Labcorp Holdings - Earnings Call - Q4 2015

Transcript

Operator (participant)

Ladies and gentlemen, and welcome to the Laboratory Corporation of America Q4 2015 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 assistance during the call, please press star, then zero on your touch-tone telephone to reach an operator. As a reminder, today's conference is being recorded. I would now like to introduce your host for today's conference, Mr. Paul Surdez, Vice President, Investor Relations. Sir, please go ahead.

Paul Surdez (VP of Investor Relations)

Good morning, and welcome to LabCorp's fourth quarter and full year 2015 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; Jay Boyle, CEO of LabCorp Diagnostics; and Deborah Keller, 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 2014 10-K and our subsequent filings with the SEC, and will be included 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. 2015 was a transformative year for LabCorp. We delivered a strong operating performance and created the world's leading healthcare diagnostics company through the acquisition of Covance. We now have employees in approximately 60 countries, generate nearly 20% of our revenue from outside the U.S., and are well-positioned to compete in a number of attractive global markets. Specifically, our addressable market now extends beyond the roughly $70 billion North American clinical lab industry and includes global opportunities in our core laboratory business, drug development, food safety, and market access. With the Covance acquisition, our company now competes worldwide in a growing addressable market of approximately $200 billion. Our financial performance in 2015 reflects our larger footprint and broader capabilities.

The combined organization delivered strong revenue growth and margin expansion in 2015, with nearly $1.5 billion in adjusted operating income, double-digit earnings growth, and over $720 million in free cash flow. In 2016, we expect our free cash flow to exceed $900 million, with attractive opportunities to enhance our market position and create shareholder value through capital deployment. Our guidance reflects our confidence that LabCorp Diagnostics will deliver another strong year and that Covance drug development will continue its solid momentum into 2016. Our success is due to execution of our strategy to improve health and improve lives. Our execution on three key strategic objectives—delivering world-class diagnostics, bringing innovative medicines to patients faster, and changing the way care is provided—led to these impressive results, reinforcing our conviction in the transformation that we undertook a year ago with the Covance acquisition.

I will discuss each objective and how we are differentiating ourselves in the marketplace. First, to deliver world-class diagnostics, we focus on organic growth through introducing new tests to our existing customers, as well as through reaching new customers, channels, and markets. We also focus on integrating diagnostic information and content and continuing our industry leadership in scientific innovation. Finally, through disciplined capital deployment, we acquire complementary businesses that enhance our offerings. Last year, we expanded our test menu with the introduction of 75 new assays and accelerated next-generation sequencing capabilities. We experienced strong demand for our innovative decision support tools, delivering over 5 million enhanced reports to help customers manage health in important conditions such as chronic kidney disease, cardiovascular disease, and type 2 diabetes.

We also added complementary capabilities through targeted tuck-in acquisitions, such as Safe Foods, a premier food safety laboratory that expands our size and reach in the fast-growing global food safety arena. In addition, we progressed on a number of important consumer-facing initiatives, including our patient portal, lab-in-an-envelope offering, and consumer-initiated testing, and we remain enthusiastic about their long-term impact on our business. Our strength in science is highlighted by our differentiated capabilities and unparalleled experience in companion diagnostics, which provides a sustainable competitive advantage. Over the last six months, three very important oncology companion diagnostics received FDA approval. For each one, we were the exclusive laboratory to partner on the clinical trials and support the regulatory submissions. In addition, we were among the first labs to launch these tests for commercial distribution.

Our ability to collaborate with sponsors at all stages of companion diagnostic development through Covance and commercialization through LabCorp gives us a preferred offering that is improving the lives and health of patients and translating to robust financial growth. Our companion diagnostic franchise achieved double-digit growth in 2015, and we remain confident that we will deliver $100 million in incremental revenue in companion diagnostics through 2018. For our second objective, bringing innovative medicines to patients faster, we are focused on commercialization of novel technology, helping partners rethink their global R&D decisions, and disciplined capital deployment to build and acquire complementary capabilities. We collaborated on 87% of the 45 new drugs that were approved by the FDA last year. Within oncology, we collaborated on 100% of the new drugs that were approved.

It is noteworthy that these collaborations included all aspects of our full spectrum of drug development services, from early development to central lab to clinical. These outstanding results demonstrate the breadth of our capabilities and the power of our combined company to provide differentiated end-to-end solutions designed to improve the success of clinical trials, reduce development timelines, and consistently deliver the highest quality services at a competitive price point. Our differentiation extends to our combined central lab, which is recognized as the industry leader in revenue, scale, service, quality, and breadth of test menu. During the quarter, this business grew double digits and secured a multi-year sole-source relationship with a large new customer, bringing great momentum as we move into 2016. We continue to lead the industry in using patient data to improve trial recruitment.

To the end of 2015, we attribute over $130 million in new orders to our backlog due to the combination of LabCorp patient data and Covance's capabilities. Our success spans multiple indications, including oncology and infectious disease, and includes wins from both new and existing customers. In the fourth quarter, we began soliciting patient consent to be contacted about potential trials through our patient portal. The initial response to our outreach has been excellent, as tens of thousands of patients have already consented, and we expect this database of patients to rapidly grow. This capability is unique and allows us to build a large cohort of potential candidates for clinical trials, phase four studies, observational trials, and a host of other real-world applications. It plainly highlights the power of our data and our combined entity.

For our third objective to change the way care is provided, we are focused on commercializing our innovative technology-enabled solutions. We are pleased with the initial successes of Beacon LBS and Xcellerate Monitoring. Beacon LBS uses technology to improve decision-making about laboratory test ordering at the point of care and began generating revenue in 2015. Accelerate Monitoring leverages the power of actionable data to better manage clinical trials, and in 2015, we announced a landmark multi-year agreement to deploy this product as an exclusive central monitoring solution for our customers' worldwide trials. These solutions delivered great value to our partners in 2015, and we expect to expand their capabilities and utilization in 2016. LabCorp looks very different from a year ago, and we have taken profound steps to transform our company and differentiate ourselves from our competitors.

I am deeply appreciative and gratified by the focus, performance, and enthusiasm that my 50,000 colleagues around the globe brought to our work throughout the past year. The acquisition of Covance created a unique business with extraordinary capabilities and significant global growth opportunities. Our execution has resulted in impressive and financially measurable progress on our strategy, and I expect this progress to continue in 2016. 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 fourth quarter results, followed by a discussion of our LabCorp Diagnostics and Covance drug development segments, and conclude with our 2016 guidance. Revenue for the quarter was $2.2 billion, an increase of 48% over last year. The acquisition of Covance contributed $670 million during the quarter, driving 44% year-over-year revenue growth. The remainder of the increase was driven by organic volume growth across both core and esoteric testing, as well as benefits from Beacon LBS, Price Mix, and Tuck-in acquisitions that were partially offset by currency. Gross profit for the quarter was $741 million, or 33% of revenue, compared to $547 million, or 36.1% last year.

The increase in gross profit was due primarily to the acquisition of Covance, as well as price mix, organic volume, and the benefits of Project Launchpad, partially offset by personnel costs and currency. The decline in gross margin was due to the mixed impact of Covance. Excluding Covance, gross margin would have increased 10 basis points over last year. SG&A for the quarter was $405 million, or 18% of revenue, compared to $310 million, or 20.5% last year. Excluding special charges of $32 million, primarily related to the acquisition of Covance and legal costs, SG&A in the quarter was $373 million, or 16.6% of revenue, a 300 basis point reduction versus last year's adjusted SG&A. The increase in SG&A was primarily due to Covance, personnel costs, and Tuck-in acquisitions, partially offset by Project Launchpad savings. The reduction in SG&A as a percent of revenue benefited from Covance's lower SG&A rate.

Excluding Covance, SG&A would have improved 20 basis points over last year. During the quarter, we recorded $54 million of restructuring charges, primarily relating to Covance. Amortization expense for the quarter was $38 million, up from $15 million a year ago due to the impact of acquisitions. Operating income for the quarter was $244 million, or 10.8% of revenue, compared to $219 million, or 14.5% last year. Excluding amortization, restructuring, and special items of $125 million, adjusted operating income was $368 million, or 16.4% of revenue, compared to $250 million, or 16.5% last year. Excluding the mixed impact from Covance, adjusted operating margin would have increased 20 basis points over last year. Interest expense for the quarter was $57 million, compared to $32 million last year. The increase was due to higher debt balances due to the acquisition of Covance.

The tax rate for the quarter was 38.5%, higher than last year's 36.1% rate due to the taxable nature of certain restructuring charges. Excluding special charges and amortization, the adjusted tax rate for the quarter was 34.1%, compared to 36.5% last year, as we benefited from Covance, which has a higher percentage of its earnings generated in lower tax rate foreign jurisdictions. For the full year, our adjusted tax rate was 35.3%, and we expect the rate in 2016 to be comparable. As a result, net earnings for the quarter were $114 million, or $1.11 per diluted share, compared to $120 million, or $1.39 per share last year. Excluding amortization, restructuring, and other special items, adjusted EPS were $1.98 in the quarter, up 20% from $1.65 last year.

During the quarter, operating cash flow was $385 million, compared to $214 million last year, with the increase due to the acquisition of Covance as well as favorable working capital. Capital expenditures totaled $85 million, up from $46 million last year, primarily due to Covance. As a result, free cash flow was $300 million, compared to $167 million last year, bringing our full-year free cash flow to $727 million. Excluding net non-recurring acquisition items of approximately $110 million, our full-year free cash flow would have been $837 million. Our cash balance at year-end was $716 million, compared to $713 million at the end of the third quarter. Total debt was approximately $6.4 billion. During the quarter, we invested $43 million in acquisitions and paid down $250 million of debt, reducing the company's leverage to 3.6 times debt to last 12 months pro forma EBITDA. Now, I'll review our segment performance.

For comparative purposes, segment results are presented on a pro forma basis for all periods, as if the acquisition of Covance closed on January 1, 2014, and exclude amortization, restructuring, special items, and unallocated corporate expenses. During the quarter, we refined our methodology for the calculation of unallocated corporate expenses, which impacts our LabCorp Diagnostics segment results and has been applied to prior periods for comparative purposes. As a result, LabCorp Diagnostics operating expenses increased by $8.5 million in the quarter and would have increased $7.6 million in the fourth quarter of 2014. Conversely, unallocated corporate expenses were reduced by $8.5 million in the quarter and would have been reduced by $7.6 million in the fourth quarter of 2014. Reconciliations of segment results to historically reported results are included in today's press release and the current report filed today on Form 8K. Now, I'll review the performance of LabCorp Diagnostics.

Revenue for the quarter was $1.6 billion, an increase of 4.3% over last year. The increase in revenue is the result of organic volume growth measured by requisitions, Beacon LBS, Price Mix, and Tuck-in acquisitions, partially offset by currency. The increase in revenue of 4.3% includes a benefit from Beacon LBS of 1.1% and an unfavorable foreign currency translation of 0.8%. Revenue per requisition increased 2.2%, benefiting from Price Mix and Tuck-in acquisitions. In addition, esoteric testing revenue grew at a faster rate than core testing revenue. Total volume increased by 1.8%, of which organic volume was 1.6% and acquisition volume was 0.2%. LabCorp Diagnostics adjusted operating income for the quarter was $293 million, or 18.9% of revenue, compared to $273 million, or 18.4% last year. The increase was primarily due to volume, Price Mix, and productivity, partially offset by personnel costs.

Improvement in productivity was driven by Project Launchpad, which delivered approximately $20 million of net savings during the quarter, bringing our full-year total to $65 million. We remain on track to achieve our three-year $150 million goal and estimate that the remaining Launchpad savings will be achieved equally over the next two years. Now, I'll review the performance of Covance drug development. Revenue for the quarter was $691 million, an increase of 4.7% over last year. The stronger US dollar negatively impacted revenue growth by approximately 230 basis points. On a constant currency basis, revenue increased 7% over last year. In addition, the anticipated expiration of the Sanofi site support agreement on October 31st impacted revenue growth by approximately 200 basis points. Excluding this item, constant currency revenue would have increased 9% over last year.

Covance drug development had strong revenue growth across all of its businesses, led by Central Lab. In addition, the revenue growth rate in the clinical business improved from the third quarter, as did the rate in early development when excluding the impact from the expiration of the Sanofi site support agreement. Adjusted operating income was $110 million, or 16.0% of revenue, compared to $90 million, or 13.6% last year. The increase in operating income and margin was primarily due to increased demand, as well as productivity and cost synergies, partially offset by personnel costs. We captured approximately $15 million of cost synergies during the quarter, bringing our year-to-date total to $45 million. We remain on track to achieve our three-year $100 million goal and estimate that the remaining cost synergies will be achieved equally over the next two years.

Net orders during the quarter were $816 million, representing a net book-to-bill of 1.18, while backlog at year-end was $6.7 billion. The trailing 12-month net book-to-bill was 1.23. Now, I'll review our 2016 guidance, which assumes January 31 foreign exchange rates for all of 2016. On a consolidated reported basis, we expect net revenue growth of 7.5-9.5% over 2015 net revenue of $8.5 billion after the impact from approximately 100 basis points of negative currency. We expect the LabCorp Diagnostics segment to grow 3.5-5.5% over 2015 pro forma revenue of $6.2 billion after the impact from approximately 50 basis points of negative currency. We expect the Covance drug development segment to grow 2-5% over 2015 pro forma revenue of $2.6 billion after the impact from approximately 200 basis points of negative currency.

The expiration of the Sanofi site support agreement will negatively impact Covance's 2016 growth rate by approximately 260 basis points. Excluding the impact from currency and the expiration of the Sanofi site support agreement, net revenue is expected to increase 6.6%-9.6%. Our 2016 adjusted EPS guidance is $8.45-$8.85, an increase of 7%-12% over 2015. We expect the distribution of earnings in 2016 to be similar to 2015, as our results in the first and fourth quarters are typically impacted by inclement weather and holidays. Our adjusted EPS guidance includes the impact of currency and an increase in our share count due to stock compensation and option exercises, but does not include any share repurchases.

We expect free cash flow to be between $900 million and $950 million, up from $727 million in 2015, and expect our capital expenditures to be approximately 3% of net revenue, consistent with 2015. In summary, we are enthusiastic about our prospects for 2016 and expect strong top-line growth and margin improvement to drive strong year-over-year earnings per share growth and robust free cash flow. This concludes our formal remarks and will now take questions.

Operator (participant)

Ladies and gentlemen, if you'd like to ask a question at this time, please press the star, 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, you may do so by pressing the pound key. Again, if you'd like to ask a question at this time, please press the star, then the number one key on your touch-tone telephone.

Our first question comes from a line of Lisa Gill with JP Morgan. Your line is now open.

Lisa Gill (Managing Director)

Good morning and thank you. I just had a couple of quick follow-up questions around your revenue guidance. First, can you maybe break down what your expectations are on the diagnostic side between volume and price? And Dave, maybe just give us an update as to what you're seeing out in the marketplace as far as commercial reimbursement. We obviously know what's going on with PAMA, but any update around your thoughts on the commercial reimbursement environment?

Dave King (Chairman and CEO)

Good morning, Lisa. We don't separately break out volume and price in the guidance, so we can't give you any further clarity on that. With respect to commercial reimbursement generally, I think the environment in terms of pricing continues to be relatively stable.

We saw nice revenue per requisition improvement year-over-year in the quarter and for the third quarter in a row. As Glenn identified in his remarks, that's a combination of test mix and esoteric growing faster than core and the benefit of some tuck-in acquisitions that brought us some higher pricing. Generally pleased with the overall pricing and reimbursement environment and pleased with, obviously, the improvement in revenue per requisition in the quarter.

Lisa Gill (Managing Director)

How about on the Covance side? 2-5%. I know last year, Dave, that you announced that at our conference there was something that was signed on the Covance side. Is there any update there? Maybe update us on the revenue synergies and how those are coming along? Also just help us understand what potentially gets you to the upper end of that revenue guidance range?

Dave King (Chairman and CEO)

Sure.

With respect to the revenue synergies, as we indicated on the call, now over $130 million in what we described as category one, which is the use of the patient data. I continue to be quite optimistic about that given the success that we've had with the patient recruitment through the patient portal. As we mentioned, tens of thousands of patients have already agreed to be recontacted. It gives us a deep base of patients that we can contact for potential trials, which I think will be a differentiator in terms of winning revenue over time, winning commitments from sponsors over time. Obviously, Central Lab is very, very strong in the quarter and very pleased with the growth and the momentum that we have going into the year. We saw nice improvement in revenue in the clinical business.

I think we're seeing very good success in our early development solutions. I would highlight again the Companion Diagnostics and our success in Companion Diagnostics. Nobody else can say that they were the exclusive lab on the three key immuno-oncology drugs that were approved in the market over the last six months. Nobody else can say they worked on 87% of the drugs that were approved or on 100% of the oncology drugs. It's just something that completely sets us apart from the market. What gets us to the high end?

What gets us to the high end would be stronger performance in the clinical business and obviously the mix of business wins because longer, more complex trials that pay us a longer stream of revenue with a better mix will lead to more profit, and that'll get us to the higher end of the revenue range and obviously help us also towards the higher end of the EPS range. I said a lot there, but Deb, if you have anything to add, happy to have you add as well.

Deborah Keller (CEO)

No, I think, Dave, the point that you made about the wins that we've had because of the clinical data as well as the strength we've had in Central Labs, early development continues to do well with capacity utilization strong in the U.S. and in China.

We've got some additional space in Europe, and we continue to look at innovative ways we can be more flexible with our space to kind of meet the changing demand in the early development space. Last but not least, as you mentioned, the mix of studies, whether it's where they are geographically or therapeutically, also can have an impact.

Lisa Gill (Managing Director)

Deb, if I can just ask one follow-up. If we look at what's going on on the biotech side right now, we think about new companies trying to come to market, and obviously this is a difficult market for biotech companies. Are you seeing any impact on these new emerging companies as far as your pipeline goes?

Deborah Keller (CEO)

Most of our business comes, about 85% of our business comes from the large pharmaceutical companies, and that continues to be strong.

As far as biotech, they're a very important part of the drug development process, obviously, and somewhat of an innovation engine for pharma. We believe that the cash on hand remains at high levels, and we've had nice wins from the biotech industry this year, specifically in our early development, but across all of our segments.

Lisa Gill (Managing Director)

Okay, very helpful. Thank you.

Operator (participant)

As a reminder, ladies and gentlemen, if you'd like to ask a question at this time, please press the star, then the number one. In the interest of time, we ask that you limit yourself to one question in order to give more people a chance to ask. Our next question comes from a line of Bill Bonello with Craig-Hallum. Your line is now open.

Bill Bonello (Senior Research Analyst)

Hey. Yeah. Thanks. Just a question. You mentioned that you added a large multi-year contract with a new Central Lab customer.

Can you give us a bit more color on that contract? If it's for a specific project, does it go across projects? Is it an exclusive relationship? Maybe just what you believe drove the win? Why did they decide to contract with you?

Deborah Keller (CEO)

Yeah. Good morning. First of all, we don't comment on the specific client, but what I will tell you is that it is a multi-year sole source. What that means is that we'll not only be the sole source provider for the Central Laboratory, but also for the bioanalytical. It was tough from a competitive standpoint, but how Covance eventually won that sole source was based on, first of all, our operational service excellence and our breadth of testing menu as well as our global reach.

Dave King (Chairman and CEO)

Bill, it's Dave.

I would comment it's a new client for us, so that's really a positive development. It also, I think in large measure, is attributable to the combination of capabilities. I mean, the LabCorp Esoteric capabilities. We start with Covance's global reach and the strong reputation for quality and service. Then add to that LabCorp's Esoteric capabilities, the next-gen sequencing capabilities. We really present a very compelling value proposition. As we've gone head-to-head with competitors for these agreements, we've been very pleased that in situations like this, we come away with the wins.

Bill Bonello (Senior Research Analyst)

Okay. Great. Can I sneak in one follow-up?

Dave King (Chairman and CEO)

Yes. One.

Bill Bonello (Senior Research Analyst)

Thank you. Also related to Covance, obviously the revenue side is looking great, the outlook there.

Now that you've had Covance sort of under your belt for a year, can you tell us what your latest thoughts are on your initial synergy targets, whether those are looking more or less conservative, and then whether you see any efficiency opportunities at Covance sort of beyond those initial synergies?

Dave King (Chairman and CEO)

Bill, it's Dave. As we mentioned in the call, we've achieved $45 million of the synergy of the $100 million that we initially set out as our target. I think for year one, that's a very strong performance against the target. We remain committed to achieving the $100 million. As Glenn said, approximately 50/50 over the next two years. Having said that, we always look to outperform on the synergies, and we always look for the opportunity to improve efficiency and productivity.

Along with that, just as with Project Launchpad, to improve the employee and customer experience. I certainly think there will be opportunities as we progress and particularly as we even more comprehensively integrate the capabilities of the organizations around oncology, for example, or around infectious disease to find more savings. We will obviously keep you closely updated as we move forward.

Bill Bonello (Senior Research Analyst)

Thanks a lot.

Operator (participant)

Our next question comes from a line of Michael Cherney with Evercore ISI. Your line is now open.

Michael Cherny (Managing Director and Research Analyst)

Good morning, guys, and thanks for the details so far.

Dave King (Chairman and CEO)

Good morning.

Michael Cherny (Managing Director and Research Analyst)

I will try and keep my one question here. It might have a couple of parts in it, so bear with me. The cash flow generation profile here continues to be robust. Obviously, it was as a standalone company.

Now you're starting to see the benefits from being a pro-pharma company, being able to generate even further cash. As you think about that cash flow generation, particularly now as you're getting towards a leverage level, which I know, Glenn, you're probably a little more comfortable with, you contrast against the backdrop of an uncertain market environment for a vast majority of the smaller players in the market, given the questions about PAMA, the broad views on utilization. How is that affecting your M&A pipeline? How is that affecting the type of deals that are being presented to you, given that you have a very active BD portfolio?

How do you think over time that will evolve, particularly if we do move to a situation where the PAMA revisions do not change and a lot of these small labs do not have the capabilities to be able to address what the reimbursement cuts could be?

Dave King (Chairman and CEO)

Mike, good morning. It is Dave. I think obviously the cash flow generation is very impressive. As I mentioned in the prepared remarks, over $900 million projected for next year. I think the M&A pipeline right now is as robust as we have ever seen it. Part of that is because we are looking at M&A in other areas where we see the opportunity for fast growth, like the food business with the Safe Foods transaction.

We've also seen a lot available in the Tuck-in opportunities in the diagnostic space, and we plan to be very disciplined in terms of what we buy and how that fits into our core strategy, which, as we've said many times around diagnostics, M&A is expansion of footprint, expansion of test menu, and continuing to build size and scale in the franchise. We feel great about the M&A pipeline, and we certainly have plans to, as we've said frequently in the past, our guidance always assumes that we're going to acquire about 1% of that we're going to do Tuck-in acquisitions that will account for about 1% revenue growth, and that's certainly in the plan for the year. I think there's ample opportunity to execute on that.

Michael Cherny (Managing Director and Research Analyst)

Thanks.

Operator (participant)

Our next question comes from a line of Jack Meehan with Barclays. Your line is now open. Hi. Thanks.

Jack Meehan (Equity Research Analyst)

Nice quarter, guys. I similarly have one question, two parts. Maybe for Dave, just curious what your views are on the volume environment on the lab side of the business, the organic volumes that look like it pulled back a little bit. Just pairing that against what you're hearing from the hospitals, what your view is for 2015 or for 2016. And then for Glenn, just surprised we're not seeing a little bit more gross margin leverage given the pricing benefit. Was wondering if you could walk us through that too. Thanks.

Dave King (Chairman and CEO)

Thanks, Jack. It's Dave. I think what we have said all year long about volume is that we knew that we were going to see a step down in volume from the first half to the second half because of the annualization of the contracts. Obviously, we highlighted that.

It hasn't been a secret, and that's been the case. I think if you look sequentially from the third quarter to the fourth quarter, taking into account the differential in the number of days in the quarter, that volume per day was actually quite consistent. We're pleased with the volume, and we're pleased with the organic volume growth that we delivered throughout 2015. For 2016, I think our volume projections, and obviously we've seen some things coming out of the hospitals that suggest that hospital volumes have been bouncing around. I think our volume projections for 2016 suggest that we would expect to see a continuation of what we've kind of seen here in 3Q and 4Q.

Absent some large contract wind or some shift in the marketplace, you're going to see organic volume continue to grow at kind of this 1.5-2% rate, depending on ups and downs and ins and outs. I think we've been obviously delivering very, very solid volume growth, and we expect to continue to do so. In particular, proud of the fact that the great majority of that volume growth is coming from organic growth, which means the introduction of new tests, our sales efforts, and our organizational leadership is extremely effective. Glenn?

Glenn Eisenberg (EVP and CFO)

Yeah. Jack, I guess just on the leverage and the margins. First, we think we obviously had a very strong year on leveraging our top line. Margins overall were up around 110 basis points year-over-year. 47% leverage on the incremental revenues is pretty strong on a pro-pharma basis.

That improvement in margins was across both gross profit and SG&A. When we talked about the margin improvement that we had, excluding Covance, to show that it was a mix impact, when you look at both segments on a pro-pharma basis, you actually see both segments seeing very strong margin growth. We characterize it as a pretty strong year, benefiting from the strong demand, benefiting from price mix, if you will, benefiting from the Tuck-ins, benefiting from our Launchpad initiative, our synergy initiative on the Covance side. Overall, we would characterize it as very good leverage.

Jack Meehan (Equity Research Analyst)

That's helpful. Thanks, guys.

Operator (participant)

Our next question is from a line of Nicholas Jansen with Raymond James. Your line is open.

Nicholas Jansen (Research Analyst)

Yeah. Two very quick ones. First, on the Beacon LBS, just wanted to get your thoughts of kind of the expansion potential of that platform.

And then secondly, back to capital allocation with $900 million-plus of free cash flow in 2016 and probably certainly growing in 2017. How do we think about the share repurchase opportunity now that you're, I would assume, by the end of 2016, you'll be within shouting distance of your kind of approaching 2.5 leverage target? Thanks.

Dave King (Chairman and CEO)

Nick, it's Dave. On Beacon LBS, the strategy across the enterprise is consistent, right? It's new customers, new channels, new markets. For Beacon LBS, the expansion opportunities in 2016 are new markets with the existing customer, which is United, new customers, which are other organizations that may be interested in subscribing to the tool, and new channels, which is the addition of more capabilities such as molecular diagnostics to the menu. All those things are underway, and we feel very good about where we are with Beacon LBS.

It has been a—this is a service that the Beacon LBS team within Labcorp has really invented, created, designed, and implemented. I am really proud of them, and they should be really proud of themselves about what they have accomplished because it is terrific. It is generating a fairly significant amount of revenue now, and we see the opportunity for great growth there. On capital allocation, we have said many times that our target leverage is 2.5 times. That is only a target. We are always going to be flexible in terms of looking at how we allocate capital. We do expect that by the second half of the year, we will certainly be in a position to consider returning capital to shareholders through share repurchase. Again, it depends on the M&A pipeline. It depends on how the cash flow stacks up. We will always be evaluating that opportunity.

As you know, I think we've had a pretty consistent history of share repurchase as a way of returning capital and creating value for shareholders.

Nicholas Jansen (Research Analyst)

Thanks, guys.

Operator (participant)

Our next question is from a line of Isaac Ro with Goldman Sachs. Your line is now open.

Isaac Ro (Equity Research Analyst)

Good morning, guys. Thank you. I wanted to ask a couple of technology questions, actually, this morning. First off, I thought it was notable you went through some commentary on the companion diagnostics opportunity. I think you said $100 million by 2018. I just want to kind of confirm that you guys were talking about that $100 million as sort of an annual run rate that you hope to achieve by that time. If so, should we assume those revenues are accretive to the EBIT margins for the company?

Dave King (Chairman and CEO)

Isaac, what we said was that we expected to generate $100 million in incremental revenue for the enterprise by 2018. We have not talked about the run rate of the companion diagnostics business specifically, other than to say we had double-digit growth in 2015, which we were very pleased with. We do not want to confuse the $100 million in incremental revenue, which was the initial target that we set out a year ago for the companion diagnostic growth, with the size of the business because the size of the business is already actually quite close to that number.

Isaac Ro (Equity Research Analyst)

Got it. Okay. Just maybe from a biotech standpoint, I think the question's been asked a couple of different ways.

I'm wondering if you could maybe benchmark for us, historically, when you've seen slowdowns in funding, how you guys think about the impact that has on the Covance side. Is there a sort of magnitude of funding slowdown or a timing there that we should keep in mind to the extent that this is a fluid environment for that customer group and the impact on the Covance business? Thank you.

Dave King (Chairman and CEO)

No, I just go back to what Deb said. I think she covered it quite comprehensively. There's billions of dollars in cash on the balance sheets of biotech. When there's a good compound that a company is looking at, it doesn't get canceled because of lack of funding. There's always a way to find funding for it. Compounds or studies get canceled because of adverse events or because of a change in focus.

We do not see the quote-unquote "funding environment" as having any near-term effect on where we are with Covance at all. Again, as Deb highlighted, 85% of our revenue is coming from what we would characterize as large pharma. The exposure to biotech is only about 15% of total Covance revenue.

Isaac Ro (Equity Research Analyst)

Got it. Thank you.

Operator (participant)

Our next question is from a line of Robert Willoughby with Credit Suisse. Your line is now open.

Robert Willoughby (Managing Director and Equity Research)

Hey, Dave or Glenn. In the 8K, it looks like you break out Covance at about 31% of your revenues now. Is that including some of the non-government-facing business, the non-managed care business as well, the forensics, the substance abuse testing? If not, what could that percentage all represent?

Glenn Eisenberg (EVP and CFO)

Yeah. Robert, all the revenue streams that we have obviously flow into the two segments. Everything is encompassed there.

Robert Willoughby (Managing Director and Equity Research)

The non-traditional businesses are 31% then of your revenues?

Dave King (Chairman and CEO)

No. No, the 31% is the Covance business. The non-traditional, the way it sorts out, Bob, is that anything that reports into diagnostics is reported as part of diagnostics. The forensics, the Orchid Cellmark, all that stuff reports in through diagnostics. That is part of what we report as diagnostics. The only thing that has changed in the way that we have historically reported is what used to be reported as part of LabCorp in the clinical trials business, which was our central lab, has moved over to Covance. What used to be reported as the Covance food safety and nutritional chemistry business is now reporting up through LabCorp.

You think of that in approximate terms as we've put a little more into Covance than has come over to diagnostics, but not materially so.

Glenn Eisenberg (EVP and CFO)

Is that a yes?

Robert Willoughby (Managing Director and Equity Research)

Yeah. I guess what I'm trying to get at, Dave, when you did the Covance deal, there was a slide I think that you threw out that a certain percentage of your revenues was now away from where maybe the problem was from a reimbursement standpoint, a government standpoint, what have you. I'm trying to get at how much of your business now, with Covance growing, with the Orchid, the Bode deals, and the other things, is it 35% or closer to 40% now that might be away from traditional managed care pressures and maybe government reimbursement challenges?

Glenn Eisenberg (EVP and CFO)

Yeah. Just take a first cut.

I think maybe what you're getting at is with the acquisition of Covance, we pick up a lot of pharma and biotech customers that we didn't have that now represents, call it, around 30% of our total. So by definition, the government reimbursement side is a lower percentage given we've added new customer base.

Dave King (Chairman and CEO)

Yeah. I think we actually published a chart that shows those percentages, Bob, and we'll get that up. But my recollection is pure government went from like 17% to 12%, and managed care went from a little over 50% to about 30%. So say we went from approximately 67% to approximately 42% in terms of managed care and government payment across the enterprise. Does that help?

Robert Willoughby (Managing Director and Equity Research)

Yeah. I will follow up with you. I'd have to go back and find the initial slide, but that is clear. Thank you.

Dave King (Chairman and CEO)

Thanks.

Glenn Eisenberg (EVP and CFO)

Our next question is from a line of Amanda Murphy with William Blair. Your line is now open.

Amanda Murphy (Principal Partner, Life Sciences Tools, and Diagnostics Senior Analyst)

Hi. Good morning. I just had a question on the patient database that you spoke to. I am wondering at this point how much of a limitation, if at all, the consent issue has been in terms of your ability to mine the data and productize the data side. In other words, as you build that database, could you see acceleration in booking as a result of your ability to have the consent there? At what point does the database have critical mass? I realize it is growing quickly, but at what point does it become sizable enough that it would move the needle?

Dave King (Chairman and CEO)

I guess there was a lot in that question.

Let me start by saying that monetizing the data in and of itself has never been something that's been an aspiration for LabCorp. We don't view data sales as it's not going to generate enough revenue to materially help us, and it's not what we want to do strategically. What we want to do is we want to use the data to further the strategy. The strategy, obviously, is to execute on our three core goals, which is delivering world-class diagnostics, bringing innovative medicines to patients faster, and using technology-enabled solutions to change the way the care is delivered. What I see in getting patient consent through the patient portal is we have patients who come to us for lab testing. They come to the patient portal to get their results.

When they come to the portal, we are now addressing the patient population in a place that we've never addressed them before and that no one else is addressing them to say, "Given your diagnosis, given what we know about you, would you be interested in being contacted in the event there was a study that could potentially improve your own health or could improve the health of the population as a whole?" The response has been very positive. As I say, we launched it in 4Q. Tens of thousands of patients have encountered the prompt. A lot have said yes. Some have said no. We're working on figuring out how we can improve the yes rate.

This is not as simple as when you go to download an update to your Apple phone and you either say yes and you get it or no, you do not. There has been a rigorous compliance review. There are protections around how we present this to the patient and what we ask them. We have gone through a very thorough review to make sure that we are doing this in a way that is going to be protective of the patient's privacy and our responsibility to honor that. Now, what does that lead to? It leads to a large database of patients, which can be accessed for a variety of things: clinical studies, phase four, observational studies, reaching out to patients to ask them questions about medication use or medication adherence.

Just a whole variety of areas in which we think this becomes a differentiating factor because we have the patient's consent to recontact them. I would contrast that with an anecdote that was told to me recently, which is a patient got a letter in the mail from a pharmacy saying, "Since you're taking this drug, would you like to be in this trial?" The patient was taking the drug for a completely different reason and was annoyed by the letter because the patient had never given the pharmacy permission to write them letters and ask them about what they want to do because of their use of drugs. We get the patient's consent beforehand, before we ever recontact them, and we ask for it.

As a result, I think we're going to have a cohort that's going to be very interested in how they might participate. In the long run, the goal is that would lead us to more bookings. It would lead us to more opportunity to show sponsors that we have a good patient cohort available when they start recruiting and would lead to more revenue and growth.

Amanda Murphy (Principal Partner, Life Sciences Tools, and Diagnostics Senior Analyst)

Got it. Thanks very much.

Operator (participant)

As a reminder, ladies and gentlemen, we ask that you limit yourself to one question in the interest of time. Our next question comes from a line of Gary Lieberman with Wells Fargo. Your line is now open.

Gary Lieberman (Senior Healthcare Services Equity Research Analyst)

Good morning. Thanks for taking the question. It had about $110 million of acquisition or integration costs this year. Where do you see that next year and maybe the year after?

Glenn Eisenberg (EVP and CFO)

Yeah.

When you say the integration, we have costs from integrating the business as well as primarily relating as well to the Sanofi site support agreement that's now expired, and we're going through restructuring there. We still anticipate having integration restructuring costs in 2016, but at a much lower level than what we've had this year. Those ultimately will go away.

Gary Lieberman (Senior Healthcare Services Equity Research Analyst)

Okay. Great. Maybe some color on the esoteric growth front, maybe more detail in terms of where it's coming from specifically. How does that break out from growth from what you're already doing versus acquisitions that you've made?

Dave King (Chairman and CEO)

Biggest areas of growth in esoteric, probably women's health, NIPT, continuing to see good momentum with BRCA, and infectious disease. Those are probably what I would highlight as the four top areas. How much of it is acquisition-driven?

The acquisition pricing benefit actually mostly came from anatomic pathology as opposed to specific test acquisition. So most of what I would characterize as the core—I'm sorry, the growth in esoteric just came from excellent execution on sales priorities by the organization.

Gary Lieberman (Senior Healthcare Services Equity Research Analyst)

Okay. Great. Thanks very much.

Operator (participant)

Our next question comes from a line of Ricky Goldwasser with Morgan Stanley. Your line is open.

Ricky Goldwasser (Managing Director and Head of US Healthcare Services and Technology Research Team)

Yeah. Hi. Good morning. Dave, obviously, you talk about token acquisitions at about 1% to top line. Can you maybe share with us your thoughts of M&A opportunities and kind of your appetite outside of the core lab business?

Dave King (Chairman and CEO)

Sure. Good morning, Ricky. So one of the things I highlighted in my opening remarks is that we're competing in a much bigger space than just the core lab business.

Now we're competing in the core lab business, but on a global basis, we're competing in drug development. We're competing in market access. We're competing in food safety. You should think about our appetite for acquisitions as spanning all of those businesses potentially. Now, a couple of caveats. The likelihood of us doing a sizable ex-U.S. clinical laboratory acquisition is relatively small just because we're much more likely to think about doing that, doing ex-U.S. clinical laboratory now that we have a global footprint by building as opposed to acquiring. We certainly are looking at global expansion opportunities in the clinical lab business, but I wouldn't put that at the top of the list from an M&A perspective.

What I would put at the top of the list is token acquisitions in the clinical lab business, acquisitions in the food business, acquisitions in drug development, acquisitions in market access, all of which we will look at through the lens of what is our return on invested capital, how does it strategically contribute to our key priorities, and what are the valuations relative to other opportunities for deployment of capital.

Ricky Goldwasser (Managing Director and Head of US Healthcare Services and Technology Research Team)

Okay. If I can have just one follow-up, and that might be a question for Deb. Obviously, 2015 was really impacted by the fact that new trial startups took longer. I think, Dave, in the past, you said that the period of time for trial startups was extended by around 6-12 months.

Can you just give us an update on where you're at now, and have we kind of have you normalized kind of your book of new starts, and is this going to be sort of a headwind to revenue conversion in 2016 and beyond, or are we now at a steady state?

Deborah Keller (CEO)

Thank you for the question, Ricky. As far as from a backlog burn, we've seen it stabilize. It started off the year, as you said, a little bit slower than expected. However, both in clinical and central labs, we saw it stabilize throughout the year, kind of similar to the trend that we've seen in the last 10 years.

Ricky Goldwasser (Managing Director and Head of US Healthcare Services and Technology Research Team)

Okay. Great. From your perspective, it's kind of like we're now at kind of a new normal.

Deborah Keller (CEO)

It's just leveled off to similar to the trends that we've seen in the last 10 years is how I would state that.

Ricky Goldwasser (Managing Director and Head of US Healthcare Services and Technology Research Team)

Okay. Great. Thank you.

Dave King (Chairman and CEO)

We are at about the top of the hour. We have six more questions in the queue, so I would encourage people to let's try to ask one, and also let's try not to ask things that have already been answered, please. We would like to be able to answer everybody's questions today.

Operator (participant)

Our next question comes from a line of Whit Mayo with Robert W. Baird. Your line is now open.

Whit Mayo (Managing Director)

Hey, thanks. Just a quick one on bad debt and self-pay collection rates. Have you seen any change or deterioration in copays deductibles? Just maybe remind us where that's trending and maybe any opportunities to improve the collection rates going forward. Thanks.

Dave King (Chairman and CEO)

Bad debt improved throughout the year, and the team did a terrific job in terms of both reducing the bad debt rate and recapturing additional revenue that previously was going to bad debt. The issue on self-pay is we're seeing, as you see more patients come through exchanges, exchanges do tend to have higher deductibles and higher self-pays. Now we're experiencing something, although in a limited way, that you've heard other providers talk about, which is people who are on and off the exchanges. They're on the exchange, then they're off the exchange, then they sign back up again. There are 29 different reasons right now why people can get on an exchange even outside the enrollment period. We're seeing some of that, and it does mean that more bills go to patient.

For now, we feel like we have the situation well in hand, but it is something that we're keeping a close eye on.

Operator (participant)

Our next question comes from a line of AJ Rice with UBS. Your line is now open.

AJ Rice (Managing Director and Equity Research Analyst)

Hi, everybody. Obviously, a lot of territory is covered, but let me ask you about Washington, if there's any updates either with respect to the CMS clinical lab fee schedule or the FDA and its efforts around lab-developed tests, what you're hearing from your congressional supporters as well as from the administration.

Dave King (Chairman and CEO)

AJ, it's Dave. On PAMA, we have not heard anything further.

Obviously, there were some very positive developments from our perspective in terms of strong letters going from the House, from the Senate, and from the chair and ranking member of the Finance Committee encouraging both the inclusion of at least a selection of key hospital labs as well as a delay in the implementation of PAMA. We continue to believe that the inclusion of key hospital labs is absolutely vital to accomplish the congressional purpose, which was a market-based price for Medicare. Realistically, we're at the end of February. The rule has not been finalized. It's hard for me to imagine how this could be implemented in January of 2017 in a way that would be fair to our industry. That's the view on PAMA.

On FDA, we continue to work closely with Congress and attempting to work with the FDA as well on a solution that would be a legislative solution that would bring clarity to whatever regulation there's going to be of lab-developed tests and that would not be dependent on subregulatory guidance as a proposed long-term solution. We feel, again, we've been very clear about this. We feel very strongly that guidance is the wrong way to go about this and that we will continue to oppose that path.

Operator (participant)

Okay. Thanks. Our next question comes from a line of Brian Tanquilut with Jefferies. Your line is now open.

Jason Plagman (VP of Healthcare Equity Research)

Hey, guys. Jason Plagman on for Brian. Just a follow-up on the M&A discussion.

To get a little more specific on the CRO side, are there any segments or markets that are interesting, both either short-term or long-term, how you view the M&A opportunity on the drug development business?

Dave King (Chairman and CEO)

I do not think we have anything to say beyond what we have already said, which is we are going to look at all opportunities and evaluate the strategic fit and the returns and the evaluations in comparison to what other opportunities there are.

Jason Plagman (VP of Healthcare Equity Research)

Okay. Thanks.

Operator (participant)

Our next question comes from a line of Bill Quirk with Piper Jaffray. Your line is now open.

Bill Quirk (Managing Director and Senior Research Analyst)

Great. Thanks. Good morning, everyone. Real quickly, Dave, you mentioned that you introduced 75 new assays in 2015.

If we just set aside the legality of what FDA is trying to do on the LDT side, how are you guys thinking about, I guess, from a preparatory standpoint, about introducing new tests in terms of potential FDA regulations that you might have to go through? Secondly, any impact from the January storms that we need to be thinking about here for the first quarter? Thanks.

Dave King (Chairman and CEO)

To the first question, Bill, before we introduce a test to the market, and some of these tests are kits, which obviously have been approved or cleared by the FDA, but before we introduce tests to market, there is a very robust validation process within our laboratories to make sure that the tests are valid, that they report what they are supposed to report, and that they have appropriate clinical utility. We have followed that path for years.

We've been very disciplined about it, and we'll continue to follow that. Again, our exposure to the LDT, the potential of at least the initial stage of what FDA has proposed from an LDT perspective is relatively low as a percentage of revenue. This is important as an industry matter, and it's important from an overall perspective in terms of innovation and development in the diagnostic industry. For the weather impact from the January storms, I'm going to turn this over to Jay to respond for the diagnostics business.

Jay Boyle (CEO)

Thanks, Dave. Bill, the weather, obviously, we're always concerned about weather at this time of the year. Fortunately for us, it was comparable to what we experienced last year. I think most of the weather in the areas that would have been impacted was, fortunately, on the weekend.

At this point, we view it as inconsequential, and we're keeping our fingers crossed for the remainder of the first quarter.

Operator (participant)

Our next question comes from a line of Donald Hooker with KeyBanc. Your line is now open. Great.

Donald Hooker (Senior Equity Research Analyst)

Thanks. Real quick, I'm not sure you talked about sort of what appears to be an improving price environment for preclinical CRO testing. I know it's a small revenue number, but I assume that's a pretty big drop-through, so small lever. Can you just maybe give a tidbit or two on kind of the broad barter pricing environment there?

Deborah Keller (CEO)

Yes. Thank you. This is Deb. You are right. The demand is increasing, and it has great incremental drop-through. What I would say is that where we see the utilization getting tighter, when U.S. and China, it is driving some modest price increases in those regions.

Operator (participant)

Our next question comes from a line of Mark Massaro with Canaccord Genuity. Your line is now open.

Mark Massaro (Principal and Senior Equity Analyst)

Hey, thanks for the question. You guys have done a very good job growing organic volumes over the last couple of years in a tough environment. This quarter, you put up 150 basis points of organic volumes. I want to make sure I understand what is contributing to the slight deceleration, if you will, in the organic volume trend line. What factors are baking in, and how are you thinking about the impact of high deductible health plans and competition from hospitals? Thanks.

Dave King (Chairman and CEO)

Yeah. I think, as we said, the biggest factor that's contributing is the annualization of contract wins. I don't think there's enough going on in high deductible plans or hospital competition to really change that.

I think the reality is that the high deductible plans and high copays have more of an impact on bad debt and collections. It does not stop the patient from coming to get the testing done. It just stops us getting paid for it. I do not think that has a significant impact on volume. We have always faced competition from hospitals. I actually think that it has been really about three years since we saw the huge shift in hospitals buying up physician practices and insourcing them. I think we are doing a terrific job on organic volume. I think the diagnostics team has done a great job. We are clearly outperforming, from my perspective, the competitive market with organic volume growth. I think we are outperforming the other healthcare services providers in terms of organic volume growth.

In spite of and again, if you look at that, what you've characterized as a slight deceleration on a per-day basis, 3Q over 4Q, it's actually essentially flat from an organic volume perspective. We're very pleased with it.

Operator (participant)

I'm showing no further questions in queue at this time. I'd like to turn the call back to Dave King for closing remarks.

Dave King (Chairman and CEO)

Once again, we're very pleased with the year that we've turned in in 2015, and I want to express my appreciation to my 50,000 colleagues and to our leadership for really an exceptional performance. We're excited about 2016. We look forward to talking to you again quarter to quarter with updates and hope you have a great day. Thank you.

Operator (participant)

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program, and you may now disconnect. Everyone, have a great day.