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Executives

David P. King - Chairman, Chief Executive Officer and President

Stephen Anderson

William B. Hayes - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Treasurer

Analysts

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Amanda Murphy - William Blair & Company L.L.C., Research Division

Darren Lehrich - Deutsche Bank AG, Research Division

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Isaac Ro - Goldman Sachs Group Inc., Research Division

Gavin Weiss - JP Morgan Chase & Co, Research Division

Albert J. Rice - UBS Investment Bank, Research Division

Dane Leone - Macquarie Research

Glen J. Santangelo - Crédit Suisse AG, Research Division

Anthony V. Vendetti - Maxim Group LLC, Research Division

Laboratory Corp. of America Holdings (LH) Q2 2013 Earnings Call July 19, 2013 9:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Quarter 2 2013 Laboratory Corporation of America Holdings Earnings Conference Call. My name is Michelle, and I'm your event operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. Now I'd like to turn the call over to David King, Chairman and CEO. Please go -- proceed, sir.

David P. King

Thank you, Michelle. Good morning, and welcome to LabCorp's Second Quarter 2013 Conference Call. Joining me today from LabCorp are Brad Hayes, Executive Vice President and Chief Financial Officer; Ed Dodson, Senior Vice President and Chief Accounting Officer; Adam Feinstein, Senior Vice President, Corporate Development and Strategy; and Steve Anderson, Vice President, Investor Relations.

This morning, we will discuss our second quarter 2013 financial results, update our 2013 guidance, discuss the payment landscape, highlight our progress on our Five Pillar Strategy and provide answers to several frequently asked questions.

I'd now like to turn the call over to Steve Anderson, who has a few comments before we begin.

Stephen Anderson

Before we get started, I would like to point out that there will be a replay of this conference call available via the telephone and Internet. Please refer to today's press release for replay information.

This morning, the company filed a Form 8-K that included additional information on our business and operations. This information is also available on our website. Analysts and investors are directed to this 8-K and our website to review this supplemental information. Additionally, we refer you to today's press release, which is available on our website, for a reconciliation of non-GAAP financial measures discussed during today's call to GAAP. These non-GAAP measures include adjusted EPS, excluding amortization, free cash flow and adjusted operating income.

I would also like to point out that we are making forward-looking statements during this conference 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 the company's financial results. Some of these factors are set forth in detail in our 2012 10-K and subsequent filings. The company has no obligation to provide any updates to these forward-looking statements, even if our expectations change.

Now Brad Hayes will review our financial results.

William B. Hayes

Thank you, Steve. On today's call, I'll review 4 key measures of our financial performance: cash flow, revenue growth, margin and liquidity. I'll also update our 2013 guidance.

First, cash flow. Our cash flow continues to be solid, although in the quarter it was negatively impacted by delays and denials of coverage for existing tests by some payors after implementation of recently adopted molecular pathology codes. Free cash flow for the trailing 12 months ended June 30, 2013, was $597.8 million. DSO at the end of June was 50 days, unchanged from year end. During the quarter, our bad debt remained 4.3%.

Second, revenue growth. Revenue increased 3.1% year-over-year in the second quarter. During the quarter, total company volume increased 5%. Organic volume increased 1.4% year-over-year. Revenue per requisition decreased 1.8% year-over-year. Managed care pricing remained stable, but revenue per requisition decreased due to previously discussed Medicare payment reductions, delays and denials of coverage for existing tests by some payors after implementation of recently adopted molecular pathology codes, the implementation of sequestration on April 1, 2013, and strong growth in our drugs of abuse testing. Dave will discuss the molecular pathology payment issues in his remarks. Growth from our MEDTOX acquisition has exceeded our expectations. And while the strong performance has positively impacted revenue, volume and profitability, it has negatively impacted revenue per requisition.

Third, margin. For the second quarter, our adjusted operating income margin was 18.8% compared to 19.7% in the second quarter of 2012. Margins were negatively affected by the previously discussed factors.

Fourth, liquidity. We remain well capitalized. At the end of June, we had cash of $111.3 million and $225 million of borrowings outstanding under our $1 billion credit facility. During the second quarter, we repurchased $362 million of stock, representing 3.7 million shares. At the end of June, $592.1 million of repurchased authorization remained under our share repurchase program. Our increased share repurchase activity during the second quarter reflects our continued disciplined capital allocation program and commitment to return capital to our shareholders.

This morning, we updated our 2013 financial guidance. We expect revenue growth in the range of approximately 2% to 3%; adjusted EPS, excluding amortization, of $6.90 to $7.10, which includes a negative impact of approximately $0.35 due to Medicare payment reductions and which excludes the impact of any share repurchase activity after June 30, 2013; operating cash flow of approximately $825 million to $850 million; and capital expenditures of approximately $200 million to $220 million. Our capital expenditure guidance is higher than historical levels due to near-term investments in facility consolidation and replacement of a major testing platform.

I will now turn the call over to Dave.

David P. King

Thank you, Brad. We're very pleased with our second quarter results. During the quarter, we grew revenue approximately 3.1%. We grew volume, 5%, and organic volume, 1.4%. We maintained pricing discipline, and we returned capital to shareholders through the repurchase of $362 million of our stock, representing 3.7 million shares.

I would now like to review the payment landscape in general. We are pleased that we have continued our disciplined approach to managed care pricing. The government payment situation, however, is quite challenging. We were absorbing approximately $55 million in payment reductions in 2013 due to Medicare fee schedule reductions, from sequestration, the 88305 reduction and other reductions. In a recently released proposed physician fee schedule rule, CMS proposed to broadly update the clinical lab fee schedule, which has already been cut by approximately 5% this year alone and by nearly 8% cumulatively since the beginning of 2010, and to make a significant change in the calculation of payment rates for flow cytometry, FISH, IHC and other critical laboratory services paid from the physician fee schedule. Most of these tests are used for the diagnosis and monitoring of critically ill cancer patients, and they are essential to patients receiving proper and appropriate care. CMS revised payment for these critical tests by using the hospital OPPS as a comparator to current physician fee schedule payment rates and proposing to pay the lower of the two. CMS' reasoning in proposing this change is fundamentally flawed.

The change in methodology, if implemented, will dramatically reduce payment to community pathologists, independent labs, hospital outreach labs and all other labs providing vital services to cancer patients. It will be detrimental to patient care into every laboratory, large and small. The change is unmerited and must not be implemented. And the laboratory community, the pathology community, the physician community and the diagnostics community are united in working to prevent this assault on cancer patients and the laboratories that serve them.

Furthermore, our payment experience with respect to the newly -- to the recently implemented molecular pathology codes has been disappointing. During 2012, we told investors that we believe the pricing of these codes would have little impact on LabCorp pricing. On reviewing the pricing established for these codes, our belief proved correct. Nonetheless, during the first quarter of this year, we experienced delays in the pricing and implementation of these codes among various payors, including Medicaid, Medicare and commercial carriers. These delays were not surprising, given the extent of the impacted procedures. Because we expected that these delays will be properly resolved and have little impact for the full year, we did not highlight them for investors on our first quarter earnings call in April. Since our last conference call, however, several noncommercial payors have still not priced key molecular codes, and a number of these payors have informed us that they will no longer cover and pay for tests that they have always covered and paid for, including cancer markers and genetic analysis. Further, several payors are requiring additional information to process claims or have implemented prior authorization policies. Many commercial payors are only now becoming aware of the impact of their claim at us, which impede patient access to services that previously were covered and paid for.

These decisions are largely being made ad hoc, not pursuant to any properly promulgated coverage policies. They are contrary to long-established standards of care and will ultimately be harmful to patients. For example, we received non-covered responses from a number of state Medicaid organizations for carrier testing and prenatal screening for cystic fibrosis, fragile X and SMA testing, which are standard of care and which are called for within guidelines set by the American College of Obstetricians and Gynecologists, as well as the American College of Medical Genetics. These genetic profiles and full gene sequencing tests offered by LabCorp and many other independent hospital-based and academic labs are critical to the health and welfare of our patients. Failing to cover and pay for these tests will lead to curtailment of services to beneficiaries and ultimately to higher, not lower, health care costs. It is particularly troubling that state governments are taking positions that not only harm all laboratories but also limit care available to the most vulnerable and underserved population. And that the federal TRICARE program is taking positions that harm all laboratories and limit care to our active-duty military and their families.

We are working diligently with payors to address these issues, and ACLA and our industry colleagues are fully engaged. We trust that reason will prevail here and believe that these payors will ultimately cover molecular diagnostic testing as they had in the past. The delays and denials of coverage for these existing and previously covered tests had a negative impact on revenue, price, operating income, adjusted EPS, excluding amortization, and cash flow in the first half of this year and is incorporated into our updated guidance for the full year.

Again, it is our expectation that we will receive appropriate payment for our services and that these unprecedented nonpayment policies will be reversed, which would result in upside to our guidance. The laboratory industry is being harmed, and make no mistake, the harm is not only to LabCorp, it is to hospital labs, academic labs and independent labs, small and large. Our industry cannot and should not be expected to provide critical services to patients without being paid.

I would now like to update our progress on each aspect of our Five Pillar Strategy. The first pillar of our strategy is that we deploy capital to investments that enhance our business and return capital to shareholders. The performance of our MEDTOX business continues to exceed our expectations, and we are particularly pleased with the growth of our drugs of abuse business. The integration is proceeding as anticipated and is nearly complete. MEDTOX provides us with an excellent opportunity to diversify our payor and testing mix, and we remain excited about the opportunity to grow this business.

Earlier this year, we announced a target leverage ratio of 2.5x net debt to EBITDA. Our share repurchase activity during the second quarter brought us to a leverage ratio of 1.9x net debt to EBITDA, a tangible step for achieving this goal. We also continued to deploy capital to small strategic acquisitions that expand our test menu and geographic footprint.

The second pillar of our strategy is to enhance our IT capabilities to improve the physician and patient experience. We continue to develop and implement new population health analytics modules that provide business intelligence tools to hospitals, physician practices and ACOs. These tools assist customers in their compliance in reporting requirements with respect to efficient management of their productivity, quality and patient outcome efforts. We also continue to organize and manage a large amount of patient data, and we expect to use population health insights to improve patient care. These industry-leading, data-driven services position LabCorp as a trusted partner to health care stakeholders, providing the knowledge to optimize decision-making, improve health outcomes and reduce treatment costs. Looking ahead, we will continue to add new analytic offerings at the point-of-lab order and result delivery to enhance the physician experience and patient care.

The third pillar of our strategy is to continue to improve efficiency to offer the most compelling value in laboratory services. The Propel installation on our Burlington campus is complete, and it is currently splitting and sorting approximately 75% of our Atlantic division volume. We expect that Propel will process 100% of this volume by the end of July, and we intend to install the system in other labs over time. Propel represents a significant financial investment in innovation and will help decrease our labor expense and increase throughput and accuracy.

Construction continues on our new Phoenix campus and we intend to initiate operations within this 240,000 square foot facility later this fall. The campus will initially consolidate 4 laboratories and will be used for further consolidation activity over the next few years.

The fourth pillar of our strategy is to continue scientific innovation at reasonable and appropriate pricing. We introduced new tests and collaborate with leading companies and academic institutions to provide our physicians and patients with the most scientifically advanced testing in our industry. We realized that investors have great interest in the recent Supreme Court ruling related to BRCA analysis. We intend to enter the BRCA testing market. At this point, we believe the ruling will have a net positive impact on our business with new opportunities the ruling likely provides.

The fifth pillar of our strategy is to integrate our offerings into emerging health care delivery models. We continue to develop LabCorp Beacon, BeaconLBS, Beacon Analytics and decision support tools to expand our capabilities and create new value-added products and services for our customers. These tools give us access to additional data beyond the clinical laboratory data we have, allowing us to provide an integrated view of the patient and deliver it to the physician's desktop. We will use all of these capabilities to provide critical insights to support diagnostic and therapeutic strategies for the patient's clinical condition. We will also continue to evaluate opportunities to expand our data gathering and analytics capabilities and to use them as tools, both to grow our existing business and create new sources of revenue. The critical components of success in the post-reform era with be quality, efficiency and a role in improving patient outcomes. LabCorp is uniquely positioned to meet these needs in the months and years to come.

Now Steve Anderson will review anticipated questions and our specific answers to those questions.

Stephen Anderson

Thank you, Dave. "Can you describe the impact of Medicare payment cuts in 2013?"

The Affordable Care Act baseline for the 2013 update to the clinical lab fee schedule was negative 0.95%. And the Middle Class Tax Relief and Job Creation Act re-baselined the fee schedule an additional 2% lower. These fee schedule reductions became effective on January 1, 2013. Due to mandatory sequestration, we received an additional 2% reduction to the clinical lab fee schedule and a separate 2% reduction to the physician fee schedule effective April 1, 2013. We are also experiencing a variety of other government payment reductions, including the reduction to CPT code 88305 and the full year impact of the TC Grandfather Clause. Summed together, we continue to estimate that these payment reductions will lower our 2013 EPS by approximately $0.35, which is already incorporated into our guidance.

"Why are capital expenditures expected to be so high in 2013?"

We typically spend approximately 3% of revenue on capital expenditures. As Brad previously mentioned, our capital expenditure increase in 2013 is driven by near-term investments in facility consolidation and replacement of a major testing platform.

"Can you update us on the mix of your business coming from esoteric testing?"

For the year, approximately 38% of our revenues were in the genomic, esoteric and anatomic pathology categories. As we reiterated last quarter, our goal is to increase our esoteric test mix to approximately 45% of our revenue within the next 3 to 5 years.

In conclusion, I'd like to mention that earlier this quarter, we provided over $1 million worth of laboratory instruments to the government of Mozambique as part of a humanitarian aid effort. Mozambique is recovering from 30 years of Civil War, which destroyed a majority of the country's schools and hospitals. With the Democratic government in place, Mozambique is striving to reestablish health care delivery for its 22 million people. As in many others sub-Saharan African countries, Mozambique's population suffers from poverty, a high neonatal mortality rate, low life expectancy and a high incidence of infectious disease such as HIV and malaria. The equipment provided by LabCorp supplements aid that Mozambique receives from the Centers for Disease Control and Prevention, the Office of the U.S. Global AIDS Coordinator, the Mozambique Healthcare Consortium; UnitedHealth Group and other public and private aid groups. We work closely with the Mozambican branch of the CDC to place this equipment in the country's national health labs and central reference hospitals to improve the diagnostic and patient management capabilities of the country's health care practitioners. These instruments and the associated training provided by LabCorp will contribute to improve health care and quality of life for a truly needy population.

Now I'd like to turn the call back over to Dave.

David P. King

Thank you, Steve. Thank you very much for listening. We are now ready to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Robert Willoughby from Bank of America Merrill Lynch.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Dave, how many course do you have to get payment back from some of these payors that denied you? And maybe more importantly, what's a reasonable time frame for recovery?

David P. King

Bob, let's separate it into the commercial, the Medicaid and then TRICARE. So with commercial payors, this is a negotiated process. As we mentioned, many of them incorporated these payment policies without the realization of the impact that would -- that it would have on the claim filing process, a lot of paper claims, a lot of additional information and the impact on patients. And so most of it is just a question of sitting down and talking with them, explaining the circumstances and then we get the coverage issues resolved. With the Medicaids, a couple of the key Medicaids still have not priced the codes, so they told us they're going to pay for the tests but they still haven't priced the codes and these are a couple of sizable Medicaids. And we have been -- we have a commitment that they will price the codes within the third quarter, but obviously claims are not going to be paid until the codes are priced. There are a couple of Medicaids that have said they are not going to pay for this testing even though they have paid for it in the past and they have covered it in the past because either they call it new tests or because of budgetary constraints. On those, it's dealing with the Medicaids, it's getting ACLA involved, and ACLA is fully engaged in this as are our other industry colleagues and it's also potentially legislative and executive remedies in those particular states. And finally, with TRICARE, initially, TRICARE placed cystic fibrosis on its no-pay code list. Our understanding is that after some inquiries from us and others, that the code is off the list but it still hasn't been priced, so we're back in the situation that we have to wait for them to price the code. So as you can tell from that discussion, the timing is somewhat uncertain. We do expect the -- we're optimistic that the commercial ones, for the most part, will be resolved within the year. Whether some of the governmental ones go over into next year, we just have no way of knowing, and that's part of the reason we say as these get resolved, they provide additional upside to the guidance because we've incorporated the view that we stated here into how we think about guidance for the rest of the year.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Okay. And has this triggered, from your standpoint -- I mean, other labs are seeing this as well, you have this factor plus some of the cuts and proposals going forward. I mean, how is this changing the M&A pipeline for you? Is it too early to call at this point? Or are you seeing more activity as a net result of this?

David P. King

I think it's a little bit early to call, but the pipeline continues to be quite robust and there are good opportunities out there for us in a variety of areas. When you think about nonpayment for molecular codes, you think about cuts to 88305. There are a number of either specialized laboratories or laboratories with broad exposure to Medicare in these payment areas that are either thinking about entering the acquisition market or are already in the market.

Operator

The next question we have comes from the line of Tom Gallucci.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

I guess, just following up on a couple of Bob's questions there. Can you just help me explain sort of how you're handling the revenues and related -- and to the molecular testing that's not getting paid for at this point? I mean, the DSOs didn't really go up in the bad debt. It didn't really go up, so you said you got it all factored in. But how is that actually flowing through? And is there any way to sort of frame the magnitude of what we're talking about?

William B. Hayes

Tom, it's Brad. The way it's flowing through and manifesting itself is in price. These kinds of adjustments, we have historically considered noncoverage items and items where payors don't pay for certain things as revenue adjustments, so that's where they're showing up. And while the DSO was flat, we expected it to be down. And if we look at why it's not down, this particular item for the delays and the nonpayment are exactly what's causing it.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

And is there any way to frame sort of the magnitude of what we're talking about here relative to, I don't know, the overall company, whether it's revenue or test or any other perspective?

William B. Hayes

Yes, what I would say is it's about 4% of our revenue that's affected by this entire process. Our molecular pathology revenue is a little bit higher, but some of it's commercial billed and capitated so it doesn't really fall into this CPT code-related process, so it's about 4% of revenue. And then a subset of that is what we're having the difficulty with here. We're not going to give a specific number about what we've seen in the first quarter and expect for the back half of the year because as Dave mentioned, we're fighting this and we hope to get it reversed because it's really not merited. And when we look at price year-over-year, the 1.8% that we reported, if you take into account sequestration and these changes and some of the other factors that we talked about, those are the issues that are resulting in that price.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, that's very helpful, Brad. And then, I guess, just more broadly on the acquisition front, I guess, Bob asked about the reimbursement changes affecting the pipeline. Dave, I know you've talked about diversifying revenue streams a bit, so maybe areas that are outside of some of these sectors that are being hit by reimbursement. Your drug testing did very well in the quarter, I think that's the idea in that business. It doesn't have exposure to some of this stuff. Can you talk about maybe where you are in the process or what the pipelines might look like for you to continue to expand into sort of areas outside of some of the Medicare, Medicaid areas that have the more pressure?

David P. King

Yes, Tom. I think if you look at the key acquisitions that we've done in the last couple of years, we made an acquisition that gave us greater international capability in our pharma services, clinical trials, central lab business. That is not exposed to government reimbursement. It's well priced. And we've been very, very pleased with that because that business continues to expand as does the clinical trial business that is -- that comes in through monograms. Our paternity and forensic testing area where we made the Orchid acquisition, that not only gave us exposure to some private revenue and some nongovernmental revenue, but also to some international revenue with the U.K. and now we're getting some work in that business out of the Middle East. MEDTOX is a commercial pay. It's a -- typically an employer pay clinical trials and commercial pay business. There's essentially no exposure to government. So we are continuing to look at acquisitions that will help us diversify the revenue base. We have looked at and decided not to make some acquisitions, for example, in pathology where we think we would be further exposing ourselves to these kinds of issues. And then we continue to look, as I mentioned in speaking about Pillar Five, in ways that we can take our data and that we can tuck things in that help us create potential revenue streams out of the data and the analytics. So I think there's a -- I think we've had a broad approach to broadening the revenue base, and at the same time, sticking close to our knitting in terms of businesses that we fundamentally understand that know how to run and that fit our long-term strategic priorities.

Operator

The next question we have comes from the line of Gary Lieberman from Wells Fargo.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Was hoping maybe you can give a little bit more color on your organic volume growth, which seems to be pretty good. A number of operators, both, I guess, other competing labs and even some of the acute care guys have noted that physician office visits were weak and overall volume seemed to be pretty weak. So what do you attribute it to? Is it share gains? Or how would you characterize it?

David P. King

Gary, it's Dave. I think, first of all, MEDTOX, the drugs of abuse testing, the pay management business, all have done extremely well. Second of all, I attribute it to good execution. I mean, sales execution, service execution, the investments that we've made in getting results back to physicians earlier in interfaces, there's -- I wish we had some secret. We don't have a secret. Our secret is we have a terrific test menu. We're very focused on execution on both the sales and service side of the business and the kudos are to our organization for executing on our priorities.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Okay. And then maybe could you update us on the status of renegotiation of any of your large commercial contracts?

David P. King

So we renewed the Cigna contract and the Humana contract. We've made progress. It's still under discussion.

Gary Lieberman - Wells Fargo Securities, LLC, Research Division

Okay. And then maybe one housekeeping item. Do you give the share count at the end of the quarter?

William B. Hayes

Gary, it will be in the Q, which we'll file shortly.

Operator

The next question we have comes from the line of Ricky Goldwasser and he's from Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

Guys, can you talk a little bit about your views on benefit from ACA Medicaid expansion next year given the change to the employer mandate and just kind of like the discussion on the lower potential enrollment?

David P. King

It's Dave. We've said all along there's a lot of moving parts in the ACA and continue to believe there are a lot of moving parts in the ACA. I think that the ACA will be a net positive for us because there will be more people covered by insurance, whether through government programs, exchanges or employer base. I don't think we can quantify it today because, as you say, there are questions about which Medicaids will expand and how significant they will be. And there are questions about the readiness of the exchanges. There was the delay in the employer mandate and in a couple of other regulations that now are not going to take effect apparently until 2015. So again, net positive, we expect to see some benefit next year but certainly not factoring it in as a game changer as we think about 2014.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And then to clarify the comments that you made on the pricing, where the negative pricing trends are really a factor of the changes in molecular diagnostic, et cetera. Suggest to kind of like ask it in a more targeted way, excluding these issues that you mentioned, would your price metric be in positive territory, similar to where it was in 1Q '13?

David P. King

Well, there are a number of moving parts in price, and the growth in drugs of abuse testing, while it's positive to revenue, it's positive to volume and it's positive to margin, is negative to price because it's at a lower price point than our typical patient encounter. Everything else that was involved in price had to do with the government reductions. So the Medicare reductions that we talked about, the sequestration and then, as we mentioned, MoPath, which we don't view as a long-term reduction but certainly has an impact in this quarter. So I just -- I don't think it's constructive to try to break down every bit and bob of pricing. I think what we can say is we maintained price discipline with managed care, and managed care pricing was flat, as we've said. And the price impact is coming from the factors we've enumerated.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And then just last follow-up on the organic volume growth because, obviously, it seems that you're gaining share, right? You're growing faster than what the industry has grown this quarter. So -- and I understand it's on execution in sales and service. But can you give us any color on where it's coming from, i.e. is it coming from the hospitals where I think there's a lot of concern as hospitals are in-sourcing? Or is it just coming from the physician market where you're just gaining share from your independent lab peers?

David P. King

Well, I think it's coming from, as we mentioned, drugs of abuse and pain management. I think it's coming from the physician market, and then I think it's coming from hospital reference business. Those are probably the 3 biggest areas in which we're seeing volume pickups.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And the drugs of abuse, just to make sure that I'm not confusing it, is the drug of abuse, that's tied to the MEDTOX acquisition? Or is it also just above and beyond that?

David P. King

It's both. It's MEDTOX. It's our, what we call our occupational testing business, and it's the pain management component of both of those businesses.

Operator

The next question we have comes from the line of Amanda Murphy and she's from William Blair.

Amanda Murphy - William Blair & Company L.L.C., Research Division

I just had a quick follow-up on the reimbursement discussion. So I may be too early yet, but have you seen any change in the physician in-sourcing dynamic with the cuts to the code 88305 from last year? And then just as a follow-up to that, they've obviously targeted physician flow this year. And I'm curious, there doesn't seem to be codes that are quite as exposed to that physician in-sourcing dynamic. So curious if you have any insight into why they're going after those particular areas specifically.

David P. King

Amanda, it's Dave. I think we've seen a slowing of the physician in-sourcing trend for sure since 88305 and believe there was also a report that came out about utilization after physician in-sourcing that -- in the last couple of weeks that suggested that physician in-sourcing led to higher utilization. So I think the point has been made to CMS about the impact of physician in-sourcing and the trend does seem to be mitigated. On the flow and the FISH, the IHC and the other pathology codes, we don't have a good understanding of why CMS has singled those out on the physician fee schedule, although it's, I think the number is 26% approximately, reduction across the board on physician fee schedule pathology codes. When you look at flow and FISH, I mean, the reductions are more in the 60% and 70% range. So we don't know why those have been signaled -- have been singled out. And again, the reasoning behind equating those to the hospital OPPS is completely erroneous, and we will fight to the end that those said proposed reductions not be implemented. It is bad for laboratories, but more fundamentally, it is bad for cancer patients and it's going to have a terrible effect on the cancer patient population.

Amanda Murphy - William Blair & Company L.L.C., Research Division

Got it. And then just a follow-up to Ricky's question on the hospital side of the world. So in terms of the opportunity that you have there to increase your -- whether it be outsourcing, work from hospitals or working with them on a partnership level, I mean, is that market, one, that's underserved at this point? Or is it that -- I'm just trying to figure out where the growth is coming from. Is it from volumes going more to hospitals as they're buying the doc practices? Or are you actually gaining share from existing competitors in that market?

David P. King

Well, I think it's always risky to say that you're gaining share. I think the numbers speak for themselves. I think the hospital changes that we're seeing with physician in-sourcing do lead many hospitals to send out more testing because they are bringing in more testing. And as they bring in complex testing, they can't perform it themselves so they send it out. So I do think that accounts for some of the trend in terms of our growth in the hospital business.

Amanda Murphy - William Blair & Company L.L.C., Research Division

Okay. And just last one from me in terms of MEDTOX. I'm just curious if you can give a little more color on -- it seems like that's turning above your expectations in terms of growth. And then just how that flows through in terms of guidance or how to think about that through the remainder of the year?

David P. King

Well, I don't think we've ever talked about the P&Ls of particular acquisitions and so we're certainly not going to do that now. MEDTOX is doing better than we expected from a revenue and a profitability perspective. As you know, the guidance incorporates all the moving pieces in the business in a wide range of outcomes and so it's -- there's nothing we can really specify as to how MEDTOX plays in the guidance other than to say we're very pleased with the performance.

Operator

The next question we have comes from the line of Darren Lehrich who's from Deutsche Bank.

Darren Lehrich - Deutsche Bank AG, Research Division

So I just wanted to follow up on the Medicare PFS proposal. Just as it relates to 2014, can you update us, please, on what your exposure is to fee schedule as a percentage of revenue and maybe just help us think a little bit more about what that proposal means?

David P. King

Darren, it's Dave. The Medicare physician fee schedule revenue in 2012 was 1.7% of total revenue. Now it will be less this year because of some of the payment reductions that have already been implemented. But if these reductions were to be implemented, as proposed in the rule, you could simply, on average, take the -- call it 1.5% of revenue and multiply that by negative 26.7% and you'd be in the ballpark of what the impact would be.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay. So you don't think your mix is necessarily different than what the 26% would imply, given what you said about FISH and flow being higher than that?

David P. King

No.

Darren Lehrich - Deutsche Bank AG, Research Division

Okay. That's very helpful. And then as it relates to molecular diagnostics issue, can you just remind us -- my recollection was that this is in the domain of the max and it's been pretty byzantine in terms of how they've been pricing codes and approving codes. But for 2014 or some point in the future, it moves into the domain of the clinical lab fee schedule and so it comes back to Medicare on more of a federal level. Is that how it's currently envisioned? And do you think that's 2014? And I guess, the real question here is, what would that mean then for the states and some of these other payors to the extent that some of those codes aren't approved?

David P. King

Well, if I understand the question, which I have to -- I'm not sure I do, but if I understand the question, the answer is the pricing has been done by individual Medicare carriers on a gap-fill basis. The process has been slow, and it has been nontransparent in the sense that we don't know what the inputs are into the pricing. We have offered to try to help provide inputs, and generally, our offers of helping with inputs have been declined by the carriers, the Medicare carriers. And they have established pricing, probably led by Palmetto, and then a number of others have followed along. As we said throughout the year last year, the actual prices set would not have had a major impact on us because they're not terribly different from the prices that we were previously receiving. The issue was the delay in setting the prices and then some of the coverage decisions are not the coverage changes that we've made reference to in the call. I believe CMS will have greater authority over these prices in 2014 because I believe after they've been in place for a year, CMS has the ability to review them. But we had our work cut out for the rest of 2013 and that's what we're focused on.

Darren Lehrich - Deutsche Bank AG, Research Division

Well, yes. It just would obviously seem like you'd have more leverage if you're dealing with one and even -- than multiples, so that's helpful. Then just the last question here is just on testing platforms. First, was hoping you might expand a little bit more on your BRCA comment. You intend to enter the market based on what you said, Dave. When do you think that will occur? And then any kind of just broad-brush comment we could get on the FC market, how you see that tracking and what do you think that market is doing? Is it accelerating? Is it just -- has it been stable the first half? Any comments there will be great.

David P. King

Sure. On BRCA, we don't have a specific time frame for entering the market. We actually are capable of performing the test today under current methodologies, but we're looking at what's the best methodology and what's the right timing. And as you probably saw, even post the Supreme Court decision, there's been another suit filed against the lab performing BRCA so this is not entirely free from controversy in spite of the Supreme Court's decision. We're going to make a reasoned decision about when we enter the market and what methodology we use and what price we offer and all I can say stayed tuned in terms of our timing there. On hepatitis C, it's been one of the nice drivers of growth year-over-year. The screening recommendations from the CDC have certainly given us some help. In addition, our hepatitis C expertise coming out of the terrific R&D that we do at Monogram and the clinical trials for the new hepatitis C drugs have all been very strong for us there and so we're pleased. We talked for long term about the opportunity in hepatitis C and we needed a catalyst in those guidelines for the catalyst.

Darren Lehrich - Deutsche Bank AG, Research Division

What share do you think you have in the hep C market?

David P. King

Just couldn't even begin to estimate.

Operator

The next question we have comes from the line of Kevin Ellich and he comes from Piper Jaffray.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Just a couple of follow-up questions. I guess, first, on the 5% volume growth, if 1.4% came organically, is it safe to assume the remainder came from MEDTOX? Or was there anything else?

William B. Hayes

Kevin, this is Brad. That's correct. That's the way we look at it.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Okay. And then on the reduced operating cash flow guidance, was that only due to the delays and denials from the MoPath codes? Or was there anything else included in that?

William B. Hayes

I would say that makes up the substantial part of that thinking.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Okay. Got it. Appreciate it. And then, Dave, I was just kind of wondering if -- are you guys seeing any increased volume coming from wellness testing as more employers adopt these various programs?

David P. King

Kevin, it's Dave. I think the answer is yes. We've had requests from a number of employers and plans, for example, to be able to do biometric testing in our patient service centers' point of service. So I think the answer is yes. Both wellness and pain management have been growers for us in the last couple of quarters.

Kevin K. Ellich - Piper Jaffray Companies, Research Division

Got it. And would that be lower-priced business, all things considering?

David P. King

Yes, probably.

So guys, we have 10 minutes -- excuse me, Michelle, we have 10 minutes before the hour. We have about 7 people in the queue so let’s try to make sure the questions we are asking are new and unique so that we can limit the call to an hour. Thank you.

Operator

The next question we have comes from the line of Isaac Ro from Goldman Sachs.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Could you maybe just show a little light on anything you're seeing with regards to the competitive environment against hospital labs ahead of ACA? And specifically, do you see any near-term opportunity to pick up a little bit of market share and maybe you can kind of compare that against the dynamic you see where hospitals may be trying to bring more of their own business in?

David P. King

Isaac, it's Dave. I think, as we have said, hospitals have been acquiring physician groups, which is -- which are bringing lab services in. I would say at the same time, we're seeing hospitals facing some of the similar pricing environment, particularly government pricing environment, that we're seeing and it's reflected in our numbers and in everybody else's numbers. And so I think there's a greater interest in things like laboratory management services that help them reduce their costs than there has been historically. And we've seen very good growth in laboratory management relationships with hospitals throughout the last, probably, 3 quarters and expect that to continue.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Got it. And then just want to follow up on the cost side of things. Can you give us a sense maybe of what kind of savings you think you can target here on the sourcing and supply chain side of things? And specifically, I'm referring to some of the vendor consolidation that your main competitor has undertaken recently. I'm just trying to sense -- get a sense of what you think your relative opportunity is on that side.

David P. King

Yes, I think our opportunity there is relatively small. We've done those things a long time ago, so we have standard national contracts for almost all of our major supplies from gloves to dry ice, you name it. And so I don't think there's a lot of upside to further supply chain rationalization because, as I say, we've -- we undertook that process about 4 years ago.

Operator

The next question we have comes from the line of Gavin Weiss and he's from JPMorgan.

Gavin Weiss - JP Morgan Chase & Co, Research Division

Just wanted to clarify, SG&A in the quarter came in a little bit below our expectations and showed the better trend than in the first quarter. Is there anything specific there that's driving that improvement? And how should we think about that going forward?

William B. Hayes

I would say just, this is Brad, continued integration of some acquisitions from last year. No real change to mention and bad debt driving that trend and it's sustainable. So there's nothing unusual driving it and we think that trend should continue.

Gavin Weiss - JP Morgan Chase & Co, Research Division

Okay. Great. And then Dave, you talked about the increased use of Propel in your North Carolina facility. How should we think about that technology in terms of the margin profile? Is there a point where that becomes a significant impact? Or is it more just incremental?

David P. King

As I mentioned, it's a significant financial investment in efficiency and innovation. And from a margin perspective, we should think of that -- we should think of it as it certainly is labor saving. But a lot of the times, what we do with those labor savings is that we move those positions into front-line positions so that we can continue the emphasis on sales and service that we talked about earlier in the call. So we haven't quantified it, and at the point when we have it up and running in our 8 labs, we will be able to quantify it. It will help with margin but I'd like to think of it as it more helps us to offset some of the pressures in the other direction than you would see a dramatic impact on margins overall.

Operator

The next question we have comes from the line of A.J. Rice from UBS.

Albert J. Rice - UBS Investment Bank, Research Division

First, a numbers question. On the operating cash flow guidance, it looks like you reduced that about $50 million from previous range, anything behind that worth highlighting?

David P. King

It's Dave. As Brad stated, that is essentially due to our expectations for the timing of payment for the molecular pathology issues that we've discussed.

Albert J. Rice - UBS Investment Bank, Research Division

Okay. And then maybe just quickly on the -- if I look at your guidance for the back half, you're at -- you're looking at it for $3.47 in the back half versus the $3.53 of non year-to-date. I know sequestration, you get 2 quarters of that in the back half versus one in the early part, but you've also got the benefit of the buyback kicking in. I know we've talked about a lot of different items on the call so far but if you look at the overall macro environment, is there any reason? Are you thinking it will be a little tougher in the back half? Or would you describe that as your normal seasonal pattern, even taking into account the buyback benefit?

William B. Hayes

A.J., it's Brad. I would say it's normal seasonal. I mean, the fourth quarter is a tough EPS quarter just given the holidays and everything. So as I look at the calendarization of our expectations, I don't see anything unusual in it.

Albert J. Rice - UBS Investment Bank, Research Division

And no change in the macro basically from what you guys...

William B. Hayes

Not thinking of any at this point.

Operator

The next question we have comes from the line of Dane Leone from Macquarie.

Dane Leone - Macquarie Research

I know it's early days since the Supreme Court ruling and you're still trying to figure out a strategy with BRCA. But I think it would be helpful, especially in historical context of your comments on where you ultimately think the growth potential of the lab industry is, what type of scope and potential is there for the broader implications of the ruling? And what type of content could that ultimately unlock for LabCorp as it continues to push into a more esoteric product mix?

David P. King

It's Dave, Dane. I think that, as we said, the BRCA decision in and of itself unlock certain market opportunity to launch a -- the BRCA test more fundamentally, or more broadly, it opens up opportunities in other areas that have been patent protected and it raises the question of whether other things that have patent protection will continue to have that patent protection over time. So as we think about next-generation sequencing, as we think about the ability to do broader genetic testing, longer reads, sequence-full genes and add the content to that, the interpretive content of that which is part of what we're developing in the second and fifth pillar, I think the opportunity is very promising for us. It would be really -- just it wouldn't make sense to try to quantify that now because the uncertainty is too great, but we definitely view it as a long-term positive and is fitting nicely with our strategic focus.

Operator

The next question we have comes from the line of Glen Santangelo from Crédit Suisse.

Glen J. Santangelo - Crédit Suisse AG, Research Division

Dave, just a couple of quick questions. You only spent a fair amount of time on this call talking about the government reimbursement environment and appropriately so. But I'm just kind of curious, could you comment on the commercial environment? You made some comments earlier on, talking about that you have a disciplined approach to pricing and you renewed Cigna and is currently in negotiations with Humana. Could you give us a sense for how those negotiations are going? And do you -- are you nervous at all about any vulnerability on the commercial front, given all the potential pressure on the government side?

David P. King

I've said for a long time that the fundamental process of negotiation with commercial payors is they want us to do more for less and we want to be paid more for what we do, so it's a negotiation, and I'm pleased that we have maintained good pricing discipline. I'm pleased that pricing in the quarter on managed care remained stable. And we're going to continue to do the best we can to maintain pricing discipline and keep that trend. We have a long-standing partnership with Humana. We value the relationship and our hope is that we're going to come to contract terms that are good for everybody.

Glen J. Santangelo - Crédit Suisse AG, Research Division

Maybe just really quick. Are you seeing any success or focus on behalf of the commercial payors regarding their efforts to narrow their lab networks?

David P. King

I don't think we're seeing a lot of impact there, Glenn. I think, obviously, there's been a lot of press given to some of the actions that Aetna has taken fairly publicly. But I think the actual, are we going to have more narrow networks? We're just not seeing a lot of it.

Operator

The next question we have comes from the line of Anthony Vendetti from Maxim Group.

Anthony V. Vendetti - Maxim Group LLC, Research Division

This will be quick. I was just wondering if you could give the growth rate for drug in abuse testing and also for the esoteric and genomic testing for the quarter, year-over-year?

William B. Hayes

Okay. Esoteric testing for the quarter was up, I believe, 3.5%. The drugs of abuse testing for the quarter...

David P. King

10.6%.

William B. Hayes

It's a race to see who can find it, and Dave found it, 10.6% year-over-year. Now that is excluding the impact of MEDTOX. That's our core drugs of abuse.

David P. King

Exactly.

William B. Hayes

Just as a comparison, in Q1, it was 10.2% on a per day basis, excluding MEDTOX.

Operator

Thank you for your question. I would now like to turn the call over to David King for closing remarks.

David P. King

Thank you very much for listening to our second quarter earnings call, and we wish you a good day.

Operator

Thank you for your participation in today's conference call. This concludes your presentation. You may now disconnect. Thank you, and have a good day.

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Source: Laboratory Corp. of America Holdings (LH) CEO Discusses Q2 2013 Results - Earnings Call Transcript
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