Labcorp Holdings - Earnings Call - Q3 2016
October 26, 2016
Transcript
Operator (participant)
Ladies and gentlemen, and welcome to the Labcorp's third quarter earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. If anyone should require any operator assistance during the conference, please press star then zero on your touchstone telephone. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Paul Cerdes, Vice President of Investor Relations. Sir, you may begin.
Paul Cerdes (VP of Investor Relations)
Good morning, and welcome to Labcorp's third quarter 2016 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 8-K 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 2015 10-K. 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, Paul, and good morning, everyone. We reported another solid quarter with year-over-year revenue growth of 4.5% and adjusted EPS growth of 9%. We expanded margins at an enterprise level and within Labcorp Diagnostics, an impressive accomplishment in light of lower demand. We also continue to augment our growth through the deployment of Free Cash Flow to strategic acquisitions. It is our expectation that our strong Free Cash Flow will also enable us to restart our long-standing program of returning capital to shareholders next year. We are steadfastly committed to improve health and improve lives around the globe, led by our focus on our three strategic priorities: delivering world-class diagnostic solutions, bringing innovative medicines to patients faster, and developing technology-enabled solutions to change the way care is provided. I will now update you on our key activities during the quarter and our progress on each of these objectives.
First, to be the world's leading provider of diagnostic solutions, we continue to expand our test menu, innovate in science, and complement our robust capabilities with key acquisitions. In the third quarter, we completed the strategic acquisition of Sequenom, and our integration plans are on track. The addition of Sequenom positions us as the market leader in NIPT, women's health, and reproductive genetics. We now offer patients and physicians one source for the most complete range of women's health diagnostics, simplifying the customer experience. Non-Invasive Prenatal Testing is an exciting long-term growth opportunity that continues to gain traction with payers, as evidenced by increasing coverage for average-risk pregnancies.
We also see increasing interest from providers, as evidenced by the American College of Medical Genetics and Genomics' updated position statement, which recommends that providers inform all pregnant women that non-invasive prenatal screening is the most sensitive screening option for traditionally screened aneuploidies. We are also investing in technology that increases patient and consumer engagement and creates a better experience with Labcorp. Our most recent initiatives include our real-time insurance eligibility capability, which was implemented nationally earlier this year and allows our personnel to determine whether a patient is insured at the time of service. This tool benefits our patients by helping them avoid unexpected coverage denials. In addition, we are testing enhancements to this capability in select locations to provide a pre-service disclosure to patients, itemizing their expected payment responsibility, which will benefit patients by reducing surprises in their bills.
Both of these initiatives will also help us reduce bad debt. As part of our commitment to customer engagement, we also expect to launch our consumer-initiated lab test offering before year-end, giving consumers access to certain lab tests online in an expeditious, compliant, and responsible manner. In addition, we expect to launch a mobile-optimized version of our patient portal in early 2017, which will improve the customer experience by enabling patient-friendly functionality, such as scheduling an appointment or paying a bill anytime, anywhere from any mobile device. Second, to bring innovative medicines to patients faster, we continue to enhance our data capabilities, develop differentiated solutions, and expand our therapeutic expertise in critical areas of drug development. Last month, we announced the addition of John Ratliff as the CEO of Covance Drug Development.
We are thrilled to have John join us, and he has already engaged the Covance team and many of our key clients. We're excited to have John's experience and vision to further enhance our ability to provide superior drug development services. John is deeply engaged in tactical actions of our clinical business, as well as the development of the strategy for the entire Covance portfolio, and we look forward to his contributions to Labcorp in the year to come. Clients continue to be attracted to the insights extracted from our combined Labcorp Diagnostics and Covance Drug Development data to optimize clinical trial recruitment. We are focused on effective data utilization for enhanced patient identification, patient engagement, protocol feasibility, and site selection to drive faster recruitment for our clients.
Since the acquisition of Covance, our customers have awarded us a dozen studies based on the unique value of Labcorp's data, and we continue to use our integrated data capabilities as a point of differentiation. We are committed to enhancing our therapeutic expertise with a particular focus on the growing areas of oncology and rare and orphan disease. Our combined scientific expertise and experience in these categories is substantial. For example, we work on all 14 oncology drugs approved by the FDA last year, and we are the only company to provide diagnostic support for all three immuno-oncology drugs approved to date. In rare and orphan disease, we worked on 20 of the 21 FDA-approved drugs in 2015.
Over 80% of rare diseases are genetically defined, and we offer clients more than 480 tests in this category, as well as biomarker development, genetic sequencing, specialty testing, and market access services, all of which create a clear differentiator for us in the marketplace. We are further strengthening our enterprise-wide sales force to target clients that will benefit from our scientific leadership in these important therapeutic categories. Our success in combining Labcorp and Covance's scientific and operational expertise is particularly apparent in companion diagnostics. Our clients seek scientifically driven, cost-effective options for companion diagnostic development, and we are delivering. We are currently supporting more than three dozen companion diagnostic programs, a third of which are proprietary programs where we are developing the companion diagnostic for the customer. We look forward to sharing the progress of these programs as they advance the regulatory process.
We continue to look at all technology platforms for companion diagnostic applications. For example, we are presently conducting studies on the MiSeqDx next-generation sequencing platform, analyzing a collection of genes that represent a potential CDX application. This work is being performed in our industry-leading Covance Central Lab Genomics facility, which has broad experience in NGS technologies and applications and is a qualified sequencing provider for all leading platform manufacturers. Our market-leading central laboratory capabilities are generating revenue growth opportunities beyond companion diagnostics. For example, Covance's central lab is on pace to win new orders in 2016 that will translate into 150,000 tests for Labcorp's esoteric laboratory network, up from 18,000 tests last year. In one year, this would be a nearly tenfold increase in the number of complex tests awarded from Covance to Labcorp rather than to other laboratories as a result of our successful lab integration efforts.
We also continue to enhance our central laboratory offering through integration with Labcorp's capabilities and complementary partnerships. Clinical trial investigators' enthusiasm for our enhanced offering is evident in the responses of more than 250 investigators worldwide provided in a recently published survey. Our central lab was rated the most preferred by 60% of surveyed investigators compared to 16% and 11% for the second and third-ranked labs, respectively. This was a substantial increase from the 2013 survey, which was the most recent, using the same methodology where Covance was preferred by 47% of investigators compared to 23% for the next-ranked lab. Importantly, 98% of investigators stated that the pharma-sponsored selection of a central laboratory impacts the investigators' willingness to work with that sponsor in the future. For our third objective, we are changing the way care is provided through the use of information and technology-enabled solutions such as Beacon LBS.
The Beacon LBS United Healthcare pilot in Florida has demonstrated positive results, including improved quality of care. Compliance with evidence-based guidelines when ordering lab tests has increased by nearly 50% since the initiation of Beacon LBS. The use of their network labs has also increased, helping United Healthcare members maximize their benefits coverage and reduce out-of-pocket costs. Following the successful pilot program in Florida, United Healthcare recently announced that the program will expand to Texas in 2017, a significant milestone for the Beacon LBS team. In addition, Beacon LBS will enhance the technology by the end of the year to incorporate molecular and genetic test decision support, an area of confusion for many providers and a driver of lab spend overall.
Next year, we expect to introduce additional Beacon LBS functionality for health plans, physicians, and consumers, including the potential use of the Beacon LBS platform for applications beyond lab testing, such as support for HEDIS and STAR ratings. Beacon LBS is an important component of our unique strategic relationship with United Healthcare, and the decision to implement it in an additional market reflects our mutual commitment to the partnership. Although earnings and cash flow for this quarter are slightly below our aspirations, this is principally due to deliberate actions on our part. Those decisions include exiting certain accounts in diagnostics, acquiring Sequenom, and entering into a strategic collaboration in our central lab's business. In addition, our cash flow expectations were diminished by increased DSO in the Covance segment, which reflects a broader industry trend. Despite all of this, our earnings guidance is essentially unchanged.
We will finish the year with record cash flow, and we remain excited about and confident in the long-term outlook for our business. We remain sharply focused on executing our three foundational strategies. The progress we are making positions us as the go-to partner, bringing the critical solutions to address our customers' needs. Our progress on all of these initiatives furthers our mission to improve health and improve lives, something that every one of our 50,000 employees around the globe is committed to every day. We look forward to updating you on our continued progress. 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 third-quarter results, followed by a discussion of our Labcorp Diagnostics and Covance drug development segments, and conclude with an update on our 2016 guidance.
Revenue for the quarter was $2.4 billion, an increase of 4.5% over last year, due to organic growth and acquisitions partially offset by unfavorable currency translation of 50 basis points. Organic revenue growth in the quarter on a constant currency basis was 3.6%. Gross profit for the quarter was $788 million, or 33.2% of revenue, compared to $765 million, or 33.7% last year. The increase in gross profit was due primarily to price-mixed acquisitions, our Launchpad business process improvement initiative, and Covance's cost synergies, partially offset by an unusually high level of rework in the clinical business and personnel costs. The decline in gross margin was due to lower margins in Covance's drug development. SG&A for the quarter was $400 million, or 16.9% of revenue, compared to $386 million, or 17% last year.
Special charges in the quarter were $16 million, primarily related to the acquisition of Sequenom and our Launchpad initiative, compared to $5 million a year ago. Excluding special charges, SG&A in the quarter was $384 million, or 16.2% of revenue, compared to $381 million, or 16.8% a year ago. We continue to leverage our SG&A expense well, as evidenced by our 60 basis point improvement in the SG&A rate, which was primarily due to continued expense control, including our Launchpad and cost synergy initiatives. Excluding acquisitions, SG&A dollars would have been down from last year. During the quarter, we recorded $23 million of restructuring charges, primarily due to the closure of redundant facilities and associated severance. These closures include our progress on consolidating our eight main central laboratory facilities to four by the end of 2017 as part of the integration of Covance.
Operating income for the quarter was $324 million, or 13.7% of revenue, compared to $308 million, or 13.6% last year. Excluding amortization, restructuring, and special items of $80 million, adjusted operating income was $404 million, or 17% of revenue, compared to $384 million, or 16.9% last year. The increase in adjusted operating income and margin was primarily due to price-mixed and our Launchpad and cost synergy initiatives, partially offset by higher rework in the clinical business and personnel costs. Interest expense for the quarter was $58 million, compared to $56 million in the third quarter of 2015. The increase was due to a $6 million non-recurring expense for the early retirement of debt assumed as part of the acquisition of Sequenom, partially offset by lower debt balances. The tax rate for the quarter was 31.7%, compared to 38.4% last year.
Excluding special charges and amortization, the adjusted tax rate for the quarter was 32.2%, down from 35.3% last year. Two accounting changes impacted the tax rate. First, the early adoption in the third quarter of the new FASB pronouncement relating to tax benefits of stock compensation lowered the GAAP in adjusted tax rates by 1%. Second, the reclassification this quarter of certain gross receipts taxes from income tax expense to SG&A expense lowered the GAAP in adjusted tax rate by 0.6%. This reclassification does not impact EPS and has been adjusted for prior periods. These two accounting changes resulted in a 1.6% improvement in our tax rate for the quarter. In addition, the reversal of expired tax reserves, as well as the geographic mix of earnings, also contributed to the improvement over last year's tax rate.
For the year, we expect our adjusted tax rate to be approximately 34%, which represents our prior expectation of 35.3%, less the impact from these two accounting changes. Net earnings for the quarter were $180 million, or $1.71 per diluted share. Excluding amortization, restructuring, and other special items, adjusted EPS were $2.25 in the quarter, up 9% over $2.07 last year. Our GAAP and adjusted results in the quarter included two special items: a benefit of $0.02 per diluted share from the adoption of the new FASB pronouncement and a loss of $0.02 per diluted share from the impairment of an investment in our venture fund. In addition, the company incurred a loss of $0.01 per diluted share during the quarter from the acquisition of Sequenom. However, we continue to expect the acquisition to be accretive to results during our first year of ownership.
During the quarter, operating cash flow was $250 million, compared to $288 million last year. The decline was primarily due to fees associated with the acquisition of Sequenom and higher working capital requirements, including an advance payment we made as part of an exclusive strategic alliance for our central lab business. Capital expenditures totaled $66 million, or 2.8% of revenue, down from $68 million, or 3% last year. As a result, Free Cash Flow was $184 million in the quarter, compared to $220 million last year. At quarter end, our cash balance was $568 million, down from $640 million at the end of the second quarter. Total debt was approximately $6.2 billion. During the quarter, we invested $253 million in acquisitions and assumed $130 million of Sequenom debt, which was retired in October.
The company's leverage at quarter end was 3.3x gross debt the last 12 months pro forma EBITDA, unchanged from the second quarter. Now, review our segment performance. Segment results exclude amortization, restructuring, special items, and unallocated corporate expenses. Reconciliations of segment results to historically reported results are included in today's press release and the current report filed today on Form 8-K. Now, I'll review the performance of Labcorp Diagnostics. Revenue for the quarter was $1.7 billion, an increase of 4.4% over last year. The increase in revenue is the result of price-mix and acquisitions, partially offset by organic volume, measured by requisitions, and currency. Revenue per requisition increased 4.2%, benefiting from price-mix and acquisitions. In addition, esoteric testing grew at a faster rate than core testing. Total volume increased 0.3%, with organic volume down 0.3% and acquisition volume up 0.6%.
The decline in organic volume is explained by our decision to exit certain low-margin accounts and to discontinue relationships with third-party providers of consumer-initiated testing. These decisions accounted for 70 basis points of organic volume decline. Also, as a reminder, we do not include requisitions generated by our hospital lab management agreements in our reported volumes due to the lack of similarity to our core business in terms of both testing frequency and revenue per requisition. Labcorp Diagnostics' adjusted operating income for the quarter was $342 million, or 20.4% of revenue, compared to $319 million, or 19.9% last year. The increase in operating income and margin was primarily due to price-mix, our Launchpad initiative, and acquisitions, partially offset by personnel costs. We remain on track to achieve our Launchpad savings of $150 million over the three-year period ending in 2017. Now, I'll review the performance of Covance's drug development.
Revenue for the quarter was $701 million, an increase of 4.8% over last year. Excluding the impact from approximately 150 basis points of negative currency and the expiration of the Sanofi site support agreement, which annualizes at the end of October, revenue increased 9.5% over last year. The revenue growth was broad-based across our early development, clinical, and central lab businesses. Adjusted operating income was $96 million, or 13.6% of revenue, compared to $97 million, or 14.5% last year. The decline in operating income and margin was primarily due to the expiration of the Sanofi site support agreement, an unusually high level of rework in the clinical business and personnel costs, including investments in CRAs and the Salesforce to support ongoing growth. This was partially offset by increased demand and cost synergies. We remain on track to deliver cost synergies of $100 million for the three-year period ending in 2017.
Net orders during the quarter were $755 million, down 7% from last year, representing a net book-to-bill for the quarter of 1.08 and a trailing 12-month net book-to-bill of 1.14. Despite the lower-than-expected book-to-bill ratio, proposals are at a high level. Backlog at the end of the quarter was $7.1 billion. Now, I'll update our 2016 guidance, which assumes September 30th foreign exchange rates for the remainder of the year. We expect revenue growth of 10%-11% after the impact from approximately 60 basis points of negative currency. This is an increase from our prior guidance of 9.5%-10.5%, primarily due to the acquisition of Sequenom. We expect the Labcorp Diagnostics segment to grow 5%-6% over 2015 after the impact from approximately 30 basis points of negative currency.
This is an increase from our prior guidance of 4.5%-5.5%, primarily due to the acquisition of Sequenom. We expect the Covance drug development segment to grow 7.5%-9% over 2015 pro forma revenue after the impact from approximately 110 basis points of negative currency. This is an increase from our prior guidance of 7%-9%. Excluding the impact from currency and the expiration of the Sanofi site support agreement, we expect net revenue to increase 11.2%-12.7%. We expect adjusted EPS of $8.70-$8.90, which implies a growth rate of 10%-13% over 2015 versus our prior guidance of $8.60-$8.95.
Our adjusted EPS guidance now includes $0.05 per diluted share of special items, consisting of an $0.11 benefit from the adoption of the new FASB pronouncement, $0.04 of dilution from the acquisition of Sequenom, and a $0.02 impairment from an investment in our venture fund. Finally, we expect Free Cash Flow for the year of $840 million-$880 million versus our prior guidance of $900 million-$950 million. This change in our guidance reflects the cash costs associated with the acquisition of Sequenom and advance payment we made as part of an exclusive strategic alliance for our central lab business and an increase in DSOs in Covance's drug development, which reflects a broader industry trend. This concludes our formal remarks, and we'll be now happy to take questions. Operator.
Operator (participant)
Thank you. Ladies and gentlemen, if you would like to ask a question at this time, please press the star and then the number one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from the line of Bill Bonello with Craig Hallum. Your line is now open.
Bill Bonello (Analyst)
Hey, good morning, guys. A couple of follow-up questions. We talked about an unusually high level of rework at Covance during the quarter. Can you elaborate on that a bit? What is that? Why does that happen? What do you do to address it, etc.?
John Ratliff (CEO)
This is John Ratliff, Bill. When you look at specific clients, certain projects, in this case, we had remonitoring, additional queries and data management, additional workload and project management that was caused by specific areas. It all comes down to really process and process improvements at the end of the day and enabling price to be gotten for that rework. When you look at it, very specific clients, very specific projects, and a number of different areas that we believe we can improve on in the upcoming quarter.
Bill Bonello (Analyst)
Okay. Okay, that's helpful. Then just separately, you talked about deliberate actions that impacted some of the results this quarter, particularly on the lab side, moving away from customers, moving away from the consumer initiatives. Can you just sort of talk about sort of why now, what prompted those decisions? That's all.
Dave King (Chairman and CEO)
Sure, Bill. It's Dave. Good morning. As we've said, we intend to launch our own consumer-enabled testing service this year. Part of the preparation for that is to discontinue relationships with the existing third parties that are essentially using our brand and our capabilities to provide consumer-initiated testing. That was the first part. The second part in terms of the low-margin accounts was every year we look at profitability by account. We look at return by account. We look at trends by account. We had several accounts where we felt that the demands that were being placed on us in terms of workload and service were significantly above what we felt was the level of return we were getting. We made the decision to exit those. It is not particular timing in any quarter. It is just part of an organized annual review that we do.
As Glenn said, the combination there accounted for about 70 basis points of volume that we decided we were not going to continue with.
Bill Bonello (Analyst)
Okay, that's helpful. I'll hop back in the queue. Thanks.
Operator (participant)
Our next question comes from the line of Lisa Gale with JPMorgan. Your line is now open.
Lisa Gale (Analyst)
Thanks very much. Dave, I just wanted to follow up on that point. If we think about that 70 basis points of volume, if we added that back, it still looks like volume is below where it was trending the last few quarters. Can you maybe talk about what you're seeing in the market? I'm just curious around especially high-deductible health plans. Are they having an impact on what you're seeing from quarter to quarter around volumes? Would you expect that to pick up in the fourth quarter because of people needing deductibles?
Dave King (Chairman and CEO)
Lisa, good morning. If we look at the quarters sequentially this year, we did have the benefit in the second quarter of Easter actually having fallen in the first quarter. That gave us, again, from sequential trends, it gave us the boost in the second quarter that probably was equal to 40 or 50 basis points. Normalizing for that, we would see going from 1Q and 2Q to a net of about 50 basis points in 3Q, which certainly is a downward trend, but it also reflects some seasonality, summer vacation. All that said, we still aspire to do better in terms of volume growth. To your specific question, yes, high-deductible plans have an impact. Physician visits have an impact.
We saw in the IMS data the trend is physician office visits year over year were down 5% in the second quarter, but they were down 10% in the third quarter. Obviously, that has an impact on demand. It is a combination of factors. People do get through their deductibles as you go into the fourth quarter, which is encouraging. I think there is also a lot of uncertainty. As everybody is reading about the Affordable Care Act plans, there is a lot of pressure on premium costs. There is a lot of pressure on coverage. There is a lot of pressure on providers withdrawing from the plans, withdrawing from the markets. I would not necessarily say that we have clarity in terms of what is going to happen with fourth quarter volumes aside from what the historical experience has been.
Lisa Gale (Analyst)
Just to that point, when we think about the Affordable Care Act, I think a little over a year ago, you said, "We saw some benefit, but now we're through that." If we really see, because of the rise in premiums that people don't sign up going into next year, could that be a headwind as we go into next year, or is it just really not enough to move the needle?
Dave King (Chairman and CEO)
I definitely think that if, well, a couple of things. A lot of the volume benefit we gained from the Affordable Care Act was through Medicaid expansion. So that volume has been pretty persistent since the ACA passed, and you didn't see kind of one-time engagement. On the other hand, what comes through the exchanges, unless there's a fix of some sort to premium increases and plan withdrawals from markets, there certainly is the possibility that you'll have fewer people enrolled in the exchanges next year. That would potentially have an impact on 2017 in terms of a challenge for volume growth.
Lisa Gale (Analyst)
Okay, great. Thank you.
Operator (participant)
Our next question comes from the line of Robert Willoughby with Credit Suisse. Your line is now open.
Robert Willoughby (Analyst)
Hey, Dave, I guess if I look at your cost-cutting program and the pricing trends seem stable, if not improving a little bit, I guess I look at your culling out some of the lower-end accounts. It would just seem to me you're in a better position to do more business with those accounts and still earn a margin based on some of your internal improvements. How is it possible there are still accounts that are just grinding you lower with the improvement we've seen you make to date?
Dave King (Chairman and CEO)
Rob, we always have customers who want more service for less price. Particularly in situations where these are not customers where there's third-party reimbursement involved, but where they're direct customers, we have to make decisions at some point that we're not interested in the business at the price that's being demanded or the return that's being offered. There are always going to be customers who are asking more than what we feel that we can provide, being responsible to our investors and our employees. This quarter, there were a couple of more sizable ones that obviously had an impact on our reported volumes.
Robert Willoughby (Analyst)
Even with the offsets you're able to generate internally, these guys are still going well below that. I mean, where do they get their service then?
Dave King (Chairman and CEO)
I don't know where they get their service, but they're not going to be getting it from us any further. Look, I mean, yes, there are always customers who, for whatever reason, expect that they're going to be provided rates that we feel are not appropriate.
Robert Willoughby (Analyst)
All right. Thank you.
Operator (participant)
Our next question comes from the line of Jack Meehan with Barclays. Your line is now open.
Jack Meehan (Analyst)
Thanks. Good morning, guys. Sorry, I hate to beat this over the head, but just looking for a little bit more detail in the lab trends, was the consumer testing the bigger piece of the 70 basis points? I'm just trying to gauge how we should be modeling this next few quarters. When did it occur in the quarter? Did it actually build a little bit into the fourth quarter? Then a third piece to that, just with pricing and Sequenom, how much did that add to the rev correct in the quarter?
Dave King (Chairman and CEO)
I'm going to start with your question about the consumer. The answer is that the consumer was slightly smaller, I would say, than the accounts that we chose to discontinue service to. In terms of Sequenom and the contribution to revenue per requisition, we do not typically break out the moving parts like that, Jack. I would just say it was not a huge contributor to revenue per requisition, in part because we did not have it for the full quarter.
Jack Meehan (Analyst)
Got it. That is helpful. Maybe just taking a step back, I think there are a few more moving parts than we have grown accustomed to, but overall, the results were good, and it is good to see the guidance moving the right way. Could you just help us with visibility into 2017 earnings? Any puts and takes at this point that we should be thinking about relative to where the street consensus is today?
Dave King (Chairman and CEO)
I think it's too early, particularly with some of the items that have already been highlighted in the call around coverage, exchanges, ACA premiums. I think it's too early to really have a particularly clear view, Jack. We'll give our guidance as we traditionally do in February with the fourth quarter call. At that time, we'll be in a position to articulate not only what the guidance is, but sort of what's the underlying rationale behind the guidance
Jack Meehan (Analyst)
Okay. Thank you.
Operator (participant)
Our next question comes from the line of Amanda Murphy with William Blair. Your line is now open.
Hi, this is Arthur in for Amanda. I was wondering if you could perhaps walk us through a bit of the trajectory that you expect from the Sequenom acquisition in terms of not just the revenue per rec, but also how you expect it to change its margin profile over time.
Dave King (Chairman and CEO)
Okay, it's Dave. Good morning. Obviously, over time, we do not expect Sequenom to be diluted. We've said that very clearly. Within the first year of ownership, we expect it to be accretive. In terms of how that happens, obviously, there are some redundant public company costs. I want to be clear that it's our intention to keep that laboratory in San Diego open and to actually send more NIPT volume through that laboratory because of its licensure and because of some of the tools that they've developed.
At the same time, we know that we can bring some efficiencies to the laboratory just in terms of automation and other tools that we've developed because of our size. That's sort of on the expense side. On the revenue side, we highlighted broader payer acceptance with average risk pregnancies. We highlighted the American College of Medical Genetics and Genomics physician statement saying this was the most sensitive screening method. I would also highlight to you this is Sequenom provides us with a platform that we can continue to expand and offer more testing. Sequenom rounds out our women's health and reproductive genetics portfolio. I think there's a very attractive opportunity for top-line growth as well as the ability to reduce the expense base. I would expect Sequenom certainly to be equal to or better than overall company margin by the end of the first year of ownership.
Thanks. That's helpful. In terms of capital deployment there, is it similar kinds of targets that we should start to think about in terms of opportunities, or was this specific to women's health kind of acquisition?
We've always said capital deployment was traditionally we've thought about pre-Covance, half to acquisitions, half return to shareholders. That continues to be our overall philosophy. We've talked about a two and a half times target leverage ratio. We've been clear that that is a target. It is not a commandment written in stone, and we're going to be flexible about it in the market depending on conditions. I think the biggest thing to be clear about is that it is our expectation based on, as we look at 2017, that we will be able to resume returning capital to shareholders as part of our use of cash next year.
Thank you.
Operator (participant)
As a reminder, ladies and gentlemen, if you would like to ask a question at this time, please press star, then one. Limit yourself to one question only. Our next question comes from Ralph Giacobbe with Citi. Your line is now open.
Ralph Giacobbe (Analyst)
Thanks. Good morning. Still a little bit confused around the rework on the CRO side. Just hoping to get a little more clarity on that. Did you say it was one client and one project related? You sort of talked about remonitoring and process improvements. Did the client sort of come back to you and basically want rework on something you had done that maybe was not done correctly, and you had to eat the cost of that? Just trying to basically get a better handle. Then maybe if there is a dollar amount that we can think about, is this somewhat of a one-time in nature issue, and does it have any impact, you think, on the relationship with the client going forward? Thank you.
John Ratliff (CEO)
It is a specific client, so it is not just one. If you look at the number of projects and you look at the number of clients involved, it is not bigger than a bread box. It is something you can attack in terms of it is, to give you at least a little bit of an indication, it is unusually high this quarter.
It does get into specific remonitoring at the end of a trial. It gets into specific data management queries for a trial and additional workload in order to push to the end of that trial. As to the customer satisfaction side, it's interesting in a lot of those cases, you are doing the work at the client's demand, and they get better satisfaction from the finishing of that trial at that requested time frame. There is a lot of handholding at the end of trials, and you are trying to basically meet the deadlines. In this case, the revenue generation from that workload was not in line with the amount of workload that you gave, and thus the inefficiency that has shown up in the margin itself.
Dave King (Chairman and CEO)
Ralph, it's Dave. Just agree with everything John said and would just comment in addition that a couple of these were sizable customers of the clinical business. They're not walking away from the business. We obviously are helping them work through these issues and have every expectation that we'll move forward with this strong relationship with them.
John Ratliff (CEO)
Okay. That's helpful.
Ralph Giacobbe (Analyst)
Any dollar amount, though, that we can think about in terms of what the impact was?
Dave King (Chairman and CEO)
No. I don't think there's any way that we could break out specific dollars for you.
John Ratliff (CEO)
We gave you the margin and total in terms of the business. And there's other areas of that margin deterioration, whether it's increased CRAs in terms of the business and the solid growth that's there, or whether it's the sales force increase due to the fact that you're attempting to increase the book-to-bill. There are other impacts in that margin deterioration, but it shows the proactiveness of the business in terms of trying to increase performance.
Ralph Giacobbe (Analyst)
Okay. Thank you.
Operator (participant)
Our next question comes from the line of Stephen Valliquit with Bank of America. Your line is now open.
Stephen Valliquit (Analyst)
Thanks. Good morning, everybody. You mentioned in the press release that the year-over-year decline in the operating income in Covance was due primarily to the expiration of the Sanofi contract. The good news is you'll anniversary the roll-off on October 31st. I guess, despite the comments you just made on the rework of the clinical business within that segment, it seems unlikely that we would see another quarter of down operating income in that segment for the fourth quarter and beyond, at least I'm hoping anyway. I'm just curious if you can give any more color on just confirming that the anniversary of the Sanofi piece should help to even turn back positive year-over-year from here. Thanks.
Glenn Eisenberg (EVP and CFO)
Stephen, this is Glenn. I guess, as you know, we don't guide to segment margins, but we can give you the clarification of your comment. We annualize the Sanofi contract in October, so there's just, call it, one month in that period that that would be a headwind relative to the overall margins. The other thing we would say is that as we progress, and again, you look at the performance relative to last year, we had a very strong quarter in the fourth quarter last year, but we do expect to see improved performance with that less headwind. You would expect to see improved results as we move forward through this year.
Stephen Valliquit (Analyst)
Okay. Great.
Just quickly, just curious, with some of the changes in leadership for Covance, are there any preliminary thoughts on any strategy shifts that we could potentially see over the next year or two with the change in leadership? Thanks.
John Ratliff (CEO)
This is John. I think if you look at kind of my top priorities, there would be four. One is to clearly drive more and more value of the Labcorp-Covance combination, and whether that is through the data from Labcorp within the therapeutic expertise areas, as an example, oncology, or whether it is delivering unique solutions, as an example, in the compliance pan and diagnostics, that would be one. Number two is really regaining the leadership and the profitable growth in the clinical development.
That is expansion on the therapeutic areas, expanding the geographic and sales presence, as well as focusing on some of the process improvements that are needed. We have got a great franchise and strong momentum in the central labs and early development. Like to use those market-leading assets as more of a differentiator for clinical. Finally, as you would expect, it is really focused on the strategy itself, where are you going to compete, how you are going to compete, and differentiating yourself. A lot of the time, my time in these initial three weeks, now in the fourth week, has been with customers, with our employees, and with our senior leadership. That gives you at least a little bit of the indications of the priority that I am now chasing.
Dave King (Chairman and CEO)
It's 10 minutes before the hour, and we still have 11 questions or people in the queue who would like to ask a question. I want to really encourage you to ask one question, and I'm also going to encourage you not to ask questions that we have already addressed, please.
Operator (participant)
Our next question comes from the line of Whit Mayo with Robert W Baird. Your line is now open.
Whit Mayo (Analyst)
Hey, thanks. Maybe just a quick one for Glenn. Can you give any more color on the central lab consolidations, where you are on that initiative, any way to frame up the savings you've realized or what you expect to realize over time? Thanks.
John Ratliff (CEO)
Yeah. This is John. Well on our way. We're consolidating from eight to four, and the consolidations will be completed in 2017, by the end of 2017. We have already done two of those main consolidations and have the actions or are in process on the other two.
Glenn Eisenberg (EVP and CFO)
Just with that, as we said on the synergies and the integration, that "towards the latter part of this year and most of next year would be the final pieces of the cost reduction initiative," which the central lab consolidation will be the biggest piece of that, and we're on track.
Whit Mayo (Analyst)
Okay. That's fair. Thanks.
Operator (participant)
Our next question comes from the line of Nicholas Jansen with Raymond James. Your line is now open.
Nicholas Jansen (Analyst)
Hey, guys. I just wanted to highlight the Beacon LBS opportunity in Texas. I know you talked about it a little bit in the prepared remarks, but just wanted to kind of remind us how much that benefited you guys in Florida. Is Florida and Texas a similar size state for you? Just any sort of color as we think about that ramping as a good guide to growth acceleration on volumes in 2017 and 2018. Thanks.
Dave King (Chairman and CEO)
Good morning. It's Dave. We do not count Beacon LBS toward volume. It shows up in revenue, and it was a nice contributor to 2016 revenue, the Florida piece. My recollection, Glenn's looking up the number, my recollection is the run rate was probably in the, for the full year of Beacon, about $80 million. Yeah, $80 million top-line revenue. Now, remember, the profitability of that, because a lot of it is pass-through, is below company margins. It will certainly, when implemented in Texas in 2017, for the portion of the year that it is implemented, certainly contribute to top-line revenue.
We have seen the business achieve better profitability over the course of the Florida pilot, partly because of enhancement, partly because of the MR integrations. As we continue to enhance it with new capabilities, we feel that it will continue to be more beneficial to the bottom line and also give us the opportunity to expand to more markets.
Nicholas Jansen (Analyst)
Thanks. I will leave it at that.
Operator (participant)
Our next question comes from the line of Ross Muken with Evercore ISI. Your line is now open.
Hey, guys. This is Luke on for Ross. I guess on the Covance side and talking about the bookings, can you guys talk about the specific demand dynamics you were seeing from small biotech to your larger strategics and across the two businesses, the early development and then the clinical business?
John Ratliff (CEO)
Sure. This is John again. We don't break out the bookings by segment, but I'll try to give you a little bit of color. In terms of the biotech side, we actually have seen strength out of the biotechs. If you look at our early development areas, very strong and a very stable pricing to even increasing pricing activities. When I look at biotechs across the portfolio, you can look at this. I know people are focused on the biotech spend rates, etc. We see that pretty stable, especially based on the NMEs in the past and then what that's looking to the future, as well as we're probably oriented to the top 50. Over 80% is in that top 50. I look at that as also an opportunity on the other side to get more and more share of that biotech side.
When you look across the portfolio and the performance there, the early development and central labs had and continue their strong momentum. Finally, on the clinical side, got more work to do. While potentially weaker than the other two areas, we do see impressive actual proposals right now, and now we need to go off and win those.
Great. Thanks.
Operator (participant)
Our next question comes from the line of Bill Quirk with Piper Jaffray. Your line is now open. Great.
Bill Quirk (Analyst)
Thanks. Two quick ones. On the exiting the unprofitable accounts, will there be a sequential impact in 4Q volume from that? Secondly, Dave, you talked about ongoing improvements to the recruitment efforts and the combined Labcorp into Covance. I know you guys are working on a few pieces of that to streamline it for the patients. Any update there?
Dave King (Chairman and CEO)
Thanks. Morning, Bill. You can assume that the accounts will be walked away from, but until they annualize that, it'll continue to be a drag on organic volume. You'll see it continue through 4Q. In terms of patient recruitment, I mean, we are continuing to work to broaden the database to refine our ability to interrogate the database. We continue to sign patients up through the patient portal who are volunteering to be recontacted. We actually had a situation recently where we went back and recontacted them. Although we did not find any patients who fit the study criteria because the study criteria was very, very tight, nonetheless, of the patients who we recontacted, I think all but two or three of the email addresses continued to be valid that they had given us. So 98%-99% of the email addresses continue to be valid.
The patients expressed appreciation that they have been contacted even though they did not fit the study criteria. We are just going to keep getting better at this, and it is going to keep differentiating us from what our competitors can do.
Bill Quirk (Analyst)
Okay. Got it. Thank you.
Our next question comes from the line of Ricky Goldwasser with Morgan Stanley. Your line is now open.
Ricky Goldwasser (Analyst)
Yeah. Hi. Good morning. Two follow-up questions here. First of all, on Beacon LBS, Dave, when we step back and you think about Beacon as a strategic asset, your contract with United is coming up, I think, at the end of 2018. Does Beacon help improve stickiness with United? Is there an expansion plan? Right? You had Florida, Texas is next. Is there a plan to expand to other states?
Dave King (Chairman and CEO)
Good morning, Ricky. Yes, I think Beacon is an important component of the strategic relationship with United. It's a tool that we invented basically to address what we perceive to be a need in the marketplace for two things: better decision support around selection of high-value testing, as well as better ability for payers to manage the trend in high-value testing. The fact that United has made the decision that they want to expand to another market, the fact that we're developing capabilities for molecular testing and want to develop capabilities to enhance not only test selection but also to use the platform for HEDIS and STAR ratings, I think these are all things. Obviously, with the support of United, I think these are all things that speak to the importance of this tool and the value that's placed on it and the relationship.
Yes, obviously, once we do the Texas implementation, we'll be looking to expand to other markets as well.
Ricky Goldwasser (Analyst)
Okay. Then on the book-to-bill, again, it is the lowest in the last two years. When do you expect to return to more historical levels? I understand that there are a lot of RFPs out there, but based on this book-to-bill, it doesn't seem that you're winning it. Again, is this kind of like a one-time quarter phenomenon? Next quarter, are we back to kind of like more of a steady state, or is there something that you think you need to address internally?
Dave King (Chairman and CEO)
Ricky, I think obviously, it's very hard to guide to book-to-bill. What I would say is remember that our trailing 12-month book-to-bill is still 1.14, which is quite healthy. Second of all, the book-to-bill is a combination of three businesses, and so the book-to-bill rates are different in different parts of the business. Obviously, we want to do better in clinical wins. As John mentioned, that's a critical part of the strategy. I can't give you a prediction on, as you've seen, there's fluctuation from quarter to quarter, and it's stronger in one quarter than in the next. We're going to be working to improve it
Ricky Goldwasser (Analyst)
Okay. Thank you.
Operator (participant)
Our next question comes from the line of RJ Rice with UBS. Your line is now open.
AJ Rice (Analyst)
Hello, everyone. It's AJ Rice, actually. Anyway, on the other aspect of the deal that was signed with United Optum, your leading competitor talking a lot about getting some enhanced help on the revenue cycle management. I want to throw out and see what your thoughts about there. Is there any opportunities for Labcorp to perhaps look at something that might help you there? Just real quick follow-up on the comment in the prepared remarks about deploying capital next year, getting back on track with the returning capital shareholders. Is the idea that you think after the first of the year, you'll be back to that 50/50, or is that something that'll happen more gradually over the course of next year?
Dave King (Chairman and CEO)
I'll take the second one first. I mean, I think the idea, and obviously, we're still framing it as we look at what we're going to have next year and what's on our target list. The idea is that we would resume the 50/50 split fairly quickly. It's not kind of a, "We'll start a little bit and dribble it out." It's, "We're going to return capital to shareholders, and we're going to think about it in the way we historically have." In terms of the outsourcing of the revenue cycle management, obviously, we have a lot of respect for the people at Optum. They do terrific work. We have been investing in our revenue cycle management capabilities literally since 1997, 1998, when we started consolidating billing systems and standardizing.
As I mentioned in the prepared remarks, I think a lot of the things that have been referenced as potential opportunities between our competitor and Optum, we're already doing. We're already doing real-time eligibility verification. We're already doing transparency and patient of what they're going to pay. We're already doing collections at the point of service.
We're going to continue to, and we use some outside tools for that. Make no mistake, it's not kind of the everything has to be invented here syndrome. We'll continue to look at what people could bring to complement our capabilities. Fundamentally, I just want to be clear that we view that direct engagement and relationship with the patient as a very important part of our business. We're not going to be of a mind that we should turn that over to anyone else to manage for us. We're always looking for tools that enhance our capabilities, but that's a core competency. As we've said over and over again, consumer engagement and that relationship with the consumer for both the Labcorp and the Covance business brings us a tremendous amount of value. Okay.
AJ Rice (Analyst)
All right. Thanks, Mate.
Operator (participant)
Our next question comes from the line of Isaac Ro with Goldman Sachs. Your line is now open.
Isaac Ro (Analyst)
Good morning, guys. Thank you. Wanted to talk a little bit about capital allocation. Dave, you mentioned in the call here a couple of times the focus on returning cash to shareholders in 2017. At the same time, you guys have been active the last couple of years with M&A. Could you maybe help frame for us the extent to which there's additional M&A still on the radar here? I know it's probably unfair to ever say never say never, but curious if it's a reasonable assumption that larger M&A is unlikely next year.
Dave King (Chairman and CEO)
I just think it's difficult, Isaac, given all of the changes in the marketplace and all of the fairly dramatic things that are going on in both businesses to rule anything out or rule anything in. It is our intention to return capital to shareholders. It is our intention to be active in M&A. I do not really think we have any more to say about it.
Isaac Ro (Analyst)
Understand. I know that is not an easy question. One follow-up, and I am sorry to belabor it. The book-to-bill dynamic in Covance, can you just maybe frame for us a little bit to the extent that parts of the business were stronger than others? Was there any area where book-to-bill was below one? I appreciate that, of course, all of this is sort of difficult to handicap quarter to quarter, but just want to get a sense of the magnitude of pressure that we might be seeing at least in 3Q.
Dave King (Chairman and CEO)
Yeah. We are not going to break out book-to-bill by business. We report by segment. We do not report by individual business. I think we've said what we can say about it, which is there were some parts that were strong. There were some parts that were not so strong. Our aspiration is always to do better.
Isaac Ro (Analyst)
Got it. Appreciate it. Thank you.
Operator (participant)
Our next question comes from the line of Gary Lieberman with Wells Fargo. Your line is now open.
Gary Lieberman (Analyst)
Good morning. Thanks for taking the question. The two reasons you gave for the reduction in the Free Cash Flow guidance was the industry increase in DSOs at Covance and then a strategic payment at the central lab. Was one of those materially bigger than the other? Can you give us some more color into the increase in the DSOs because it doesn't look like that was something that you were expecting?
Glenn Eisenberg (EVP and CFO)
Sure, Gary. This is Glenn. I mean, just as a proxy, it's fair to say that they're all in the same ballpark of numbers. Again, as we've said, we made the strategic investment on the Sequenom side and obviously a little bit diluted in the first year, plus the fees associated with it, the strategic investment in the global specimen solutions business as well. With regard to the DSOs, we had seen a pickup, if you will, in the DSOs with customers looking to push out terms, looking to push out milestones for collection. We had expected that we would see that improve as the year unfolded, which we've not yet. That's why we've adjusted our guidance to reflect that.
What we can tell you is that there are significant programs underway within the business to continue to drive an improvement in our DSOs, and we would expect that to improve over time. This year, given the pressures and given what we've seen, we're not going to see that improvement that we had expected.
Gary Lieberman (Analyst)
Okay. Great. Thanks very much.
Operator (participant)
Our next question comes from the line of Ralph Giacobbe with Citi. Your line is now open.
Ralph Giacobbe (Analyst)
Sorry, just quick follow-up. I guess any updated thoughts on PAMA and the OIG report that suggested perhaps rates would go up for certain codes and maybe even the pushback from the government sort of on that front? Just general thoughts there would be helpful. Thanks, Dave.
Dave King (Chairman and CEO)
Sure. Obviously, the study is underway. We received some regulatory guidance on the data reporting, which quite frankly has some inconsistencies with the rule and some gaps. HCLA and others have advised CMS of some of the things that we view as being inconsistent with the rule. There was the OIG report indicating, as we in the industry all knew, that there were some codes that were being paid below the amounts that Medicare had set. There would be some increases there. If anything, I would say the clarity is fuzzier than it was before in terms of how the data is going to be collected, who it's going to be submitted from, how it's going to be analyzed, and what the puts and takes will be. We're going to continue to work collaboratively with CMS. In fairness, they've been quite open to hearing about our concerns.
We will update you when we have good solid information about what we think the impact of PAMA will be on us.
Ralph Giacobbe (Analyst)
Thank you.
Operator (participant)
I am showing no further questions at this time. I would now like to turn the call back over to Mr. Dave King for any closing remarks.
Dave King (Chairman and CEO)
We would like to thank you for joining us on our third quarter earnings call today. We look forward to speaking to you again with our fourth quarter call and our guidance in February and wish you a good day.
Operator (participant)
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day.