Business context and reporting period
Laboratory Corporation of America Holdings (Labcorp) filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2018. It operates two segments: LabCorp Diagnostics (LCD) and Covance Drug Development (CDD), which generated approximately 62% and 38% of revenue, respectively. The company divested its Food Solutions business and U.K. forensic testing services business during the quarter.
Comparative 2017 results were retrospectively restated for the adoption of ASC 606 revenue recognition; the accounting change increased reported revenue, reduced earnings, and had no cash-flow impact.
Financial results and key metrics
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $2,831.3 million | $2,621.4 million | $8,545.9 million | $7,563.3 million |
| Operating income | $343.4 million | $326.7 million | $1,018.0 million | $974.6 million |
| Net earnings attributable to Labcorp | $318.8 million | $171.5 million | $725.8 million | $539.3 million |
| Diluted EPS | $3.10 | $1.65 | $7.04 | $5.19 |
- Revenue increased 8.0% in Q3 and 13.0% year to date. Management attributed nine-month growth to acquisitions (10.0%), organic growth (2.7%) and foreign currency translation (0.6%), partly offset by divestitures (0.4%).
- Q3 segment revenue: LCD $1,752.0 million, down 0.2%; CDD $1,081.5 million, up 24.7%. Nine-month revenue grew 4.3% in LCD and 31.3% in CDD.
- Q3 gross margin was 27.9%, versus 29.9%; nine-month gross margin was 28.1%, versus 30.1%. Total operating margin was approximately 12.1% in Q3 and 11.9% year to date, down from approximately 12.5% and 12.9%, respectively.
- Reported net earnings included a $258.3 million gain on the Food Solutions sale, partly offset by a $48.9 million loss on the U.K. forensic business divestiture. These unusual items substantially boosted reported earnings compared with the prior year.
- Nine-month operating cash flow was $819.0 million, down from $933.1 million. Capital expenditures were $257.6 million; operating cash flow less capital expenditures was approximately $561.4 million (derived). Investing activities provided $353.6 million, including $654.5 million net proceeds from held-for-sale asset sales. Cash and cash equivalents were $892.6 million at September 30.
- Total debt was approximately $6,462.4 million, including current debt (derived from reported current and long-term debt); the company reported a 3.1-to-1.0 total-debt-to-pro-forma-trailing-12-month-EBITDA ratio. It had no revolver borrowings, but $72.2 million of letters of credit reduced facility availability. The current ratio was approximately 1.6 (derived). The company was in compliance with debt covenants.
Material changes and management commentary
- LCD operating income declined 14.0% in Q3 and its margin fell 270 basis points to 16.5%; management cited PAMA reimbursement reductions, ransomware and Hurricane Florence disruptions, and higher personnel costs. Nine-month LCD margin fell 180 basis points to 17.4%.
- CDD Q3 operating income rose to $87.9 million from $28.0 million, with margin improving to 8.1% from 3.2%. Nine-month CDD margin improved to 6.1% from 4.0%, supported by acquisitions, organic growth and lower restructuring charges.
- Nine-month interest expense increased to $186.0 million from $167.3 million, primarily reflecting debt issued to fund the Chiltern acquisition. The company repurchased $300.0 million of shares during the nine months; $843.5 million remained authorized at September 30.
- The July ransomware incident temporarily disrupted some LCD testing, result access and other systems. Operations returned to normal within days; management said its investigation found no transfer, theft or misuse of patient or client data. The company recorded $12.6 million of recovery costs and $9.8 million of lost revenue; insurance coverage may be disputed.
Outlook, risks and contingencies
- Management expected 2018 revenue growth of 10.5%–11.0% over 2017, and a consolidated effective tax rate of approximately 29.8% (27.9% excluding the discussed divestitures). Expected 2018 capital expenditures were approximately 3.5% of revenue.
- The company expected to recognize approximately 39% of its $4,199.6 million remaining long-term contract performance obligations as revenue over the following 12 months.
- Key risks include continuing pressure from PAMA and payer reimbursement, competition and customer/payer concentration, healthcare regulation and litigation, cybersecurity and business interruption, acquisition integration, and foreign-exchange and interest-rate exposure. Management reported no material change to the risk factors in its 2017 Form 10-K.
- Numerous legal and regulatory matters remain outstanding, including False Claims Act and employment-related claims. The company said it could not estimate reasonably probable losses for certain proceedings; it did not believe currently available information indicated a material adverse effect on financial condition, though results in a particular period could be affected.
- The company had not completed its accounting for certain Tax Cuts and Jobs Act effects. It recorded additional provisional tax expense during 2018 and said estimates could change as guidance and analysis develop.
Important facts for investors to verify
- Separate underlying operating performance from the divestiture gain and loss when assessing Q3 and year-to-date earnings growth.
- Track LCD pricing and margin effects from PAMA, and whether volume growth can offset reimbursement pressure and operational disruptions.
- Assess the durability of CDD’s organic growth and margin improvement apart from acquisitions and integration effects.
- Review cash conversion and working-capital needs, capital spending, debt leverage, and the effect of share repurchases on liquidity.
- Monitor ransomware-related claims and insurance recovery, pending litigation, tax-accounting revisions, and delivery against the company’s 2018 revenue and tax outlook.