Good day, ladies and gentlemen, and welcome to the LabCorp Q4 2018 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Scott Frommer, Vice President of Investor Relations. You may begin..

Good morning, and welcome to LabCorp's Fourth Quarter 2018 Conference Call. As detailed in today's press release, there will be a replay of this conference call available via telephone and Internet.

With me today are Dave King, Chairman and Chief Executive Officer; Glenn Eisenberg, Executive Vice President and Chief Financial Officer; and John Ratliff, CEO of Covance Drug Development. In addition to our press release, we also furnished Form 8-K this morning that includes additional financial information.

Both are available in the Investor Relations section of our website at www.labcorp.com and include a reconciliation of non-GAAP financial measures discussed during today's call to GAAP. Finally, we are making forward-looking statements during today's call.

These forward-looking statements include, but are not limited to, statements with respect to 2019 guidance and the related assumptions, the impact of various factors on operating and financial results and the opportunities for future growth.

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 2017 Form 10-K and subsequent Forms 10-Q and in the company's other filings with the SEC.

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..

deliver on our patient-centric mission to improve health and improve lives. Now I'll turn the call over to Glenn..

Thank you, Dave. I'm going to start my comments with a review of our fourth quarter results, followed by a discussion of our performance in each segment and conclude with our 2019 guidance.

As a reminder, on January 1, 2018, we adopted ASC 606 using the full retrospective method, meaning that we restated our 2017 financial results to better enable evaluation of our 2018 performance.

In the press release, our prepared remarks and the Q&A session that follow, all references to our 2017 results are to the restated numbers unless we specifically note otherwise. Revenue for the quarter was $2.8 billion, an increase of 1.6% over last year, with organic growth of 2.9% and acquisitions contributing 0.7%.

This was partially offset by divestitures of 1.6% and unfavorable foreign currency translation of 40 basis points. Operating income for the quarter was $308 million or 11% of revenue compared to $331 million or 12% last year.

During the quarter, we had $31 million of restructuring charges and special items, primarily related to LaunchPad initiatives and acquisition integration.

Adjusted operating income, which excludes amortization of $56 million as well as restructuring charges and special items, was $395 million or 14.2% of revenue compared to $433 million or 15.8% last year.

The $38 million reduction in adjusted operating income and 160 basis point decline in margin were primarily due to lower pricing as a result of the implementation of PAMA, divestitures and higher personnel costs, partially offset by increased demand, mix, LaunchPad savings and acquisitions. The tax rate for the quarter was 26.2%.

During the quarter, we reported $8 million in deferred income taxes due to the revaluation of deferred tax liabilities related to the acquisition integration of Chiltern. Excluding onetime tax reform-related adjustments, other special charges and amortization, the adjusted tax rate was 24.7% in the quarter, down from 34.5% last year.

This lower tax rate was primarily due to the benefit from tax reform in the U.S. We expect the company's adjusted tax rate for the full year 2019 to be between 25% and 26% compared to 24.3% for the full year 2018, with the increase primarily due to state tax reform and the projected mix of earnings.

Net earnings for the quarter were $158 million or $1.56 per diluted share. Net earnings were reduced by $22 million or $0.21 per diluted share due to a loss on the divestiture of our U.S. forensics lab testing business, a noncash settlement charge on one of our pension plans and a write-off on an investment in our venture fund.

Adjusted EPS, which exclude these losses, amortization, restructuring charges and special items, were $2.52 in the quarter, up 11% over last year. Adjusted earnings in the quarter were negatively impacted by approximately $0.04 per diluted share due to lower volume caused by unfavorable weather.

Operating cash flow was $486 million in the quarter, which included the net tax payment of approximately $105 million related to divestitures. Excluding this onetime tax payment, operating cash flow would have been $591 million compared to $565 million a year ago.

This $26 million increase was due to higher cash earnings, partially offset by increased working capital to support top line growth. Capital expenditures totaled $122 million or 4.4% of revenue compared to $96 million or 3.5% last year.

As a result, in the quarter, free cash flow was $364 million or $469 million excluding the onetime tax payment compared to $469 million last year. We remained active throughout the quarter in terms of capital allocation. At quarter end, our cash balance was $427 million, down from $893 million at the end of the third quarter.

Utilizing free cash flow during the quarter and excess cash, we repurchased $400 million of stock, paid down $400 million of debt and invested $39 million in acquisitions.

On February 6, the board replaced the company's existing share repurchase plan with a new plan authorizing repurchase of up to $1.25 billion of stock, demonstrating our continued commitment to returning capital to shareholders.

Total debt at quarter end was $6.1 billion, and our leverage was 3x gross debt to last 12 months EBITDA, which is at the upper end of our 2.5 to 3x leverage target.

As we committed at the time we acquired Covance in 2015, we would delever back to our targeted leverage ratio, which we had accomplished while still repurchasing over $1 billion of our shares during this time frame.

Given the strength of our balance sheet as well as no mandatory debt maturing in 2019, we expect to use all of our free cash flow this year for share repurchases and acquisitions. Throughout the year, we remain focused on portfolio optimization via the divestiture of noncore assets.

Transactions included the sale of our Food Solutions business for $655 million and 2 small forensic testing businesses. Now I'll review our segment performance, beginning with LabCorp Diagnostics. During the quarter, our Diagnostics business was negatively impacted by several nonoperational items.

These items include divestitures, implementation of PAMA, adverse weather, the year-over-year impact from the calendar due to fewer revenue days and 1 extra payroll day and foreign currency translation. I'll refer to these collectively as nonoperational items.

Now I'll discuss our Diagnostics operating performance as well as the impact of the nonoperational items, which better portrays the underlying strength of our business. Revenue for the quarter was $1.7 billion, a decrease of 2.8% to last year.

This volume was due to the negative impact from divestitures of 2.6% and foreign currency translation of approximately 0.2%. Organic revenue on a constant currency basis was negative 0.4%, which was offset by the benefit from acquisitions of 0.4%.

During the quarter, the negative impacts from PAMA was 100 basis points, the calendar was 80 basis points, and adverse weather was 40 basis points. Excluding the nonoperational items, organic revenue for the quarter increased by approximately 1.8%.

Revenue per requisition excluding the impact from divestitures decreased by 40 basis points, driven by the impact from PAMA of 100 basis points, partially offset by test mix. Excluding the impact from divestitures, total volume increased 30 basis points as acquisition volume contributed 40 basis points and organic volume declined by 10 basis points.

Excluding the nonoperational items, organic volume increased by approximately 1.1%. LabCorp Diagnostics adjusted operating income for the quarter was $279 million or 16.5% of revenue compared to $357 million or 20.5% last year.

The decline in operating income and margin was primarily due to the impact from PAMA of approximately $18 million or 80 basis points, the year-on-year impact from the calendar of approximately $20 million or 100 basis points, adverse weather, divestitures and higher personnel costs, partially offset by acquisitions and cost reductions.

Excluding the nonoperational items, adjusted operating income and margin were approximately $329 million and 18.5%, respectively. As Dave noted, we expect the LaunchPad II initiative to deliver approximately $200 million of net savings over the next 3 years while incurring approximately $40 million in onetime implementation costs.

We expect roughly 1/3 of the total savings to be realized in each year. Now I'll review the performance of Covance Drug Development. Revenue for the quarter was $1.1 billion, an increase of 9.6% over last year due to organic growth of 9.3% and acquisitions of 1.2%, partially offset by unfavorable foreign currency translation of 90 basis points.

Adjusted operating income for the segment was $154 million or 14% of revenue compared to $111 million or 11.1% last year. The $43 million increase in operating income and 290 basis point improvement in margins were primarily due to organic demand, LaunchPad savings and acquisitions, partially offset by higher personnel costs.

We remain on track to deliver $150 million in net savings from Covance's 3-year LaunchPad initiative by the end of 2020 and $30 million of cost synergies from the integration of Chiltern by the end of 2019. Net orders during the quarter were $1.5 billion, up 14% from last year, contributing to a net book-to-bill for the quarter of 1.34.

For the trailing 12 months, net orders and net book-to-bill remain strong at $5.4 billion and 1.26, respectively. Backlog at the end of the quarter was $9.8 billion, an increase of approximately $360 million from last quarter. We expect approximately $3.9 billion of this backlog to convert into revenue over the next 12 months.

Now I'll discuss our 2019 guidance, which assumes foreign exchange rates as of December 31, 2018, for the entire year and the impact from currently anticipated capital allocation, with free cash flow being used for share repurchases and acquisitions.

We expect revenue growth of 0.5% to 2.5% over 2018 revenue of $11.3 billion, which includes the negative impacts of 1% from divestiture and 0.4% from currency translation.

We expect the change in LabCorp Diagnostics revenue of negative 4% to negative 2% as compared to 2018 revenue of $7 billion, inclusive of foreign currency translation of approximately negative 30 basis points. This guidance includes the negative impact of approximately 2% from divestitures in 2018.

Excluding divestitures, the change in revenue in LabCorp Diagnostics is expected to be down 2% to flat, primarily due to the impact from PAMA.

We have assumed that PAMA will reduce our Diagnostics revenue by approximately 1.6% in 2019 consisting of lower direct Medicare reimbursement of approximately $85 million and the indirect impact on other reimbursement, primarily Medicaid-related plans of approximately $30 million.

In addition, we expect organic volume to be flat to slightly down year-over-year due to the onetime impact from changes in certain managed care contracts and networks. Independent of divestitures, PAMA and managed care dynamics, we expect another year of good organic volume growth, favorable mix and contributions from acquisitions.

We expect Covance Drug Development revenue growth of 5% to 9% over 2018 revenue of $4.3 billion, which includes the negative impact of approximately 60 basis points of currency translation.

We expect Covance's first quarter revenue growth rate to be below its full year guidance range, primarily due to timing and the negative impact of foreign currency translation. Our adjusted EPS guidance is $11 to $11.40, a change of 0% to 3% compared to $11.02 in 2018.

We expect modest growth in adjusted EPS to be driven by Covance, LaunchPad across the enterprise and capital deployment, partially offset by our Diagnostics business due to the impact from PAMA and changes in managed care contracts. Our guidance assumes that the all-in impact from PAMA reduces EPS by approximately $0.85 per diluted share.

In addition, our guidance reflects the year-on-year increase in cybersecurity expenditures of approximately $25 million or $0.18 per diluted share. While we do not provide quarterly guidance, we expect adjusted EPS in the first quarter of 2019 to be comparable to adjusted EPS in the fourth quarter of 2018.

This implies a lower percentage of total year adjusted EPS in the first quarter than we have reported in prior years, primarily due to the timing of Covance revenue growth, the ramp-up of LaunchPad savings during the year, the impact from acquisitions and divestitures as well as the impact from the calendar.

Our free cash flow guidance is $950 million to $1.05 billion compared to $926 million last year. In 2019, we expect capital expenditures of approximately 4% of revenue, driven by investments in facilities, technology and automation to support growth. Now before we take questions, I'd like to announce a transition in Investor Relations.

Scott Frommer has done an outstanding job leading our Investor Relations efforts over the past several years. Scott will now be taking on a financial leadership role within our Diagnostics business. I am pleased to announce that Clarissa Willett will now take over the leadership of Investor Relations.

Clarissa has been in the financial leadership role in our Diagnostics business and has over 21 years of health care experience. Prior to joining LabCorp, Clarissa was the CFO of PAML, which we acquired in 2017. This concludes our formal remarks, and now we will take questions.

Operator?.

[Operator Instructions]. And our first question is from Ross Muken from Evercore ISI..

Congrats, Scott. So I guess maybe starting on Covance. I mean, obviously, a fantastic quarter across the board. Dave, thanks for the color.

I guess as you think about the RFP environment and just sort of new business and how that's trending, given some of the biotech volatility, how are you thinking about sort of the overall landscape as you enter into 2019? And then from a share perspective and to the point you made, Dave, in terms of your IT efforts starting to resonate in terms of patient recruitment, et cetera, do you feel like on the booking side, we'll see even more evidence over the balance of '19 of sort of some share gains potentially at late-phase part of the business?.

This is John. I think the RFP business is strong across the board, whether that's in early development, whether that's in the labs and whether that's in the late stage. So if you look at the pipelines, seeing strength, the biotech side as well as even on pharma side.

And I do believe that the data side, the solutions side of LabCorp Covance is leading to gains in bookings and allowing us to win. Very proud of the 1.34 book-to-bill on the fourth quarter on a 606 basis and the 1.46 on the 605 kind of compared to the other CROs and how they report.

So I do think that that's helping us win at the end of the day and, as Dave stated, helps on the entire site selection piece and solution side of our business..

That's helpful. And maybe just quickly, from a capital allocation perspective, obviously, you took up the buyback. You still have some ammunition if you wanted to do obviously M&A on either side of the business.

I guess given sort of where the stock got to and valuation in general on your equity, I guess how are you thinking about sort of the trade-off of what your own sort of yield provides and return versus kind of what you're seeing maybe on the M&A side of things?.

Yes. Ross, it's Dave. So we've been very disciplined acquirers, and we will continue to be disciplined acquirers. We look at every potential acquisition based on our strategic criteria and our financial criteria.

We did a couple of tuck-in lab deals last year, and we did the Sciformix deal, which was a very important complement to the Covance market access business.

So we're going to continue to look at attractive opportunities but, again, in a disciplined way and recognizing that, in our view, with the stock undervalued, that we get a very high return from deploying capital toward share repurchase..

Our next question is from Jack Meehan from Barclays..

Dave, I was hoping you could provide an update on what you're seeing in terms of hospital referral trends. That was the one variable we had the least visibility on when you were guiding in November.

So has that improved at all? And do you have any new visibility into what market dynamics were going on?.

So a couple of things on the hospital referrals. We did see, as we stated when we revised the guidance, a falloff in the beginning part of 4Q. I'm pleased to report that we saw improvement in December, and for the quarter, the referral business stabilized and started to grow again.

And built into our guidance is that, that business is going to be consistent through the year. I'd also just like to highlight, for a variety of, I think, market dynamics, health systems are increasingly looking at ways to partner.

And we have a number of ongoing and, I think, interesting partnership discussions that we hope will ultimately turn out to be productive.

Again, the combination of LabCorp's capabilities, breadth of test menu and quality of service, with the Covance piece of trial recruitment, trial enrollment and the site partnership strategy, really is an attractive differentiator when we speak to these health systems..

Great. Looking forward to those updates. And then, Glenn, just one on the PAMA commentary for 2019.

So the 39 related to other contracts, what's the assumption there? Is it basically that -- do you think all Medicaid fee schedules follow the Medicare fee schedule? What's going on in terms of floating-rate contracts? Just any commentary on why the PAMA impact will -- figure would be helpful..

Yes. Jack, it's Dave again. So as we've said all along, the market survey that was done to support the PAMA cuts was fundamentally flawed. And so the rate reductions that were imposed on us by -- for fee-for-service Medicare were far in excess of what would have been required to bring the payment rates to market.

The knock-on effect of that, which is the approximately $2 million that we called out -- that Glenn called out in his prepared comments is basically Medicaid plans, both fee-for-service and managed Medicaid, reducing their rates consistent with the Medicare reductions. This was not anticipated as part of the PAMA statute.

It was not contained within the statutory language, which specifically applied to Medicare. But it has exacerbated the impact of PAMA obviously both this year, that is '18, and next year, '19. And so the straight Medicare fee-for-service cut is about the 10% that we had projected. And Glenn gave you that number in the prepared comments.

But the knock-on effect is almost entirely the Medicaid plans following suit in terms of administratively reducing rates. These are not negotiated rate decreases..

Our next question is from Kevin Caliendo from UBS..

Would love to get a little bit of an update on pricing outside of Medicaid and PAMA and if you've seen any impact or you expect to see any impact in 2019 from the PAMA cuts if there's any contagion into your other managed care pricing and the like..

It's Dave. I don't believe that the PAMA cuts directly other than the $30 million that I just mentioned related to the Medicaid plans have bled over into the managed care negotiations. Most of the managed care payers begin a contract negotiation by asking for reductions.

But to my knowledge and speaking with the team, there's no -- none of this is referenced, because of PAMA, X should happen. And we've been pleased with the pricing on the managed care renewals. We did just conclude the renewal of the Humana contract, the extension and renewal of the Humana contract.

So basically, all of the big contracts are off the table for the foreseeable future. And we're pleased about having some certainty in how managed care is going to shape up over the next couple of years..

One follow-up, well, not on the pricing but on Covance, the margin increase was pretty material, much higher than we had expected.

Is there anything in that margin number that we should expect would not be recurring? Is this sort of the run rate? Is there anything in that as we sort of think about Covance going forward?.

Well, you always see, as Glenn stated, a bit of seasonality fourth to first, as well as you'll have on the revenue side the foreign currency headwind against you. But in terms of the strength of fourth quarter, it was built on the LaunchPad actions, it was built on strong backlog, it was built on organic growth.

We will see margin increases where projected, see margin increases in terms of full year 2019, and you'll see year-on-year improvement. But you will see 14% sequentially pull down for those reasons as well as just where the revenue feathers in based on where the backlog plays out in the mix of the businesses..

Our next question is from Lisa Gill from JPMorgan..

First, Scott, I've really enjoyed working with you, and I wish you the best in your new role. Second, the comment around organic growth outside of the shift and the managed care changes.

Dave, can you just give us a little color as to what you're seeing? Is that going back to your earlier comments around health system partnerships? Is it expectations around utilization? If you can just give us a little more color as to what your expectations are on that organic side, would be my first question..

Yes. Lisa, this is Glenn. I'll start, and Dave may provide some color. When you look at the guidance that we've given, we did talk about organic volume for '19 to be flat to slightly down. But as you commented on, the rationale for that is that the impact of the managed care contracts was going to be a net negative on organic volume.

And if you think about, historically, we've been roughly a 1% to 2% kind of organic volume growth, and we really don't see that changing with the expectation of -- or with the exception of the -- just with the changes from the managed care side..

Yes. Lisa, it's Dave. I would say, obviously, we've said this many times, when you look at the size of United compared to the size of Aetna, we're going to end up from a volume perspective on the negative side of the equation. And obviously, putting Horizon into that and some projected losses in Horizon make that even more apparent.

However, as Glenn said, our business grows rough. And it grows because of the demographics. It grows because of the aging population. It grows because of new tests coming to market. It grows because of share shifts and share gains within the market.

And so we feel very confident that there will be organic growth next year as there was this year, 1.8% for the full year of '18. We feel confident there will be organic growth in '19. It will just be muted by the net impact of the managed care shifts..

And then just as a follow-up. You gave an update on Walgreens. I think you said 125 stores, still with the goal of 600 stores over 4 years.

Dave, any incremental color you can give us as to how those 125 stores have performed versus, one, your expectation? And two, are you seeing volumes kind of consistent with patient service centers? Are you seeing better volumes? Just any color around that would be helpful..

Yes. Just to be clear, the 125 will be by the end of the -- of '19. But what I can say on -- we opened a number of new patient service centers in California inside Walgreens. We track the daily and weekly volumes.

They have been consistent and growing, and the Net Promoter Scores and customer satisfaction rates -- we take immediate real-time surveys from patients either from the kiosk or through their mobile devices, have been very favorable.

So in terms of volumes from other patient service centers, when we actually relocate a patient service center into a Walgreens, what we typically see is quite comparable volume. When we add -- or even better volume.

When we add a Walgreens to complement an existing patient service center, we, of course, would typically see lower volumes at the beginning..

Our next question is from Erin Wright from Crédit Suisse..

Across the Covance business, could you comment on the traction you're seeing in the types of trials, whether it be FSP or full service and the mix of large pharma versus some of the biotech customers and where sort of the data offering resonating better and how should we think about backlog conversion trends as well as the profit profile thereon?.

This is John. It is still a mix of the FSP versus programmatic. There are companies that have embraced the FSP. I think we're stronger now in our capabilities there based on the Chiltern acquisition and adding into our monitoring FSP strength, the biometric FSP strength. But that mix of programmatic and FSP hasn't swung.

I think that our capabilities have gotten much better in regard to that. In terms of the biotech versus large pharma, obviously, if you look out there in terms of research, the majority of the molecule developments in the biotech, it was a healthy environment in terms of VC side and funding side.

And in terms of strength of the pipeline, the strength is in both sides in terms of the biotech and the large pharma. And there's been no increase in cancellations across that. Right now, you have to say the RFP volume is pretty robust in that area.

And then as to the data as the differentiator and that for patient recruitment and site selection, that plays into the total solution for the company. It's also -- as I've said on these calls, it is data. It is about strategy protocol optimization. That is also on the team that you put in front. Those are all equal weightings.

I would say that data as a differentiator resonates in both environments, whether that's on the large or the mid-tier small. And so there really is no delineation there between the two. It's pronounced in all areas as well as what Dave talked about.

Showing the data, reducing time lines in the actual trials is across all the therapeutic areas, and demonstration of that is in biotechs as well as large..

Great, that's really helpful. And then switching to the managed care contracts.

Has there been any sort of surprises in the early days with the -- how that business is rolling out as well as the offsets of other contract shifts? And anecdotally, how should we think about the quarterly progression of those contract changes over the course of 2019?.

It's Dave. There have not been any surprises in the way that it's rolled out. As I said throughout the fourth quarter, our expectation was there would be -- the losses would be relatively early.

And as I commented -- and again, I want to make clear, we commented only because of heightened market concern about the contract changes, and we're not going to start a policy of commenting about performance within the quarter.

But with that caveat, as I commented, January volumes were basically -- for those contracts were basically riding expectations. So we're pleased actually with our performance in January with respect to those contracts as well as with our -- the accuracy to this point of our estimates..

Our next question is from Patrick Donnelly from Goldman Sachs..

Appreciate the color on the Covance margins. Maybe just on the other side, the LCD margins.

Given the pricing dynamics, the managed care shift away from you guys, can you just talk through kind of the go-forward perspective there? What causing the shifts you could be most aggressive on? Just trying to think through the levers in 2019 as the offset on the margins..

Yes. Patrick, it's Dave. So one thing that I think -- I mean, we've talked about LaunchPad. That will certainly be part of the 2019 plan. And that will involve some substantial cost reductions. Just looking at $200 million over 3 years, obviously, the math is pretty straightforward. I just would like to comment separately from that.

We did in the fourth quarter, as we talked about when we revised the guidance, have the experience of having staffed up pretty heavily for what we expected to be a very strong seasonal trend in the consumer genetics business, which, as we said, did not materialize. And so we started taking those cost reduction actions in the fourth quarter.

But by the time we were fully aware of the trend, it was late enough in the quarter that you can actually see the impact of most of those actions in the first quarter of '19.

So there are a variety of levers, from personnel to facilities to all the things I've talked about in the prepared comments on LaunchPad, that I think will affect margin performance in '19.

Having said that, as we have repeatedly said, we do expect Diagnostics margins to be down in 2019 because of the combination of PAMA and the managed care changes, but we do not expect them to be down as much as they were down in 2018. So we expect the margin performance to be better in 2019 in terms of the relative decline..

Yes.

The only thing to -- Patrick, I'd add to that is just there were also some unusual items that negatively impacted the Diagnostics margin year-on-year in '18 versus '17 that we've talked about earlier, from the business disruption that we had, the unfavorable weather obviously that we would not forecast for the business in the future, the fact that we had an extra payroll day and also the impact of the divestitures of our forensics business.

All 4 of those that were, call it, a negative impact on margins within Diagnostics in 2018 will not be in 2019.

So again, to Dave's point, we'll still see the margins decline because of the incremental impact of PAMA and the managed care but offset by LaunchPad, offset by not having these recurring items as well as we do believe favorable mix and the potential for tuck-in acquisitions as well..

That's helpful. Appreciate it. And then you touched on the consumer genetics business. 23andMe had been a nice growth driver for this quarter. The other kind of biggest genetics player called out a shortfall in consumer genetics testing in general this quarter as well, so it seems to be kind of that industry slowing down a bit.

Can you just help us think about the go-forward view there, what type of growth you're baking in, what the potential surprise could be on the upside?.

Yes. Obviously, what we have to go on is projections we receive from our customers, but our plan contemplates 23andMe basically being relatively flat year-on-year. So the potential is that they do better, but we feel comfortable with what we've mapped into the -- into our budget..

Our next question is from Ralph Giacobbe from Citigroup..

The GAO's out with a report on sort of a PAMA loophole, if you will, and kind of like Grassley recently sent out a letter around that as well. Dave, I was hoping maybe to just get your take on it in terms of -- I know the overpayment numbers seem pretty outsized versus likely reality.

But just wanted to get your take first, I guess, just operationally, whether you think that has and is being sort of influencing the hospital outreach and the physician office labs in terms of what they're doing from a business perspective and maybe even pushing out sales process in terms of tuck-in M&A and then if you expect that to change in 2019 and then some of the other characteristics of that report that Grassley sort of latched on to..

Yes. Thanks, Ralph. So I would start by saying that report was really quite unfortunately erroneous on multiple dimensions. So what -- if we go back to pre-PAMA, CMS -- there are automated chemistry panels that are defined by CMS that have a certain number of chemistry components.

Let's just make up that you order an automated chemistry panel that has 8 components, and it bundles to a particular CPT code and price. Pre the change for PAMA, if you were 6 chemistries or 7 chemistries, that is short of the total in the panel, CMS would use bundling logic to bundle those together and pay you with the panel rate.

So you actually were paid less for 6 chemistries than you would have been paid initially. That was a CMS -- that was CMS bundling logic. When PAMA was passed and went to market-based reimbursement, the market did not use that sort of bundling logic.

And so what happened is PAMA -- sorry, CMS no longer bundled those panels because that is what the market does, and PAMA was supposed to be a market rate of payment. So there is no loophole. There is no labs doing anything nefarious. This is exactly what the statute told CMS to do. And the labs, and we submitted data to Sen.

Grassley's office -- ACLA did, demonstrating that the labs are continuing to follow the bundling rules exactly as the bundling rules are laid out, which is that if all the components of a panel are ordered, you bundle and you build under that bundle.

Furthermore, CMS has back-end logic that says if 8 chemistry tests are ordered, it bundles into the 8-chemistry test panel. So it's a little bit of a mystery to me how this has even become an issue, much less with these, as you mentioned, grossly exaggerated overpayment numbers.

In fact, I think the GAO report had a potential overpayment number bigger than the entire Medicare lab spend. So this is just a -- this is a very unfortunate misunderstanding, which ACLA and the industry are educating both Congress and the GAO on.

Unfortunately, it's created a distraction about the outsized and excessive impact of the PAMA cuts, which we talked about earlier, both from a Medicare perspective and now with the follow-on Medicaid.

So I hope that's helpful, Ralph, and I apologize it was a little long, but I do think it's important that this be well understood as this is what the PAMA statute called for, and it's the implementation of the market-based payment rules..

Yes, no, I appreciate that. And if I could squeeze one more in, you've talked a lot about sort of the partnership discussions on the managed care side and mentioned it earlier in the call as well.

I was just hoping you can perhaps flesh those out a little bit more and, maybe more importantly, just timing now as we start thinking about 2019 and whether that has an influence or could have an influence on the business and volume more near term as opposed to 2020 and beyond..

Yes. I think a lot of the partnership discussions, as we've talked about, are focusing on benefit design, participants in the network, value-based payment rates.

And so particularly, things like benefit design and how the network benefits and minimizing the use of out-of-network utilization, there are changes that need to be made by the payers and by ASO employers in benefit design.

So I think those changes are going to start to be made in 2019 for the 2020 selling season, but I think you'll start to see the impact really next year..

Our next question is from Dan Leonard from Deutsche Bank..

So just a quick clarification on the knock-on or indirect impact of PAMA.

Is it fair for modeling purposes to assume that these indirect impacts persist beyond 2019 into 2020 and whatever residual might exist beyond that?.

Dan, it's Dave. I would say yes..

Okay. And then my follow-up. Looking back on the fourth quarter, Dave, appreciate that you mentioned that the referral volume from hospitals and health systems recovered in December.

Thinking back on it, do you have any sense for why that dipped below plan early in the quarter? And was there anything happening in the industry that you needed to tactically respond to, which drove the improvement in December?.

So in speaking to customers, really, the big drivers were lower admission rates and delayed flu season. I mean, those -- at least as far as we were able to tell from speaking with the customers, they were seeing similar -- yes, they were seeing similar trends in admission rate and calendar rate, bed rate, and we did have a delay in flu.

So I wish I had a lot more color on it, but that was the high-level takeaway from our customers..

Our next question is from Ricky Goldwasser from Morgan Stanley..

So one question on managed care. Obviously, in 2018, we've seen a number of contracts opening up. Dave, in the prepared remarks, you said that Humana renewed, and all big contracts are off the table.

But at this point, do you see any additional opportunities for managed care contracts that previously were exclusive to open up?.

Well, I think it's pretty well known that the major remaining exclusive is the Florida Blue contract that we are not a participant in. And we have been engaged in conversations with Florida Blue on a number of fronts. We have Walgreens-located patient service centers in the Florida market.

So we're hopeful that we're going to see some progress there, but I can't give you a firm prediction about how it's going to turn out. We've been pleased with the fact that they've been willing to engage with us because we've been out of that contract for a good number of years..

Okay. And then going back to the impact and the timing for managed care contracts, Glenn, you gave a lot of different data points. They're very helpful in trying to kind of like get to organic growth.

But from what I've heard, is it fair to assume that the changes in share in a managed care contract could be kind of like a net 160 basis points kind of like headwind this year?.

It's the one area obviously we didn't provide a quantitative number to, just given the newness of it. And obviously, we're dealing with these kind of operational issues for the company.

The way we try to get you, at least directionally there, and I think that -- the number you're saying is directionally there, but -- was that our organic volume would be flat. And given that historically we've been a 1% to 2% kind of organic volume growth business, it's fair to assume that that's the reason why we're flat instead of that other level.

So we've kind of given you at least a band, which your number clearly falls well within. So it's a reasonable way of thinking about it..

Our next question is from Kevin Ellich from Craig-Hallum..

So Dave, the call has been going on a long time. Just a quick question on the free cash flow in Q4. Looks like accounts payable was a $123 million source of cash. Glenn, just wondering if there was anything unusual there. Is that just in reverse? And that's one.

And then I also wanted to clarify, you stated all of your free cash flow in 2019 is going to be used on share repurchases and M&A.

Is that correct?.

Yes, Kevin. Yes, first, on the fourth quarter free cash flow payables, as you did see, was a source. Obviously, it's timing related. Fourth quarter, we tend to see the payable number to be a source. But I would just say more broadly, we really feel good about the progress that we've made overall on working capital management.

We continue to manage cash tightly. We continue to see and saw in 2018 a continued improvement in our DSOs as well as a continued expectation when we look to the expectations for 2019, continued progress there. So overall, positive on the working capital front.

With regard to the outlook for free cash flow next year, the $1 billion, we commented that the balance sheet now is within our targeted leverage, albeit at the upper end.

We do expect that we will use all of our free cash flow between share repurchases as well as acquisitions, so that -- obviously, it's implying that we'll stay towards the upper end of our guidance range.

But the benefit, as we have no maturing debt, we can continue to take advantage of the share repurchase program, especially where the shares are valued, and as well as have the financial flexibility to look at M&A where that makes sense..

And Kevin, it's Dave. I just want to stress, financially disciplined acquisitions. So no, we're not just going to go spend money on acquisitions that don't make sense strategically and financially. And I'd also like to comment, thank you for giving the warning, so it's 5 after 10. We do have 5 questions in the queue, so we'd like to get to all of them.

Let's try if we can to make the questions short and limit the follow-ups, particularly if your questions have already been answered..

Our next question is from Donald Hooker from KeyBanc..

So a quick follow-up question. In terms of the Covance growth of 9% in the quarter, looks really strong. I think the last quarter, you called out the early development preclinical side as being a big driver.

Did that continue this quarter? Maybe can you parse out the different parts of Covance, how that reflects and revolves around that 9% segment growth?.

Yes. We saw strength in the second half in terms of both on the early development and the late stage and, in the first half, on the labs in terms of the revenues and strength across the board on all the bookings.

We don't give out the individual segments in terms of the quantification, but in terms of, yes, continued strength in the ED areas as well as even on the late-stage clinical on the growth within the 9%..

Our next question is from Derik De Bruin from Bank of America Merrill Lynch..

So we've seen really good backlog numbers and books-to-bill across most of the CROs, but Covance is one of the few that you've actually seen organic revenue growth accelerating.

Could you quantify your level of backlog conversion, the sort of the trends there and what you're doing to speed that up? I guess basically just the question is, are you north of 10% in your backlog conversion?.

In terms of the -- and I'll try to do this in a little bit different quantification of the backlog itself. Highly dependent on the type of therapeutic area you're in, we are almost approximately 50% in terms of oncology, and rare and orphan has a little different draw out in terms of the way that revenue conversion has.

It's a volatile measure that seems to have stabilized. Glenn actually stated that about 40% of our aggregate backlog should convert. That's been pretty consistent in terms of the last four quarters. And then as we enter into 2019, about 85% of our revenue estimates are covered by that backlog. So hopefully, that's helpful there..

Great. And just one quick follow-up on you've been a partner with Lilly for a long time. And obviously, they've got the Loxo deal going on, and this can cancel some trials. So if there's anything that we should be concerned about in terms of changes in that relationship just given everything going on there..

No, won't see ending partnership and continued very good relationships, and contracts come up in normal course and no issues presently in the relationship..

Our next question is from Brian Tanquilut from Jefferies..

John, just a follow-up in the CRO question.

So are you seeing any change in pricing structures in the industry? Meaning, are you seeing competitors taking more risk around project milestones or time lines?.

No. That's been the way for the last few years on the risk side. And as to pricing in general, it's a competitive marketplace in terms of the late-stage and in terms of the labs, but -- from the standpoint of pretty stable in the early development side.

And in terms of aggregate risk-based pricing, that's been a feature of what we've been doing for a while based on milestones, et cetera..

Our next question is from Bill Quirk from Piper Jaffray..

So Dave, appreciate that you're not seeing PAMA rates bleed into your managed care discussions. But it does appear that some of the smaller providers, particularly hospitals, are seeing some pressure for managed care related to PAMA.

So when we think about that and then also just balancing that against the expanded data collection with more hospitals included this time around, how are you thinking or how should we be thinking rather about PAMA kind of 2020 and beyond?.

So obviously, the expanded data collection is not the solution to the flaws of PAMA, but at least it is an improvement, and then we'll see more commercial hospital rates in the database.

And we appreciate CMS being willing to take that step, although as we've said all along, legislative or regulatory or judicial relief is required to right the wrong that's occurred here. I think in terms of what's going to happen, there's another data collection that's supposed to be beginning relatively soon for the next 3-year period.

And good news is most of the impact of the reductions will have occurred in the '18, '19, '20 cycle. And so at the same time, there's another reduction coming in 2020, and it will have a similar -- an impact of similar size this year.

And that's going to increasingly, I think, cause others in the industry to look at partnering or other ways in which they can optimize the cost side of their business because the revenue side, particularly for those that are more dependent on Medicare, now Medicaid payment, is going to be under pressure. So I think there will be opportunities for us.

And as we highlighted in the prepared remarks, some of those with health systems have accelerated last year.

As you observed, it was a pretty light year for deal flow in terms of what we thought were attractive deals, but there's every reason to think that particularly, the smaller deals, there'll be more of them in 2019 than one would think in 2020..

Got it. And then just one quick follow-up on the consumer genetics business. You're -- I appreciate that you're modeling this flat for '19.

If we see this outperform those expectations, can you just remind us of the margin flow-through here? I seem to recall it's slightly lower than corporate average, but can you cue from that?.

No, Bill. The pricing is lower than corporate average, but the margin is comfortably within the -- our corporate expectations..

Our next question is from Mark Massaro from Canaccord Genuity..

Dave, as it relates to M&A, obviously, a lot of hospital executives don't seem to be all that familiar with PAMA.

But do you get the sense that, that awareness is increasing? And if so, do you see the potential to do more deals first or second half of 2019 as it relates to hospital outreach?.

Yes. Mark, I think consistent with what I said in response to Bill's question, I do think the awareness of PAMA is higher, and we indicated that in the prepared remarks as well. And I do think it will, in all likelihood, lead to a more robust deal flow in '19 and '20..

Great. And I know that you are a leader in women's health testing.

Can you maybe talk about what you're doing to try to encourage the adoption of average-risk NIPT?.

Yes.

Obviously, the noncoverage of NIPT by a couple of major players is quite frustrating, particularly because the recent scientific and clinical evidence indicates that actually, a fairly high percentage of women of so-called average maternal risk nonetheless have microdeletions or other things that would be concerning in terms of the genetic impact on their fetuses, as well as recent papers indicating that there's actually a higher-than-previously reported prevalence of Down syndrome in so-called average-risk pregnancy.

So we are working with ACLA, we're working with our coalition of providers that offer noninvasive prenatal testing. And we're working with women members of Congress to try to influence the coverage decisions by the major plans and, of course, the ACOG and ACMG and the thought leader groups as well.

And I think the -- certainly, among the thought leaders, the tide is turning in support of prenatal screening for the average-risk population. And it's our hope that, that will persuade the payers that this is indeed a better approach and also a more cost-effective approach to prenatal screening..

At this time, I am showing no further questions. I would like to turn the call back over to Dave King for closing remarks..

Thank you very much. Thank you all for listening this morning. I also want to add my personal thanks to Scott Frommer, who's really done a terrific job in Investor Relations over the past years. And although we will miss him, we are thrilled to have Clarissa who came to us from the CFO role with PAML to step into his place.

So we wish Scott all the best in the diagnostic role where he'll continue to be reporting to me, just in a different iteration, and welcome Clarissa. Thank you all for joining us this morning. Appreciate your continued interest in the company and look forward to updating you over the quarters ahead. Good day..

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect..