–$6.80. Operating cash flow is targeted at $760–$780 million, while capital expenditures are projected to be $200–$205 million. As a result, free cash flow is now projected at $555–$580 million. The lower free cash flow range is reflective of additional working capital needs to support our strong top-line growth, as well as investments associated with our business process improvement initiative and restructuring activities. This ends our formal remarks, and now we’ll be happy to take any questions. Operator?

Dave King (Chairman and CEO)

Ladies and gentlemen, at this time, if you would like to ask an audio question, please press star one on your touch-tone telephone. Your first question comes from the line of Robert Willoughby of Bank of America. Please proceed.

Hey, Dave. Can you speak to your expectations for Enlighten Health Genomics and how the money will flow there — what kind of payer support we should see — and also, what are your plans for the Canadian infrastructure, with some business moving away from you there?

Good morning, Bob. It’s Dave. The plans for Enlighten Health Genomics, at least initially, are that the offering will be directed largely toward the self-pay market. Part of the reason that it’s under Enlighten Health — and part of the reason that it’s a broader whole exome offering than our traditional reproductive genetics business — is, as we indicated, it’s targeting the market for early childhood development, developmental delay, and early childhood severe genetic diseases. I’m sure over time there will evolve to be a commercial payer component of that, and our expectations are, given the severity of the disease states that we’re looking at, that we’ll have a successful payment experience even with the commercial payers. With regard to Canada, I’m going to ask Glenn to comment on that, as he is directly involved in the day-to-day handling of that situation — which, as you know, is the Alberta RFP.

Steve Anderson (VP of Investor Relations)

Yep. Robert, this is Glenn. To your point, we are currently servicing the Alberta Health Services system, and they did an RFP a while ago and have chosen to go with another company — at least at this stage — to now negotiate a new transaction with them. As you know, we’re a minority investor in that company, DynaLife, and while the results are not material to us, obviously, we’re very disappointed with the decision that’s been made by AHS. Having said that, we’ve not been debriefed yet by them as far as why we didn’t go ahead and have our business re-up, and then there is an appeals process that follows that should we elect to do that. Again, disappointed with it. We feel Canada is a very attractive market.

We are already there outside of just this minority joint venture that we have elsewhere in Canada, and we will continue to pursue all the options we have to continue to perform business up there.

All right. Thank you.

Dave King (Chairman and CEO)

Your next question comes from the line of Josh of Deutsche Bank. Please proceed. Mr. Josh, please check your phone for the mute feature.

Steve Anderson (VP of Investor Relations)

Hi, this is Josh in for Darren. Hoping you can shed some light on your operating leverage and with the increased volume you've been getting. Is there any reason why you haven't been getting better operating leverage out of the operating income?

Dave King (Chairman and CEO)

Josh, it’s Dave. I’ll start and then turn it over to Glenn. I mean, I think the obvious answer is that the difference in operating leverage is the decline in price. If you look at versus last year, we’re down 70 basis points in price. If you add that price differential back in, our operating leverage is basically about the same. When you think about the foundation model, which we’ve talked about for years, the assumption in the foundation model is that price is flat to slightly up. You may recall that with the benefit of positive mix, we used to get 50–100 basis points of positive price just from mix-driven price.

When price is flat to increasing, there is great leverage — and obviously, as price is declining, it is more difficult to get leverage because every incremental specimen that comes in the door requires reagents, requires labor, requires infrastructure costs. In a declining price environment, it is difficult to get leverage. We are very pleased with the price improvement sequentially from the second quarter to the third quarter and from the beginning of the year through this point in the year, and have every reason to expect that that would continue. Glenn?

Steve Anderson (VP of Investor Relations)

Yeah. No, maybe I’ll just add a little bit of color because I think that addresses it pretty well. I think where we’re pleased is the amount of organic growth that we’re experiencing in the company, pleased with the amount of productivity that we’re getting through that as we leverage our lab. As Dave said, when you have price and mix issues, obviously, that falls down to the bottom line. In addition, we’ve had some bad debt rate increase and expense that, again, we think we peaked out on. As we go forward, we would expect to see that start to show favorable comps, which will help. Again, I don’t know if you’re looking at it on a NASH-adjusted basis, but we also had some restructuring and special items.

To that point, in recognition of the fact that we are seeing the margin squeeze because of pricing, we’re really looking at this business process improvement initiative and restructuring in order to continue to leverage our cost structure, which will continue to benefit the company as we go forward.

Okay. Great. Thanks. If I could just ask one more — can you guys give us an update on the progress with molecular pathology payment denials out of state Medicaid programs?

Dave King (Chairman and CEO)

Yeah. It’s Dave. We continue to work with the state Medicaid programs we have, and there are some managed Medicaid programs as well that have been challenging for us. While we have made some progress there, the progress has been slower than I would like. We have now undertaken a review of accounts that are generating a large amount of MOPAS volumes and high write-offs. We’re starting to shed those accounts because they are generating a large amount of MOPAS volumes, high write-offs, and there’s a significant amount of expense in performing the MOPAS. We’re attacking the problem on both sides.

One is continuing to work with the payers, and the other is pruning accounts that are basically, in our view, just using the opportunity to send us MOPAs with a recognition that we’re not going to get reimbursed for it.

Steve Anderson (VP of Investor Relations)

Okay. Thanks, guys.

Dave King (Chairman and CEO)

Your next question comes from the line of Per Ostland of Craig-Hallum. Please proceed.

Thanks. Good morning, guys, and thanks for taking the question. Just wanted to ask quickly about the cash balance. It’s grown here over the last couple of quarters quite nicely. I’m sure some of that here in Q3, you’ve kind of got that set aside for the LipoScience transaction. Just wondering if we could get your most current thoughts on the appropriate leverage for the company and share repurchase. Thanks.

Steve Anderson (VP of Investor Relations)

Yeah. Sure. Per Ostland, as Dave mentioned in his opening remarks, we do recognize that our cash balances have increased. The good news is, obviously, we continue to generate good free cash flow that’s providing capital while we continue to pursue acquisitions and do share repurchases. We’ve not changed our — call it — targeted leverage, the two and a half times debt-to-EBITDA, which we realized that on a net basis, we would be below that level right now given our cash balances. We continue to look at opportunities. We continue to expect to redeploy our capital, and we would continue to expect that that cash balance will decline over future periods.

Okay. Thank you.

Dave King (Chairman and CEO)

Your next question comes from the line of Lisa Gill of J.P. Morgan. Please proceed.

Thanks very much. Dave, I know I asked about this last quarter around Beacon LBS, but just given the things you’ve highlighted today around the doctor making the right test decision at the right time, etc., I’m just curious — if you compare those doctors that are using this versus a similar doctor, are you seeing them doing more lab tests, fewer lab tests? What do you think that means for the future if you continue to see this roll out to other physicians?

Morning, Lisa. It’s Dave. I think it’s too early to draw any conclusions about more lab tests or fewer lab tests from the population of users of Beacon LBS. I would point you to the slide in our investor deck that talks about 20% over-utilization of lab tests in certain circumstances and 45% under-utilization in other common disease states. The point is, Beacon LBS is really less about over-utilization or under-utilization than it is about choosing the right test for the patient at the right time, based on a Q&A that’s presented to the physician.

I think as we think about over time and, again, refer you to the investor deck — the slide that shows the growth in number of lab tests per patient in the population from 1997 to 2008, and also the increase in lab tests per patient per year as patients age — I do not think we are talking about dramatic decreases in volume of laboratory testing as a result of trying to manage cost and trend. I think what we are talking about is exactly what we have always talked about: better use of lab testing for diagnostic choices, better use of the tools to get at the disease state, and better use of lab testing in support of precision medicine and personalized care. That is the goal not only of Beacon LBS, but also of our decision support programs.

It’s all about how we get the right test to the right patient at the right time because we are here for the patient, and how we use lab testing to integrate with other data that will enhance the care the physician is able to provide to the patient

Okay. And then, just thinking about the right tests, can you maybe give us any update you have around BRCA as far as what you’re seeing around test volumes there? Thank you.

Sure. We’re very pleased with BRCA volumes. We’ve seen very nice steady growth since the time that we launched it. Moving to the next-generation sequencing platform has enabled us to significantly increase the speed of performing the test. Most of the BRCA backlog that we have is due to pre-authorization requirements, and we wait for pre-authorization. Volume continues to grow. The throughput in the lab is excellent, and we’re very, very pleased with where we are in the market.

Thanks, Dave.

Your next question comes from the line of Brian Brookmeyer of Maxim Group. Please proceed.

Hi. Good morning. Last quarter, you mentioned that it was hard to identify the benefit from ACA, but there was a slight benefit. Now, about three months later, it seems that it may have been a greater impact in the quarter. As we look to people getting more coverage next year, should we think about it taking us about three months for members to get their benefit cards and to start utilizing benefits? Or any sort of thoughts on what benefit you’ll get next year?

Brian, it’s Dave. I think the benefit from ACA has been greater than we have expected from a volume perspective this year. I think if you go back and look at what we said starting in the fourth quarter of last year that we expected ACA to be relatively neutral, maybe a slight net positive. I mean, obviously, from a volume perspective, I think ACA has contributed to our growth and particularly to the very strong organic growth. I think it’s hard to know next year because there are many factors up in the air: the potential of Medicaid expansion in some additional states, some of the grandfathered plans or the plans that were allowed to be grandfathered for one more year that were non-compliant going away, and people moving to the exchanges, pre-Medicare patients moving to exchanges, and even some managed Medicare moving to the exchanges.

I’m hesitant to forecast what it would be, particularly given the inaccuracy of my earlier forecast. We do see ACA as a net positive in terms of volume. Again, as we have mentioned, there is somewhat of a drag on price due to test mix and also due to payer mix.

All right. Thanks. I know that your guidance does not include future share repurchases or M&A, but could you talk a little bit about what other assumptions are built into your outlook in terms of healthcare utilization, molecular pathology reimbursement, or other key issues that are being built into your outlook?

Steve Anderson (VP of Investor Relations)

Yeah. Brian, this is Glenn. You’re right. For the share repurchases and M&A, we don’t. After the third quarter, so project that out. Obviously, we continue to be in the market and, again, have an acquisition that we announced, albeit it would not be material to our fourth-quarter results, albeit hopefully we do close it in the quarter. The rest of the guidance is based upon just essentially the organic growth that we’re seeing. We’ve given guidance at the top line for the year, so you kind of get an implication of what that means for the fourth quarter. Similarly, we expect to have good operating performance and results in the fourth quarter. I think this was a question earlier with the pressures that we’ve been having from price and mix.

You can see that the comps for the quarter compared to the quarter a year ago, each time the margin differential is narrowing. We’re starting to see that price mix abate a bit. Hopefully, with good volume, we’ll start to see good leverage with pricing and mix not impacting it as much. Hopefully, we’ll start to see some favorable comps on margins year over year.

Dave King (Chairman and CEO)

Brian, thanks a lot.

Steve Anderson (VP of Investor Relations)

Yeah.

Dave King (Chairman and CEO)

It’s just one other thing. We’re not assuming any improvement in the MOPAS. Specifically, we’re not assuming any improvement in the MOPAS payment experience. We also have not factored in any financial benefit from the enterprise-wide reengineering, although obviously, the cost side of that is factored in.

Steve Anderson (VP of Investor Relations)

Okay. Great. Thanks.

Dave King (Chairman and CEO)

Your next question comes from the line of Amanda Murphy of William Blair. Please proceed.

Hi. Good morning. Just to follow up on the mix conversation. So just given all of your new test introductions, specifically the NGS testing, I guess, what are your expectations longer term around mix? I know, obviously, not expecting guidance commentary, but do you think that possibly we could see an improvement, at least from a test mix perspective, in 2015?

Amanda, it's Dave. Good morning. Yeah. I think that if you look at the tests that we're launching, the InformaSeq, the various NGS methodologies, all of the infectious disease-related tests that follow on the HCV screening, the exome business, I mean, all of these are high value. We also were pleased to see that from a mix perspective, we had an increase in pathology volume this quarter, which, as you know, has been a challenging area for us. So all of these things help mix. I think, again, all other things being equal, we would expect to see mix improve next year. The unknown in that is that the mix component, particularly of the ACA/managed Medicaid, is a mix that is more driven towards or more weighted towards the core testing.

That offsets some of the benefit of, and partly that’s because of payment policies of not paying for molecular pathology and genetic testing, and partly it’s just because of patients new in the system are getting tests that are more weighted toward core testing. There are a lot of moving parts in there, but we continue to strive to return to that 40% esoteric mix. Obviously, over time, we’ve said 45%, and we think that’s a realistic aspiration for ourselves.

Got it. Just again on the next-gen topic, I’m wondering, how close are you guys or how much visibility do you have into some of the pricing of the new next-gen codes for 2015? I guess I’m wondering, is there risk around that side of the business similar to what we saw with MOPAS where you see new test codes come online and maybe payers are more reluctant to pay for them?

I don’t think we have a lot of visibility into next-gen codes. So far, our experience with payment for next-gen methodology has been fine because, again, it’s a different methodology for performing testing that already has codes assigned. It’s too early to tell at this time, but I will tell you that we’re working very hard to avoid a repeat of the MOPAS situation in terms of payer policies and utilization.

Got it. Thanks very much.

Your next question comes from the line of Gary Taylor of Citigroup. Please proceed.

Hey. Good morning. A couple of questions. Just to follow up on your ACA volume comments, I just wanted to see, are you suggesting as the year progressed that you've just continued to see more Medicaid volume coming through, or are you seeing more healthcare exchange volume, or is the answer both?

Gary, it’s Dave. The Medicaid volume was a much bigger percentage of growth in the earlier quarters than it is now. That’s actually abated over time. It’s very hard to attribute that with any precision, but you could argue that that was people who were getting coverage for the first time under the ACA and were going to the doctor at the beginning of the year. The % Medicaid, make no mistake, managed Medicaid has grown significantly this year, but the % of overall growth that it accounts for has declined from the first quarter to the second quarter and declined again from the second to the third. In terms of the exchanges, we don’t have a lot of visibility about who are exchange patients because, again, they just come to us with an insurance card, and that insurance card says that they have XYZ insurance.

It doesn’t say that they’re exchange patients. We are seeing, as Glenn mentioned, strong revenue growth from the managed care payer set, and some of that undoubtedly is exchange-based, and some of it is growth in commercial lives.

Okay. Thanks. Second question, just looking at the gross profit this quarter, which you guys did touch on, but what's interesting to me is I think as far back as our model goes, I don't think we've ever had gross profit dollars up sequentially from 2Q to 3Q. I just wondered if you could—I mean, obviously, the revenue growth in the quarter was part of that dynamic, but even the sequential gross profit margin decline was much less than we would typically see. I just wonder, is there anything else on that dynamic worth discussing? It doesn't look like much of that was really carried into what's left for the fourth quarter in terms of gross margin assumptions. Any extra on that?

Steve Anderson (VP of Investor Relations)

Yeah. Just as a general comment to your point, gross profit’s growing because of the benefit of the volume that we’re getting. We talked earlier about just the price mix. While it’s a little bit of a headwind, it’s been mitigating. So the additional volume we’re getting is helping the gross margin. As we look forward, again, we’ve got kind of given implied numbers for the fourth quarter, so we actually expect to see a pretty good comparison year over year, still having a bit of the headwinds. When you look sequentially, the fourth quarter normally would be a lower-volume period for us compared to the third. From a trend, if you will, expect that. We’re pleased, at least, with the volume there, with the productivity that we’re getting.

Gross profit is going to be holding into that kind of range, and we should start to see now even better leverage on our cost structure as we go forward, especially—now this is on the S&A side—as the bad debt now starts to compare favorably from period to period.

Okay. Great. Last question. Just kind of big picture from an investment perspective and kind of going back to the foundation model that you talked about. But when you look at overall operating income margins have declined since 2008, we all know the reasons for that. But as we look into 2015, Dave, you talked about an expectation that mix would improve. I do not know if that yet means that revenue per rec actually can grow in a material way in 2015 or not. But really, it seems like with volumes having recovered, that the bulk of the margin outlook from here is really predicated on that pricing outlook. So as we look into 2015, you have got a new cost-saving program you are going to talk about. You are expecting mix to improve. Is it fair to have expectations at this point that operating margin actually grows in 2015?

Dave King (Chairman and CEO)

Gary, we obviously are in the process of working through our budget, which leads to our guidance in February. I’m not going to answer the question directly because I think it would be unfair to do so. What I will say is when we think about 2015, at least what we’re seeing in the trends, we have no major managed care renewals. We have a trend of volume strengthening through 2014. Now, again, some of that could be one time because of ACA, but obviously, we’re very pleased with the volume and particularly the organic volume contribution in this quarter. Price has been moderating, and no guarantee that that continues, but we’ve lapped some of the major pricing events, the doc fix cut, sequestration, the major impact of MOPAS.

What I would say is there aren’t any obvious reasons, as I think about the performance in 2014, why we shouldn’t see operating margin improvement in 2015. There are no obvious headwinds that are blowing in our faces at the moment, and we feel good about that. Things can change, and so I’m not going to kind of put a stake in the ground right now and say, ‘Yeah, you should expect to see operating margins improve.’ That would be our hope based on the continuation of the—if we see the continuation of these positive trends.

Great. That's helpful. Thank you.

Your next question comes from the line of Ricky Goldswasser of Morgan Stanley. Please proceed.

Yeah. Hi. Good morning. I just have a lot of questions on the growth you’re seeing for your managed care business and really how it compares to total. So I think, Dave, you mentioned 10% growth in the managed care business. And if we think about it as being about 45% of the revenues, is it fair to assume that it contributed about 4.5% to top-line growth, and then maybe the rest of your payers and businesses are growing more in line with the market at the 1.5%–2% revenue growth? I mean, is that a fair way to look at it?

Steve Anderson (VP of Investor Relations)

Yeah. Hi, Ricky. This is Glenn. Overall, again, we did comment that managed care was the strongest growth of the payer groups that we have, but it is a little bit of a mix. Some of that growth is coming out of other areas as opposed to just natural growth, such as patient, if you will, and third party that may have moved into that. Overall, when we look at it from a test perspective, we saw pretty broad growth really across both the core and the esoteric parts of our business. From a shift, to your point, managed care is coming in at roughly around 45% of the business that we have. From a mix standpoint, it increased greater than our other payer categories. Again, with the exception, I guess, of client, that would have been up a fair amount as well.

Others would have come down and moved into those categories.

Dave King (Chairman and CEO)

Okay. Just as a follow-up, just to tie it to the margin discussion because I think this is one of the areas that are a little bit confusing to us, should we assume that given the moving parts in that managed care bucket with ACA lives, etc., that maybe for the time being that managed care payer segment might be lower margin than some of the other payers, and that’s why you haven’t seen the leverage in the margins yet?

Ricky, it’s Dave. Again, managed care is a very large— we have over 2,000–2,500 managed care relationships and contracts. It is not accurate to paint managed care as having a particular margin. We do not have margins within our business, as I think we have said on a number of occasions. When a specimen goes through the instrument, the instrument does not care if it is a Medicare specimen, a Medicaid specimen, or a managed care specimen. We do not have margins by payer. What I would say is that in managed care, particularly what you saw in the first quarter and to some extent in the second quarter of the year, was overweighted toward movement of patients who previously were uninsured into managed Medicaid. That just from a pure price perspective accounted for a lot of the drag that you saw, and you saw that starting to abate in the third quarter

Okay. That's helpful. Just also just lastly, I know that in the past you talked about on average 2-3% top-line growth as kind of a base growth. Once you've kind of like passed it, you can start seeing the leverage of the margin. Again, not assuming the moving parts around Medicaid population, does that still hold?

Yeah. As long as price is flat to up, that still holds.

Thank you. Your next question comes from the line of David Clair of Piper Jaffray. Please proceed.

Hi. Good morning. First one for me, I'm just curious if maybe you can give us your thoughts on FDA regulation of LDTs and how that might impact your business.

David, it’s Dave. Good morning. My perspective on FDA regulation of LDTs is quite clear, and I’ve been pretty vocal about it. Diagnostic testing is not a device. It’s a medical service. LDTs, the FDA in our view does not have the authority to regulate LDTs as medical devices. They don’t have the statutory authority to do that because medical tests are not devices. On top of that, the attempt to make this kind of regulatory change through a guidance document, which on its face says that it’s not binding on the FDA and only reflects their current views, and yet in this document lays out a 10-year regulatory plan with registration requirements and penalties for those who don’t register, to me is just incomprehensible.

My perspective is this is one of the biggest land-grab attempts in the history of regulation, and from my perspective, we intend to vigorously oppose it. What could it do to our business? I mean, first of all, it could dramatically affect the practice of medicine, and it is the practice of medicine when doctors select what test to use. I don’t understand how FDA thinks that somehow creating this great regulatory system around laboratory-developed tests is going to help doctors practice medicine. It interferes with the practice of medicine where doctors make rational choices about the test that they want to use. Furthermore, there’s been no study of the economic impact on our industry, on patients, or on the practice of medicine related to this because FDA has not followed the proper administrative procedure for doing what it’s trying to do.

I think you can tell that I feel very, very strongly about this, and my perspective is that we as an industry need to oppose this attempt at regulation as strongly as we possibly can.

Okay. Thank you. I was hoping to get an update on the non-invasive prenatal testing business. Do you think that right now we're primarily—you are seeing primarily high-risk volume, or do you think we're starting to see some average-risk volume there?

My understanding is that the test is approved and being offered for high-risk patients. Now, there is no question that—again, let’s go back to the last question you asked, which was LDTs in the practice of medicine. Some physicians in the course of the practice of medicine are choosing non-invasive prenatal screening for average-risk patients. That is the physician’s choice. We are certainly not marketing the test or presenting the test that way. I will say that most of the payers have policies against payment for non-invasive prenatal testing for average risk, and I think to get payment in place, the test is going to just need more data to support its use in the average-risk population.

Thank you.

Your next question comes from the line of Isaac Rowe of Goldman Sachs. Please proceed.

Good morning. Thank you. I wanted to talk a little bit about utilization in the context of fourth quarter. I think we've seen a relatively steady uptick in seasonality into fourth quarter the last few years, and was wondering if your guidance assumes that we'll see another sort of seasonal uptick versus past years.

Isaac, it’s Dave. The guidance assumes that the fourth quarter will be much like prior fourth quarters in the sense that major contributors to our performance are holidays, weather, a fewer number of revenue days because of Thanksgiving and obviously the Christmas and New Year’s season. What we do is obviously we build the guidance off the full-year model, and we look at prior fourth quarter experience and incorporate that in. I can’t say that it does or does not include seasonal upticks in volume or seasonal downticks in volume. It’s just the guidance, as we always say, encompasses a wide range of outcomes, and it’s built on a model based on past experience.

That’s helpful. Thank you. Then just secondly, a question on bad debt. I think earlier in your comments, you said that you thought the bad debt dynamic has peaked here. Just hoping you could help us understand the reasoning for that process

Steve Anderson (VP of Investor Relations)

Yeah. Hi, Isaac. This is Glenn. Again, it's just a very proactive approach to doing it. Bad debt, just given the volumes we have, will go up. What we've seen is that from a rate standpoint, based upon historical performance, we saw our rate rise. We now have seen a trend for this current quarter is now down from the prior quarter around 20 basis points. If we maintain that level currently, which is at least our expectation, now that'll start to comp favorably to the rate that we would have had the same period a year ago. We continue to be a very proactive part of our business process improvement initiative as well, encompasses how we go about our efforts to collect, and we're encouraged about the initial progress that we're seeing, and we would expect that to continue.

Got it. Thanks so much, guys.

Dave King (Chairman and CEO)

Your next question comes from the line of Michael Cherney of ISI Group. Please proceed.

Steve Anderson (VP of Investor Relations)

Good morning, guys, and thanks for all the details. Glen, one quick question. I apologize if I missed this. Did you give the actual contribution from non-organic revenue in the quarter? We did not. We gave that kind of from a volume standpoint. We were up around 6.9% with most of that coming from organic. You're looking at a little over, call it 5.5%, give or take, would come from organic and call it 0.5% coming from acquisitions.

Thanks. That's quite helpful. Dave, a question for you. Going back to a topic that I know has been one you're focused on from a government perspective. Now that we're a little bit ways past the doc fix and the clinical fee schedule review pushout, how have you started to think about the positioning ahead of the review that's going to go into place for the 2017 adjustments? How are you guys positioning yourselves with CMS and going about, again, proving your point as to the value you provide relative to the review that's going to come up and the market-based pricing that will be put in place? I just want to get a sense now that we're six months past now, so maybe you have a differentiated view versus where you had been before.

Dave King (Chairman and CEO)

Sure. So we've actually quite recently, the ACLA membership went and met over at CMS with the folks who are working on how the market survey is going to be formulated and how they're going to evaluate market pricing. I think the good news coming away from that discussion is that, first of all, CMS recognizes it's a complex task that they've been assigned. I think, second of all, they genuinely want to do a good job because I think the understanding of all the parties was that what was intended was, yes, market-based pricing, but it had to be based on true market. It's not just independent lab market. It's not just select market pricing or select test pricing.

It’s the true market, and the true market has to include commercial payer pricing to hospital laboratories that are paid on an outreach basis or paid off a commercial lab fee schedule. Obviously, there’s a lot of work to be done here, and there will be, my understanding is there’ll be a proposed rule on how the surveys will be conducted that’s going to be coming out from CMS later this year. We are working collaboratively with them as an industry to try to make this a fair process and to get the outcome that the Senate Finance Committee and the government and we agreed, which was the right outcome, which is a market-based pricing benchmark, but again, representative of the true market for laboratory services, including all competitors in the marketplace.

Thanks, Dave. Appreciate the color.

Your next question comes from the line of AJ Rice of UBS. Please proceed.

Thanks. Real quick, I guess. If we took your 6% organic growth or 6% revenue growth this quarter and you're maintaining your full-year guidance at 3%, I think that implies that your fourth quarter year-to-year growth steps back down to 3%. I know I understand that every year the fourth quarter has some seasonal issues in it, but I guess is there any reason to think that the pace of year-to-year growth that you're seeing in the third quarter would moderate in the fourth quarter?

Steve Anderson (VP of Investor Relations)

AJ, this is Glenn, and then ask Dave if he wants to share in the color. You're right. Our expectation for the fourth year-over-year is to call it the 3.3 based on the implied guidance. That would take the seasonality out, if you will, from a year-over-year. Clearly, it's a reason why sequentially our fourth quarter estimate is down from the third quarter for the reasons that Dave alluded to earlier. Again, we still feel that there's good, strong organic growth that's in that. We're still seeing some negative implications from price mix that will affect it, but it's becoming less and less. The good news is that while the growth on the volume is now at that 3 plus or minus % growth, we're starting to now get leverage even off of that level.

That we’ll continue to see comparability in our margins and earnings, if you will, year-over-year at that 3% level of revenue growth, and hopefully we’ll see even better leverage than that.

Dave King (Chairman and CEO)

It’s Dave. Just the only other comment I’d make is to look back to an earlier observation about we did see a relative spike in the fourth quarter of last year. Again, it’s the year-over-year comp that you’re looking at. We think about the sequential comp as being reasonably consistent in terms of the growth rate.

Okay. And then maybe if I could just ask you, I think you mentioned the Alberta contract, and I think we know how much in volumes that is, but is there any commentary about how much revenues and when would that roll off if you're not successful on your appeals?

Just to be clear, AJ, we do not consolidate the revenue, so it does not have any revenue impact. It only has an impact below the line, and it is quite immaterial.

Steve Anderson (VP of Investor Relations)

Yep. AJ, the contract that we currently have, I believe, takes us through 2016. As Dave said, given that we're a minority investor in it, we don't consolidate it, so revenues don't show. The earnings, obviously, we take below the line, which again, we don't want to give up, but it's not material.

Okay. All right. Thanks a lot.

Dave King (Chairman and CEO)

At this time, I would like to turn the conference over back to Mr. Dave King for closing remarks. Please proceed, sir.

Thank you very much. We thank you all for joining us on our call this morning, and we hope that you have a great day. Good day.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a wonderful day.