Labcorp Holdings - Earnings Call - Q3 2017

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to LabCorp Third Quarter 2017 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 operator assistance, please press star then zero on your touch-tone telephone. As a reminder, this conference call may be recorded. I will now turn the conference over to Scott Frommer, Vice President of Investor Relations. You may begin.

Scott Frommer (VP of Investor Relations)

Good morning and welcome to LabCorp's Third Quarter 2017 conference call. As detailed in today's press release, there will be a replay of this conference call available via telephone and internet. With me today are Dave King, Chairman and Chief Executive Officer; Glenn Eisenberg, Executive Vice President and Chief Financial Officer; Gary Huff, CEO of LabCorp Diagnostics; and John Ratliff, CEO of Covance Drug Development. In addition to our press release, we also filed a Form 8K this morning that includes additional financial information. Both are available in the Investor Relations section of our website at www.LabCorp.com and include a reconciliation of non-GAAP financial measures discussed during today's call to GAAP. Finally, we are making forward-looking statements during today's call. These forward-looking statements include, among others, statements about our expected financial results, the implementation of our business strategy, and the ongoing benefits from acquisitions.

These statements are based upon current expectations and are subject to change based upon various factors that could affect our financial results. Some of these factors are set forth in detail in our 2016 Form 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, Scott, and good morning. LabCorp delivered record results in the third quarter with year-over-year revenue growth of 10%, adjusted operating margin expansion of 20 basis points, and adjusted EPS growth of 9%. We also reported another quarter of solid free cash flow, enabling us to raise our full-year outlook to a new record of nearly $1 billion. During the quarter, we remained active with capital deployment, highlighted by our strategic acquisition of Chiltern and the continued return of capital to shareholders. In diagnostics, we had outstanding results, driven by robust organic and total volume growth, even more impressive given the drag on growth of approximately 100 basis points from the impact of the hurricanes. Organic growth was broad-based, led by women's health, medical drug monitoring, and our strategic collaboration with 23andMe.

In addition, the integration of Mount Sinai's outreach business and panel are proceeding as planned, contributing to our strong performance. Speaking of the multiple hurricanes, our employees and operations team in the impacted regions performed remarkably in the face of adversity, swiftly restoring operations for our patients without any substantial disruption in processing collected specimens. All of our colleagues also contributed generously to relief efforts for each other and for the affected areas. We appreciate their outstanding efforts on behalf of patients and communities in need. In drug development, we had a solid quarter, highlighted by strong net orders and a continuation of our improving trailing 12-month book-to-bill to 1.33 versus 1.11 at year-end 2016. We continue to invest strategically in our team and expanded capabilities, positioning the business to grow organically in line with historical performance in 2018.

Before I update you on our key strategic priorities, I will briefly comment on PAMA. We find CMS's actions deeply disappointing and continue to highlight that its actions may significantly reduce beneficiary access to critical laboratory services. In PAMA, Congress specifically instructed CMS to determine market pricing for commercial laboratory services. Market price was to be determined by a survey of the industry, which the congressional floor dialogue expressly stated was to include hospital laboratories and to represent the entire market. Unfortunately, CMS overlooked the statutory intent and designed a survey that vastly overweighted the pricing of independent laboratories, ignoring higher-priced physician office and hospital labs, which, as we have repeatedly demonstrated, typically charge commercial customers anywhere from one and a half to five times as much as independent labs. CMS also apparently overlooked OIG reports warning that no hospital labs were expected to report their pricing.

Thus, it is not surprising that the preliminary rates published by CMS last month do not reflect market-based Medicare rates for lab testing. How could they, when fewer than 1% of the labs Medicare paid in 2015 even reported data? In fact, only 1,106 physician office labs and 21 hospitals in the entire country reported their commercial rates. It is disappointing that in its first attempt to implement the desirable goal of market-based pricing for Medicare, CMS has missed the mark so badly and proposed unmerited cuts in a critical service that consumes only 3% of Medicare spending in the first place. We and the industry have again submitted comments to CMS, and we will continue to work closely with Congress and all stakeholders as we explore possible remedies, including legal action as appropriate, focused on aligning the implementation of PAMA with Congress's clearly expressed intent.

Now, I will update you on our progress on key strategic priorities, beginning with our initiatives focused on the combination of diagnostics and drug development. We continue to advance innovative solutions and patient recruitment into studies that utilize the combination of LabCorp Diagnostics' real-world patient and provider data and Covance's global physician investigator performance data. During the quarter, we won multiple awards based on this unique capability. For example, we were involved in a competitive bid process to conduct a global phase two liver disease study for a biopharmaceutical sponsor that had not previously used Covance. Using lab parameters such as mitochondrial antibody level and total bilirubin, we matched the sponsor's protocol criteria against the LabCorp patient population, identified a large number of potential patients, and secured the award.

In another example, we had previously been selected to run a global ulcerative colitis study for a sponsor that had not previously engaged Covance. We followed up this quarter by conducting indication-specific outreach to ulcerative colitis patients who had provided their consent to LabCorp to be contacted about potential clinical trial opportunities, resulting in the identification of protocol-eligible individuals interested in being placed in an active Covance study. Beyond direct engagement with patients and physicians, we continue to work closely with health systems that have expressed interest in becoming preferred partners for LabCorp and for Covance's clinical trials. We have signed agreements with several major health systems to form such partnerships, which will enhance efficiency in patient recruitment, increase access to diverse patient populations, and deepen our broad-based health system relationships. We continue to lead the industry in our capabilities around companion and complementary diagnostics.

We delivered another quarter of double-digit revenue growth year-on-year and won more than $50 million in new awards from a broad mix of pharma and biotechnology customers. These unique capabilities have established LabCorp as the go-to partner in precision medicine. During the quarter, we entered into an agreement with Thermo Fisher Scientific to join its NGS Companion Diagnostic Center of Excellence program, and we have launched the Thermo Fisher Oncomine DX target panel for non-small cell lung cancer patients. We also entered into an exclusive agreement to distribute OmniSeq immune profiling and tumor profiling tests, strengthening our oncology offering to U.S.-based physicians and global biopharmaceutical customers. In addition to progress on enterprise-wide initiatives, both our diagnostics and drug development business delivered important successes this quarter. In diagnostics, we made strong progress on consumer and patient-facing initiatives. Our LabCorp Walgreens collaboration is off to a terrific start.

We are pleased with patient volumes, net promoter scores, and patient feedback on the experience at these sites. We expect to expand LabCorp Walgreens to additional sites in 2018. We continue to make progress in other elements of our consumer strategy. We are introducing LabCorp Express, a solution that allows patients to check in at select PSCs through a custom-built tablet that automatically scans the customer's insurance card and driver's license. We also deployed LabCorp PreCheck, a mobile-optimized web application which allows patients to complete demographic and insurance verification steps prior to arrival at the PSC. These solutions enhance our patients' experience and convenience by streamlining PSC workflow, reducing wait times, helping to reduce bad debt by improving the quality of patient information that we collect, and create opportunities for patients to learn more about clinical trial opportunities.

We will also launch a mobile app version of LabCorp Patient early next year, which will be available for download at various app stores. In our drug development business, we are focused on driving future profitable growth through expanded solutions and enhanced operational capabilities. The acquisition of Chiltern closed on September 1, significantly strengthening our strategic position in clinical development and accelerating revenue and profit growth within Covance. Chiltern has added highly complementary capabilities to our offering, including scale in Asia-Pacific, broader reach into the fast-growing emerging and mid-tier biopharma customer segment, enhanced FSP capabilities, and expertise in medical device trials and oncology drug development. The integration of Chiltern is off to an excellent start, and we warmly welcome our new Chiltern colleagues. Our focus on profitable growth encompasses organic investments as well as strategic acquisitions.

For example, Covance's new biopharmaceutical chemistry manufacturing and control facility is scheduled to open later this year. This investment enhances our ability to provide comprehensive analytical capabilities for development of large molecule therapies used in the treatment of such life-changing diseases as rheumatoid arthritis, hepatitis C, Crohn's disease, and cancer. In the past four years alone, Covance has supported more than 1,000 biologics and more than 40 integrated new drug submission packages, including 9 of the 10 biologics approved by the FDA in 2016. This investment will enhance our ability to serve this important and growing market. We completed the consolidation of our central lab network as planned and expanded our central laboratory business by opening a European operations center in Mecklenburg, Belgium. The site allows faster, more cost-effective production and delivery of kits and other clinical trial supplies to our customers outside the U.S.

Finally, our Covance's Launchpad initiative is progressing well. We are finalizing plans for longer-term projects to re-engineer our drug development solutions, integrate new tools and technology, enhance the customer experience, and sustainably increase our margins. Underpinning our progress on key strategic priorities is our ongoing investment in strong leadership and top-tier talent. Last month, we welcomed Dr. Brian Cavaney to LabCorp as our enterprise-wide Chief Medical Officer. Dr. Cavaney is a nationally recognized clinician and health policy expert who joined us from Blue Cross and Blue Shield of North Carolina. In addition, we are pleased to promote Dr. Dorothy Dot Adcock, one of the foremost coagulation pathologists in the United States, to the role of LabCorp Diagnostics' Chief Medical Officer. Dr. Adcock succeeds Dr. Mark Brecker, who announced his intention to retire after eight years of exemplary service. We are deeply grateful to Dr.

Brecker for his many contributions to LabCorp. The expertise, experience, and vision of our team are important differentiators for LabCorp. To provide you with an opportunity to hear directly from our leaders, to learn more about our long-term strategy and success with key strategic initiatives, as well as to experience a demonstration of our key innovation projects, we will hold an event for analysts and investors on the morning of February 27th, 2018, in New York City. We hope to see you there. In closing, we are pleased with our performance in the quarter and optimistic about the years ahead. We continue to make substantial progress on key strategic growth initiatives, advancing innovative solutions available only from LabCorp to a wide range of customers.

Thanks to the dedication of more than 57,000 employees around the world who are motivated by our mission to improve health and improve lives, LabCorp continues to deliver significant value to patients, employees, customers, partners, and shareholders. 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 2017 guidance. Revenue for the quarter was $2.6 billion, an increase of 9.5% over last year, as acquisitions added 6.9%, organic revenue increased 2.3%, and we benefited from foreign currency translation of 30 basis points. This revenue growth was constrained by around 70 basis points due to the impact from multiple hurricanes during the quarter.

Operating income for the quarter was $341 million, or 13.1% of revenue, compared to $324 million, or 13.7% last year. During the quarter, we had approximately $50 million of restructuring charges and special items primarily related to the acquisition of Chiltern, facility closures, and the forgiveness of amounts owed from patients in areas heavily impacted by hurricanes. Adjusted operating income, which excludes amortization, restructuring charges and special items, was $447 million, or 17.2% of revenue, compared to $404 million, or 17% last year. The increase in adjusted operating income and margin was primarily due to acquisitions, organic volume, price mix, and Launchpad savings, partially offset by higher personnel costs. In addition, adjusted operating income was negatively impacted by around $15 million due to multiple hurricanes. The tax rate for the quarter was 34.8%. The adjusted tax rate, excluding special charges and amortization, was 33.6%, compared to 32.2% last year.

This increase was primarily due to the geographic mix of earnings. We continue to expect the full-year tax rate to be approximately 34%, which brings the tax rate in the fourth quarter in the range of 35-36%. Net earnings for the quarter were $181 million, or $1.74 per diluted share. Adjusted EPS, which excludes amortization restructuring charges and other special items, was $2.46 in the quarter, up 9.3% over last year. Adjusted earnings in the quarter were reduced by approximately $0.09 per diluted share due to multiple hurricanes, which reduced our revenue and caused us to increase our bad debt reserve based upon our historical experience. Operating cash flow was $351 million in the quarter, compared to $250 million a year ago. The increase in operating cash flow was due to higher cash earnings and improved working capital management.

Capital expenditures totaled $75 million, or 2.9% of revenue, compared to $66 million, or 2.8% last year. As a result, free cash flow was $276 million in the quarter, compared to $184 million last year. At quarter end, our cash balance was $409 million, up from $300 million at the end of the second quarter. During the quarter, we invested $1.2 billion in acquisitions and repurchased $42 million of stock. As of September 30th, we had $447 million of authorization remaining under our share repurchase program. Total debt at quarter end was $7.2 billion. Following the acquisition of Chiltern, both rating agencies reaffirmed the company's investment-grade ratings. The company's leverage was 3.5x pro forma gross debt to last 12 months EBITDA as of September 30th. We expect to use a portion of our free cash flow in the fourth quarter to lower the company's leverage by year-end.

Now, I'll review our segment performance, beginning with LabCorp Diagnostics. Revenue for the quarter was $1.8 billion, an increase of 9.9% over last year. The increase in revenue was driven by acquisitions, organic volume measured by requisitions, price mix, and the benefit from currency translation of 20 basis points. Revenue per requisition increased 2.4%, benefiting from price mix and acquisitions, including Sequenom, which annualized in September. In addition, esoteric testing grew at a faster rate than core testing. Total volume increased 7.3%, of which organic volume was 2.3%. We achieved this result despite the negative impact on volume of approximately 1% from multiple hurricanes. Acquisition volume was 5.1%, led by the PAML and Mount Sinai transactions. LabCorp Diagnostics' adjusted operating income for the quarter was $374 million, or 20.3% of revenue, compared to $342 million, or 20.4% last year.

The $32 million increase in adjusted operating income was primarily due to strong organic revenue growth, acquisitions, and Launchpad savings. The 10 basis point decline in margin was due to the impact from multiple hurricanes during the quarter, which negatively impacted margins by 70 basis points. In addition, the company achieved its three-year goal to deliver net launch capital of $150 million. Although we have reached our targeted savings, the Launchpad process will continue to drive business process improvements throughout the segment as we complete a number of projects that are underway and identify new opportunities. Now, I'll review the performance of Covance's drug development. Revenue for the quarter was $761 million, an increase of 8.6% from last year due to the acquisition of Chiltern, organic growth, and the benefit from 60 basis points of foreign currency translation.

Adjusted operating income was $109 million, or 14.3% of revenue, compared to $95 million, or 13.6% last year. The increase in operating income and margin was primarily due to the acquisition of Chiltern, organic revenue growth, cost synergies, and Launchpad savings, partially offset by increased personnel costs. During the quarter, we completed the consolidation of our central lab facilities in Europe and the U.S., achieving our three-year target to deliver $100 million in cost synergies. In addition, we're on track to generate savings from Covance's Launchpad initiative of $20 million this year, which will annualize to $45 million beginning in 2018. Our planning for the expansion of this three-year initiative is progressing well, and we will provide additional details early next year.

The strategic investments that we've made to enhance the business's leadership, sales force, and capabilities continue to pay off as we posted another strong improvement in net orders and book to bill. For the trailing 12 months, net orders were $3.8 billion, an increase of $370 million over last quarter's trailing 12 months, producing an improved net book to bill of $1.33. Backlog at the end of the quarter was $6.8 billion, of which Chiltern added $1 billion. We expect approximately $2.7 billion of this backlog to convert into revenue over the next 12 months. Now, I'll update our 2017 guidance, which assumes foreign exchange rates as of September 30th for the remainder of 2017 and includes anticipated capital allocation. We expect revenue growth of 8%-8.5% after adjusting for the negative impact from approximately 10 basis points of foreign currency translation.

This is an increase over our prior guidance of 5%-6.5%. We expect LabCorp Diagnostics' revenue growth of 8.5%-9%. This is an increase over our prior guidance of 7%-8%, primarily due to the consolidation of a joint venture related to the acquisition of PAML. We expect Covance's drug development revenue growth of 6%-7.5% after adjusting for the negative impact from approximately 10 basis points of foreign currency translation. This is an increase over our prior guidance of 1%-3% due to the acquisition of Chiltern. Our 2017 adjusted EPS guidance is $9.40-$9.60, an increase of 6%-9% over 2016, and an improvement over our prior guidance of $9.30-$9.65.

We have narrowed the range and modestly increased the midpoint of guidance as the negative impact from multiple hurricanes during the quarter is expected to be offset by the accretion from the Chiltern acquisition. Finally, we expect free cash flow to be between $970 million and $1.01 billion, an increase of 8% to 13% over last year and higher than our prior guidance of $925 million to $975 million. The improved outlook is driven by the company's continued strong earnings and working capital management. This concludes our formal remarks and will now take questions. Operator?

Operator (participant)

Thank you. Ladies and gentlemen, if you have a question at this time, please press star and then the one key on your touch-tone telephone. If your question has been answered or you wish to move yourself from the queue, please press the pound key. In order to allow time for others, we ask that you please limit yourself to one question and one follow-up. Again, if you have a question at this time, please press star one. Our first question comes from the line of Lisa Gill of JPMorgan. Your line is now open.

Lisa Gill (Managing Director)

Thanks very much and good morning. I apologize. There are three calls going on this morning, so I may have missed your specific comments on PAMA, but I just wanted to have a better understanding. We've heard your competitor talk about it, but is there any way to maybe think about the financial impact as we go into 2018? It looks like at this point we haven't heard anything, so my expectation would be that the cuts are going to go forward. Anything that you can help to frame the potential impact to earnings would be one. Then just secondly, I just wanted to better understand if you had any comments around United and updated on timing around where you are in renegotiating your relationship.

Dave King (Chairman and CEO)

Okay. Sure. Good morning, Lisa. With respect to PAMA, what we have been saying since the beginning of the year is that we expected the reductions, starting with our clinical lab fee schedule revenue, we expected the reductions to be in the range of 6%-8%. Based on the preliminary rates that have been proposed and assuming a couple of corrections of obvious errors, for example, the lipid panel and the general health panel were actually proposed to be cut almost 50% in the first year, which is far in excess of the statutory limit of 10%.

Assuming those are corrected, we think at this point that the impact will be toward the highest end or the higher end of that 6%-8% estimate that we've given of clinical laboratory fee schedule revenue. Hopefully that helps frame what we think the financial impact is going to be. Obviously, that's all price, and so it largely falls through. I will say, as we've mentioned, there are a number of offsetting items when you think about earnings. Obviously, the continuation of Launchpad, the projected growth at Covance, the benefit from Chiltern, the benefit from PAMA and Mount Sinai, and the Covance Launchpad process will all be offsets to the PAMA reductions.

We also believe that as we continue to expand our patient-facing capabilities with things like the patient estimator, simplified check-in, rolling those out to our in-office phlebotomists, we also have some opportunity to offset some of the PAMA impact with bad debt. Finally, of course, capital allocation also helps us to offset in terms of EPS, although not necessarily in terms of earnings in year one. That is how we think about the impact of PAMA and hope that helps frame it a little bit. On United, we continue to have a regular and positive conversation with United, including at the most senior levels of the organization. I do not have any update to give you other than that we are pleased with the progress of the conversations.

I would say I think it's in our interest, and I think United believes it's in their interest to get some clarity as soon as we can, recognizing that the contract continues through the end of 2018, and so there isn't any obvious 2018 impact from any of the ongoing conversations.

Lisa Gill (Managing Director)

Okay. Great. Thank you.

Operator (participant)

Thank you. Our next question comes from line of Jack Meehan of Barclays. Your line is now open.

Jack Meehan (Equity Research Analyst)

Hi. Thanks. Good morning. I wanted to continue on there just in terms of your thoughts on the commercial pricing environment. Obviously, the negotiation of national payer contracts is underway. Just if you could give us an update on your philosophy as you're negotiating on price versus value proposition versus network access in these discussions. How do you view commercial pricing in the context of PAMA as a possible offset?

Dave King (Chairman and CEO)

Jack, good morning. Obviously, the commercial pricing environment over the last several years has been pretty stable, and we expect it to continue to be stable. I certainly think as we go into these conversations, we are making it known to the commercial payers that any price reduction—remember, PAMA is an ongoing process with reporting requirements every three years—so any price reductions that they seek would roll through to government pricing in the future. I think that is a constraint, at least on our willingness to think about significant price reductions in terms of commercial contract renegotiation. Obviously, the discussions are not all about price. They are about the value proposition. They are about what else we bring to the table with Covance beyond pure laboratory services.

They are about the value proposition, about our companion diagnostics capabilities and industry leadership in a number of areas of esoteric testing and our centers of excellence. I think there are multiple factors that are part of these conversations, but realistically, there is always a conversation around unit price. We absolutely do our best to maintain unit price stable, and we will continue to do so.

Jack Meehan (Equity Research Analyst)

Great. That is helpful. Then on Covance, great book-to-bill, glad to see pivot to organic growth. Could you give us an update on just some of the tangible data points related to the integrated offering, whether it is net awards tied to the strategy or number of patients that have opted in for recruitment? Finally, just with Launchpad coming up, what the appropriate margin for this business long-term is?

Dave King (Chairman and CEO)

Yeah. I'll make a couple of comments, and then I'll ask John to fill in the details. The consented patients in the database, I believe, is up around 175,000 now. As we introduce our more customer-facing tools in the patient service center through mobile devices, we're optimistic that that number is going to continue to increase and hopefully grow even more substantially. The data points, I cited a couple of them in the prepared remarks. We continue to be at the table. We don't win every study because there's more to study than data. There's therapeutic expertise. There's global presence. There are a whole variety of things. Frankly, there's prior experience with Covance that a number of these companies have not had, but we're getting to the table. We're in the conversations. The data is seen as a valuable asset.

I think that's why you see the strong net orders and the strong book to bill in the business. With that, John, any further color you'd like to provide?

John Ratliff (CEO)

No, just that now that we've been awarded the $500,000,000 in studies based on that data, we understand that that capability is highly valuable to the customers, an important component of the biopharma offering. We saw strength across the segments in terms of the 1.33. Obviously, in order to push the 12 months up continuously, we're getting higher than the average, but from the 1.1 to the 1.15 to the 1.23 to the 1.33. Showing strength across all segments, especially the central labs.

Jack Meehan (Equity Research Analyst)

Great. Thank you.

Operator (participant)

Thank you. Our next question comes from line of Dan Leonard of Deutsche Bank. Your line is now open.

Dan Leonard (Managing Director and Research Analyst)

Thank you. Just one question on the Covance guidance. The range of revenue guidance seems rather wide with two months left in the year. Can you offer a bit more color on what the variables are? Is it just one or two big trials, or are there more factors in play? Thank you.

Dave King (Chairman and CEO)

I think from the standpoint of now incorporating and integrating Chiltern in has a little bit of volatility. Anytime you're coming up the range of the organic growth from the cancellations that have impacted revenue up in the lab side now into stronger growth across the segments allows for the reason why the range is where the range is.

Glenn Eisenberg (EVP and CFO)

Yeah. The only thing I'd add too is we do get different ranges. Segments, obviously, diagnostics being the bigger one. We use a narrower range and, frankly, a little less volatile over historical trends anyway, but we did narrow the range as we get closer through the end of the year.

Dan Leonard (Managing Director and Research Analyst)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from line of Nicholas Jansen of Raymond James. Your line is now open.

Nicholas Jansen (EVP and CFO)

Hey, guys. Thanks for the questions. First one for me is just kind of organic growth in Covance for both the quarter and for the implied 4Q. I'm just trying to better understand the contribution from Chiltern. I think you kind of called out $550 million of total revenue in 2017. You have it for four months. Just back of the envelope math suggests that there might be a little bit of delta versus prior expectations on organic growth. So just wanted to flesh that out. Thanks.

Dave King (Chairman and CEO)

Yes. I'd say our organic revenue growth in the quarter was slightly below our prior expectations, but let's keep the focus. We had strong improvement sequentially. We had improvement in revenue growth year on year. With the book-to-bill of 1.33 over the last 12 months, we see now that getting back to the stronger organic growth of that single to mid to high single-digit growth in the future, and strong quarter.

Nicholas Jansen (EVP and CFO)

That's very helpful. Secondly, I appreciate the comments on PAMA, Dave. Just wanted to kind of better understand the mechanics for you guys. Is it your interpretation that 2019 would be worse than the 2018 level given the differences between the NLAs and Max? Just trying to flesh out if that 6%-8% cut that you're kind of highlighting towards the higher end of that range, is that a better guide in 2019 or a worse guide in 2019? Thanks.

Dave King (Chairman and CEO)

Nick, thank you. I think let me first say that obviously 2019 is very uncertain. PAMA's statute provides for a three-year process. In our meetings with CMS, one of the concerns that they have expressed with the statute is normally they do things on a one-year cycle. If it's not working right after a year, they have the ability to change course. This statute does not seem to provide them with that. One of the things we're talking with them and Congress about is a legislative fix that this thing does not become a perpetual three-year process, but gives CMS some opportunity to adjust it.

Having said that, I would assume that 2019 would be about the same as 2018. Again, we do not have a lot of visibility into what changes CMS may make administratively, but I think in terms of assumptions, that is a reasonable assumption over time.

Nicholas Jansen (EVP and CFO)

Thanks, guys. I will hop back in to you. Great quarter.

Operator (participant)

Thank you. Our next question comes from the line of Amanda Murphy of William Blair. Your line is now open.

Amanda Murphy (Analyst)

Hi. Good morning. I was just hoping you could give a bit of an update on BeaconLBS. I know that you had talked about that program expanding, and I think it has with United. There has been some discussion as of late around prior auth programs, and I think United has one coming up here in November where they are automating prior auth. Wanted to just see how those were going to work together and then just more broadly how you're looking at BeaconLBS as a growth driver longer term.

Dave King (Chairman and CEO)

Yeah. We're in the process of implementing in Florida, call it a version two of BeaconLBS, which responds to some of the concerns that have been expressed by customers and by United about ease of use and other factors. I'm pleased with the fact that we've developed that, and we're in the process of rolling it out. We don't have any plans between us and United to roll into further markets at this point, but BeaconLBS has been selected to be the tool for United's molecular test management, which will be starting later this year.

We see positive trajectory here, and we'll continue to evaluate what's the best way that BeaconLBS can become what we want it to be, which is a physician decision support and utilization tool that leads doctors to right test, right time for the right patient.

Amanda Murphy (Analyst)

Got it. Just switching gears to the CRO side. You've talked in the past too about the building database of consented patients that you've been, I guess, building since the acquisition, really. Where do we stand with that? Obviously, you talked about data being an important driver of decision-making for biopharma, but is that, how important is this database? Do you view that as sort of a differentiated asset for you at this point?

Dave King (Chairman and CEO)

Let's stay here. I'll start and you can have John ask further comments. As I mentioned, I think the database is up around 175,000 consented patients. Now, to be clear, that's only one of the ways that we can use our data to approach patients because we can look at the data as we did in the liver study that I spoke about in the prepared remarks, identify patients, and then contact them through their physician to treat them. That really gives us access to much broader than just the consented database. The consented database is people who have given us consent to contact them directly. In the ulcerative colitis study, the thing that was encouraging was when we reached out to the consented patients, we had a very high response rate of people who were interested in learning more about the opportunity to enroll in the study. I do think it's a differentiator.

I do think the data, particularly because it is identifiable to specific patients and specific results, is a very valuable tool. As I mentioned earlier, and as I'm sure John will elucidate on, it's not the only decision point for a sponsor in determining how to award a study. John, any further comments?

John Ratliff (CEO)

No. I just think from the standpoint of when you talk database, you probably need to just broaden that out to data in general. As Dave said, whether it's the diagnostics data and getting the 500,000 specimen tests a day and/or the global data that we have within the central lab, that's identifying sites. That's getting patient recruitment in an accelerated basis, and that's becoming pervasive on anytime we go out on clinical trial, bid defenses, etc.

As Dave stated, it also depends upon your medic, your PM, your team that you put out there. It depends on the preferred sites that we now have that is advantageous. The solutions we now bring to the table with companion diagnostics, with the actual health systems now that are becoming part of the network, we feel like we have a differentiated solution in that regard, and that's helping us win in general and contributing factor to the 1.33 book-to-bill. Amanda, just quickly on that because I did not mention it. We shouldn't overlook the power of the Covance investigator database because we have information on investigators, all the investigators who conduct trials, not only that Covance runs, but also that Covance is involved in, for example, through the central lab.

Not only can we look at patients, but we can look at investigator sites, who's enrolled patients, who's successfully completed trials, who's had a high retention rate in trials. That's extremely important because more than half of the trial sites never enroll a single patient. To be able to eliminate those from early consideration is a very valuable asset for a sponsor.

Amanda Murphy (Analyst)

Okay. Thanks very much.

Operator (participant)

Thank you. Our next question comes from line of Kevin Ellich of Craig-Hallum. Your line is now open.

Kevin Ellich (VP of Corporate Development)

Good morning. Thanks for taking the questions. Dave, just wanted to go back to PAMA. I don't have questions about the mechanics, but just wondering, can you remind us how much of your commercial revenue is tied to Medicare?

Dave King (Chairman and CEO)

Kevin, a small portion of our commercial revenue is tied to Medicare, and it mostly would fall in the Medicare and managed Medicaid area. That in and of itself is not going to significantly change the impact of whatever is implemented with PAMA.

Kevin Ellich (VP of Corporate Development)

Okay. That's helpful. One quick one for Glenn. Looking at the strong cash flow, which was really nice this quarter and the increased guidance, looking at some of the changes in working capital, it looks like accounts payable and unbilled services were sources of cash, AP to the tune of $59 million and unbilled services $16 million. Can you talk about the moving parts? Should that AP reverse in Q4, or what should we look at?

Glenn Eisenberg (EVP and CFO)

Yeah. Overall, the improvement in the free cash flow as well as our guidance obviously was tied to the earnings, but also in the broader case of working capital management. We've seen a lot of progress that we've done through our Launchpad initiative that's been focused on order to cash and using tools to improve DSOs. Each quarter, as you can imagine, there's always going to be some timing difference between different working capital categories, whether they be receivables or payables. We did get a benefit in payables in this quarter, which was a nice contributor. Again, some of that will be timing that should go the other way. Obviously, that would be factored into the full-year guidance that we have and therefore the implied guidance.

The fourth quarter still is to generate a pretty substantial free cash flow, which also includes the benefit year over year from working capital management.

Kevin Ellich (VP of Corporate Development)

Right. Can you describe the unbilled services? What is that?

Glenn Eisenberg (EVP and CFO)

It's effectively where we're billing or we recognize revenues, but we've not billed it yet. It's just going along the timelines of working to various milestones with our customers. To some extent, it's treated like a receivable. Again, we've recognized the revenue, which is included, but we've yet to bill the customer. Therefore, we know that's additional proceeds that will come in or cash comes in when we ultimately bill them.

Kevin Ellich (VP of Corporate Development)

Sounds good. Thank you.

Operator (participant)

Thank you. Our next question comes from line of Erin Wright of Credit Suisse. Your line is now open.

Erin Wright (Analyst)

Hi. Great. Thanks so much. A couple on Covance here. Sorry if you gave this, but can you speak to the nature of the new business wins? Did you break out a book to bill trend for the underlying Covance business or a comparable book to bill excluding Chiltern? Any sort of commentary on RFP flow that you're seeing would be helpful. Thanks.

Glenn Eisenberg (EVP and CFO)

The Chiltern new business was immaterial to the book to bill. On the RFP, we saw progression first to second, second to third, so a nice trend rate in terms of proposals. I think 3Q was comparable to a little bit up from 2Q. In terms of the segment approach of the performance of the business, Central Labs was strong. Obviously, the clinical business integrating in Chiltern in terms of after the September 1 completion. On the early development, nice momentum on the order rates. That's a little bit of description in terms of the individual silos.

Erin Wright (Analyst)

On the preclinical segment or early development segment, I guess, how big is that business for you now? What's your commitment, I guess, to that business over the longer term within your Covance asset? Thanks.

Glenn Eisenberg (EVP and CFO)

It's a great business. We don't break out the segment results. It's strong. Obviously, we're in number one, number two position depending on which area of the segmentation within the preclinical, both the chemistry and the non-chemistry side of the business. With that leadership position, we feel like we can now really broaden out even some of the areas of service and the menu of science that we bring to the table. As Dave even stated, our commitment in terms of investing in the areas of the business, whether that's the bio-CMC or the bio-A or in the base infrastructure and large molecule, etc., is evidenced by the capital allocation that we're putting to the business unit.

Erin Wright (Analyst)

Okay. Great. Thank you so much.

Operator (participant)

Thank you. Our next question comes from line of Bill Kort of Piper Jaffray. Your line is now open.

Bill Kort (Analyst)

Great. Thanks. Good morning, everybody. A couple of questions here. Dave, I guess first question, help us think a little bit about capital allocation in general. I guess specifically, has this changed at all in light of PAMA? I would presumably suggest that, I suppose, some lab acquisitions may be a little cheaper now than they were, say, a couple of months ago.

Dave King (Chairman and CEO)

I think, Bill, if you look at our history of acquisition activity, we always start with it has to be strategic. You look at the two significant transactions that we've done this year on the lab side, Pamel and Mount Sinai, highly strategic, health system integrated, New York City market, Pacific Northwest market, multiple joint ventures underneath the Pamel structure. Just great transactions for us in terms of long-term positioning of the business and growth. There is a quite robust pipeline of potential acquisitions. There has been for some time. Again, we are very selective in terms of what we acquire from strategic fit, from geographic fit, from therapeutic fit. I feel optimistic that we're going to see some good opportunities. I don't know that Pamel has changed it that much.

It may be that once PAMA is implemented, we'll see some greater activity around the smaller assets. We continue to look at all of these assets as they fit our strategic model. If they do, then are the valuations reasonable?

Bill Kort (Analyst)

Okay. Got it. I appreciate the comments around PAMA and the potential effect on private pay business and your comments there. Just a word maybe, Dave, on the traditional fee-for-service Medicaid business. How much of that is tied to Medicare pricing? Just remind us, how should we be thinking about potential exposure? Thanks, guys.

Dave King (Chairman and CEO)

Traditional fee-for-service Medicaid is a very small part of our book. It's probably about 2% of the book. It is not tied to Medicare per se, but fee-for-service Medicaid is not allowed to pay more than the Medicare national limitation amount, the NLA. If the Medicare NLA is reduced and now the Medicaid NLA is above it, that, I'm sorry, the Medicaid payment rate is above it, then the Medicaid rate will be reduced. It's required by law. The reality is that many state Medicaids already pay well below the current Medicare NLA. I do not think there is going to be a significant impact from fee-for-service Medicaid in terms of the PAMA pricing.

Bill Kort (Analyst)

Great. Thank you.

Operator (participant)

Thank you. Our next question comes from line of Ricky Goldwasser of Morgan Stanley. Your line is now open.

Ricky Goldwasser (Analyst)

Yeah. Hi. Good morning. I have a couple of follow-up questions. First of all, obviously, a lot of discussion around PAMA and a lot of moving parts next year. If the proposed rate cuts do hold, do you think that you can keep margins flat for the lab segment next year?

Dave King (Chairman and CEO)

Ricky, it's Dave. I think it's too early to make a prediction about what will happen with margins. Obviously, PAMA will be a headwind. We do have the tailwinds that I mentioned earlier, and I'm not going to run through them all again. We also have the potential to deploy capital toward acquisitions that could be incremental margin as well. Instinctively, it's going to be difficult to keep margins flat, but I'm not prepared to say that we won't be able to at this point without knowing what's really going to happen.

Ricky Goldwasser (Analyst)

Okay. That's fair. Then on the M&A point, volumes in the quarter, both organically but from acquisitions, were strong. On the M&A, were there any additional acquisitions that you didn't announce that benefited and drove that 5% contribution to volumes? Or should we just account for everything that you announced last quarter and not assume anything new?

Glenn Eisenberg (EVP and CFO)

Yeah. Ricky, nothing, if you will. For the quarter, we did three acquisitions. Obviously, Chiltern for the drug development being the largest, and we did two small tuck-ins there. The acquisition number is not just for the last quarter. It will be for any acquisitions that we would have done over essentially the last 11 months. Anything that has not annualized would be a factor that shows up into what the contribution from M&A is. Each quarter, new acquisitions coming in, and then those that annualize off will change. In the case of diagnostics, we commented that Sequenom annualized in September. Obviously, it was not for a period of the quarter. This time, next quarter, Sequenom will now be part of our organic growth.

Ricky Goldwasser (Analyst)

On a sequential basis, to your point, in the diagnostic business, there were a couple of acquisitions that were not there in the second quarter.

Glenn Eisenberg (EVP and CFO)

Very, very small. Would not move the numbers, but we continue to be acquisitive. Again, they were not meaningful at all.

Ricky Goldwasser (Analyst)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from line of Tim Evans of Wells Fargo Securities. Your line is now open.

Tim Evans (Senior Analyst)

Hi. Thanks. I wanted to come back to the Covance revenue growth guidance. If I am doing my math correctly, using the full-year guidance, and if we assume that Chiltern is on track to do the $550 million that you have guided to already, it looks like the organic constant currency revenue for Covance would be about $50 million lower on a full-year basis. Am I looking at that correctly? If not, where might the delta be?

Glenn Eisenberg (EVP and CFO)

I'd say the comment that you take the annualized number that we've provided, obviously, for Chiltern and take the four months, will give you a good proxy for the contribution that will come from the acquisition. We've given you as well the impact from currency. We do expect organic growth year over year within the, call it the legacy Covance prior to Chiltern. Similar comment within the third quarter. We've enjoyed good sequential growth off of the base business organically as well as year over year. The trends, given the strength of the bookings and our existing backlog and what we'll convert, again, gives us a lot of confidence, as John commented earlier, that we'll continue to see good revenue growth within Covance going forward based on all those attributes.

Tim Evans (Senior Analyst)

Okay. I think John did say that organic growth was maybe a little bit less than you were expecting this quarter. Can you talk about why that might be? Was it preclinical, central lab, clinical, anything in particular there that you can help us characterize that?

Dave King (Chairman and CEO)

I think from the standpoint of the segments, just slightly less in terms of the early development and clinical, but still having aggregate growth year on year in terms of the Covance organic and then sequential growth in all of those segments.

Tim Evans (Senior Analyst)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Mark Mussaro of Canaccord Genuity. Your line is now open.

Mark Massaro (Managing Director and Senior Equity Research Analyst)

Hey, guys. Thanks for the questions. A two-parter if I can. I guess given that a number of tests are facing high single-digit or even 10% cuts per year, Dave, can you speak to how you're thinking about potentially walking away from providing access to certain lower margin tests, assuming PAMA goes through? The second part of that is now that the draft rates have been out for some time now, can you just—and there's been some broad support joining ACLA—can you just speak to the receptivity maybe you've been hearing with some of the comments and maybe some of the momentum you think that might be communicated through to CMS?

Dave King (Chairman and CEO)

Sure. First of all, I certainly have never said or meant to imply that it was our intention to walk away from providing any particular test or any particular service to our patients. We're here for the patients first and foremost.

That would not be something in our thinking. That said, obviously, we and everybody else in the industry will be looking at our infrastructure, looking at access points, looking at size of the business. We have about 1,800 patient service centers. We have phlebotomists in doctors' offices. We're going to have to look at whether we're right-sized given the changes if PAMA gets implemented. I think a more concern in terms of beneficiary access is rural areas where the impact of PAMA will be most demonstrably felt. Yet, fewer than 2% of the data points were from rural laboratories or rural hospitals. Nursing homes, which is a very unique service provided largely by local providers, it's a completely different model from our model, which largely is focused on ambulatory patients. These are typically their patients who are obviously, they're in a nursing facility.

Many of them are in a bed. Someone has to go out there and draw them. I won't go into all the detail, but it's a very different business model. Our concern as an industry is that's where the access will be lost. Those are the people who actually most critically need laboratory services, which again, 3% of total Medicare spend. If you look at the OIG reports, the spending trend has been flat over the last three years. The impact of these cuts is completely out of proportion to what Congress ever intended. In terms of the receptivity, the industry collectively—and I want to compliment my CEO and executive colleagues from around the industry who've had a tremendous amount of activity on Capitol Hill and otherwise—the ACLA, the 21 other healthcare groups that joined the letter from ACLA urging a delay in the PAMA rates.

There's a very strong consensus, including the American Medical Association, the American Hospital Association, the College of American Pathology, that these rates are not right and that CMS should wait to get them right and should do the appropriate thing here. As we said, this is the first foray into market-based pricing for Medicare. It's a bad start to what Congress is trying to accomplish. There is receptivity to thinking about both a near-term and a long-term solution. Obviously, the challenge is going to be in the details of how do you get that done given that we've just filed comments, CMS proposes to finalize the rates. It's the end of October, and these rates are supposed to go into effect in two months.

Mark Massaro (Managing Director and Senior Equity Research Analyst)

Great. Thank you.

Operator (participant)

Thank you. Our next question comes from line of Ralph Giacobbe of Citi. Your line is now open. Thanks.

Ralph Giacobbe (Analyst)

Good morning. Just the revenue impact from the hurricane, it looks like about $18 million. EBITDA about $13 million. I'm assuming that's just the sort of leverage of lack of volume. I'm assuming I'm thinking about that right. Is that a good proxy of understanding margin of incremental volume as well?

Glenn Eisenberg (EVP and CFO)

Yeah, Ralph. A couple of things that come into play. One, the impact from the reduced volumes. Also, we did build up our bad debt reserve during the quarter for the potential challenges of collections in those affected areas, again, based upon what our historical experience. You have kind of the dropdown on the impact of volume. Obviously, incremental volume for us is very profitable. That comes down, plus the increase in the bad debt expense, if you will, as a result. The two of those caused around a $15 million negative impact on our operating income. To your point, around $17 million-ish impact on the revenue line.

Ralph Giacobbe (Analyst)

Okay. That's helpful. Medicare Advantage, just want to confirm, that's in the commercial bucket. Is that right? If you could, maybe just give us a sense of how much is current MA revenue. Is that rate closer to commercial or closer to Medicare?

Dave King (Chairman and CEO)

Ralph, it's Dave. It is in the commercial bucket. I think it's broken out as part of managed care revenue. We don't break out specifically how much is Medicare Advantage. Typically, those rates would tend to be commercially negotiated as opposed to set by the Medicare fee schedule.

Ralph Giacobbe (Analyst)

Okay. That's helpful. Thank you.

Dave King (Chairman and CEO)

We're five past the hour, everybody. We have three more people in the queue. I'd just ask you to make sure that the question you're asking has not already been answered, please. We'll try to get to everyone.

Operator (participant)

Thank you. Our next question comes from line of Dave Windley of Jefferies. Your line is now open.

Dave Windley (Managing Director)

Hi. Thanks for taking my question. Focused on Covance and wondering if you could comment on, first, the pricing environment across the segments, particularly clinical and preclinical pricing environment, and then opportunities for growth apart from the traditional target areas. For example, Asia-Pacific that you've talked about, phase four, real world, late phase type areas as examples. Thank you.

Dave King (Chairman and CEO)

Hey, Dave. In terms of the pricing, it's pretty stable. Obviously, all of pharma is looking for efficiencies and more effective approaches to trials. We need to continue then to develop our own efficiencies in-house. There is always going to be that dynamic.

It's a pretty stable environment. From the standpoint of the opportunities, we consider when I look across the spectrum, number one, the Chiltern acquisition now opens up a much broader infrastructure, a much broader base to now attack the faster R&D growth environment of the small, medium emerging because their dollars are growing more in the high singles than the large pharma. We do see opportunities in terms of the real world areas. Asia-Pacific, we just added now another 700+ employee base that can go attack the Asia-Pac environment. We see early clinical in terms of a very positive opportunity base. Even some of our base businesses, Dave, in terms of whether it's on the safety assessment, the metabolic lead optimization, the central labs, building upon your strength, building upon the significant technical resources that you have, we see even the base growing.

Appropriate question. We're all looking for those adjacent opportunities. We see Covance is primed to take advantage of that.

Dave Windley (Managing Director)

Great. Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Isaac Ro of Goldman Sachs. Your line is now open.

Isaac Ro (Analyst)

Good morning, guys. Thank you. Question for you as it relates to M&A. If we look at the PAMA situation here as it relates to your competitors, mostly the smaller ones, how do you expect this to precipitate potentially a broader opportunity set for M&A? Some of these smaller labs like to sort of make strategic decisions here as to whether they want to stay independent. I'm just curious, to the extent that plays out, whether or not you think that'll take a few months to start accelerating, or could it take a lot longer than that?

Dave King (Chairman and CEO)

Yeah, as you could say. As I said in response to this question when Bill Quirk asked it, I think that the M&A environment and the pipeline has been pretty robust. I think it's going to continue to be robust. I'm not sure what the impact will be on the smaller labs, whether it'll be M&A, whether it'll be that they'll try to throw in their lot with the hospitals. It's just very unclear. We like the acquisition pipeline, and we will continue to be selective in the deals that we choose to do.

Isaac Ro (Analyst)

Maybe more specifically then, sorry, I didn't ask it properly. Is it fair to say that you're not seeing a change in behavior from those other labs at this point because it's early? I'm just trying to get a sense of what the reaction's been.

Dave King (Chairman and CEO)

Yes. That's an accurate state.

Isaac Ro (Analyst)

Thank you.

Dave King (Chairman and CEO)

Thank you. Our next question comes from line Rohan Abrol of KeyBanc Capital. Your line is now open.

Rohan Abrol (Portfolio Manager)

Yeah. Just a quick one for me. Just wanted to know if you're seeing any particular trends you'd like to point out with respect to the FSP and full-service elements of the CRO business.

Dave King (Chairman and CEO)

I see that continuing. I haven't seen the shifts from programmatic to FSPs. I've just seen a continuing penetration of the FSPs. We've seen a couple of companies actually go more balanced from just an FSP strategy to more of a, as an example, programmatic in the oncology versus FSP on all other. With that in mind, we then, with Chiltern, now add a greater talent base where their focus on the FSP business was more in that data management, stats programming to now bring forward an enterprise offering with Covance having the FSP co-source business with respect to the monitoring. Now being an enterprise offering that encompasses all the different segments and now trying to take advantage of that broader-based service offering.

Rohan Abrol (Portfolio Manager)

Thank you. Appreciate it.

Operator (participant)

Thank you. I'm showing no further questions at this time. I'd like to hand the call back over to Mr. Dave King for any closing remarks.

Dave King (Chairman and CEO)

Thank you very much. In closing, I just want to, again, thank all of the 57,000 colleagues for a really terrific performance in the quarter. Again, recognize the efforts on behalf of patients and the community in response to these very impactful storms. We are very, very pleased with our very strong performance in the quarter. We are extremely optimistic about the future of our business in the years ahead. Thank you and good day.

Ladies and gentlemen, thank you for participating in today's conference. That does conclude today's program. We will disconnect everyone.