Labcorp Holdings Inc. Q2 FY2022 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Labcorp Second quarter 2022 Earnings Call. Thank you. Chas Cook, Head of Investor Relations, you may begin your conference.

Thank you, operator. Good morning, and welcome to Labcorp's Second Quarter 2022 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 Adam Schechter, Chairman and Chief Executive Officer; and Glenn Eisenberg, Executive Vice President and Chief Financial Officer. This morning, in the Investor Relations section of our website at www.labcorp.com, we posted both a press release and an Investor Relations presentation with additional information on our business and operations, which includes a reconciliation of the non-GAAP financial measures to the GAAP financial measures discussed during today's call as well as a presentation on additional information on the spin-off of the clinical development business. Additionally, we are making forward-looking statements. These forward-looking statements include, but are not limited to, statements with respect to the estimated 2022 guidance and the related assumptions; the proposed spin-off of the clinical development business; the impact of various factors on the company's businesses, operating and financial results, cash flows and/or financial condition, including the COVID-19 pandemic and general economic and market conditions; future business strategies; expected savings and synergies, including from the LaunchPad initiative and from acquisitions; and opportunities for future growth. Each of the forward-looking statements is subject to change based upon various factors, many of which are beyond our control. More information is included in our most recent annual report on Form 10-K and subsequent quarterly reports on Form 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 Adam.

Thank you, Chas, and good morning, everybody. Today, we announced we are pursuing the spin of our clinical development business, and we released our second quarter results. It's an exciting day for Labcorp, and we have a lot to cover. So I'll start with the spin. We are pursuing the spin of our clinical development business to shareholders through a tax-free transaction. This transaction will create two leading, independent, and global public companies that will each be well positioned to innovate, grow significantly and enhance shareholder value. This announcement marks the beginning of an exciting new chapter for our businesses and is a testament to our team's growth mindset, resilience, and determination over the last several years. The decision to spin off the clinical development business resulted from our Board and management team's ongoing review of opportunities, including discussions with third parties, that best position us for growth, success with our customers and shareholder value creation. When we announced the conclusion of our strategic review in December of last year, we determined that the company's structure was in the best interest of stakeholders at that time. We reiterated that management and the Board were committed to continuing to evaluate all avenues for enhancing customer and shareholder value. We have now determined that spinning off the clinical development business is the best path forward to achieve this objective. The planned spin will position our businesses to thrive as two independent companies with greater strategic flexibility and operational focus to innovate, to pursue their distinct priorities and to better meet customer needs and capture growth opportunities. Each company will benefit from its own capital structure, enhanced investor alignment through a more targeted investment opportunity and a differentiated value proposition. Each will be well capitalized and positioned to generate substantial top and bottom line growth with strong free cash flow and attractive returns. We expect this transaction to drive significant value for shareholders as we'll provide investors with the opportunity to participate in the significant upside potential of two leading global businesses in the health care sector. This transaction allows Labcorp to move forward as a strong, global, innovative laboratory services business with significant growth potential. The Labcorp business will include routine and esoteric labs, central labs and early development research labs. In 2021, these businesses reported testing for 82% of the therapeutics submitted to the FDA, tested patients in over 100 countries and performed over 650 million tests globally. Each is a leader in their respective markets. The combination of these businesses creates a cohesive global provider of laboratory-focused services with complementary resources, significant scale and a diverse customer base poised to grow in a global addressable market of over $150 billion. Labcorp's customers will continue to benefit from its deep scientific expertise, our innovative mindset, our vast health data and insights as well as our advanced global laboratory network. With a more focused platform for growth, we expect Labcorp will be able to capture upside as we advance innovations to deliver on our customers' future needs. Over the last four quarters, the lab businesses delivered total revenue of $12.7 billion or $10.5 billion excluding COVID testing revenue. These businesses grew at a 5.5% CAGR from the second quarter 2019 to the second quarter of 2022, excluding COVID testing revenue. Going forward, Labcorp is expected to deliver mid-single-digit annual revenue growth, and we remain firmly committed to our capital allocation strategy and to maintaining an investment-grade credit rating. The clinical development business will continue to be a leading global provider of Phase I through Phase IV clinical trial management, market access and technology solutions, serving a broad customer base, including pharmaceutical and biotechnology organizations. It will be positioned to compete and to win in a growing and dynamic market, including extending its leadership in oncology, cell and gene therapy, rare diseases and other emerging therapeutic areas. The clinical development business will be able to implement a capital structure that is tailored to support its growth strategy and enhance stakeholder value. Importantly, we expect the clinical development business will retain access to Labcorp's vast health and clinical data set through an arrangement to support clinical development customers with the ability to tap into Labcorp's unique data and capabilities. The clinical development business will be poised to capitalize on its innovation and technology platform to drive significant growth. Over the last four quarters, the clinical development business delivered total revenue of $3 billion. This business grew at an 8% CAGR from the second quarter of 2019 to the second quarter of 2022. Going forward, the clinical development business is expected to deliver high single-digit revenue growth. We will have a strong balance sheet and significant financial flexibility. I want to emphasize that each business has delivered strong performance, and we expect that Labcorp and the clinical development business will be poised for even greater growth as independent, more focused companies. We expect to close the transaction in the second half of next year, and we look forward to sharing more about its progress in the future. I'll now move to cover the company's second quarter performance and provide an update on progress against our strategy before turning it over to Glenn. The Base Business in the quarter continued to perform well despite ongoing impacts from COVID, the Ukraine-Russia crisis, and foreign exchange rates. In the quarter, revenue totaled $3.7 billion, adjusted earnings per share reached $4.96, and free cash flow was $429 million. In Diagnostics, Base Business revenue for the quarter was up 3.9% versus the prior year due to increased demand for both routine and esoteric testing. The Base Business CAGR was 4.3% from 2019 pre-COVID, demonstrating strong, continued underlying performance. Drug Development revenue was flat in constant currency data in the quarter versus last year, with growth in early development and clinical development offset by central labs. Central labs was impacted by the significant slowdown in COVID-related work and the Russia-Ukraine crisis. On a CAGR basis, in 2019, pre-COVID, the Drug Development Base Business grew 9%. Margins in Drug Development improved in the quarter to 14.7% and are expected to continue to increase throughout the year. Glenn will provide more detail on our second quarter results in a moment. Now I'll provide a brief update on our efforts to address the COVID-19 pandemic, and most recently, assist in the monkeypox outbreak. COVID PCR volumes totaled 2.8 million for the second quarter, averaging 31,000 per day. Time to results remained one day on average. With respect to the monkeypox outbreak, in collaboration with the CDC and FDA, we became the first national laboratory to begin testing for monkeypox using the CDC test. I'll now turn to progress against our strategy. In addition to today's announcement, we've made significant progress against our strategy by putting science, innovation, and technology at the center of all we do. The company introduced multiple innovative and high-quality diagnostics to consumers and physicians in the quarter. We continued to expand our at-home test offerings through Labcorp OnDemand, including a first-of-kind blood collection device for diabetes risk screening. In addition, we launched an FDA-approved men's rapid fertility test. For brain injuries and neurodegenerative disease, in July, we were first to begin offering a test that can help physicians diagnose conditions, including concussions, Alzheimer's and Parkinson's. Finally, we expanded our central labs kit production capabilities to improve delivery and address growing demand across Europe, the Middle East and Africa. We announced the planned expansion of our central labs presence and drug development capabilities in Japan in collaboration with BML. Turning to oncology. We continue to deepen our leadership position by expanding our cancer-related diagnostic screening and testing portfolio and by partnering with our pharmaceutical clients. During the second quarter, we launched a new skin cancer test that gives doctors actionable insights to help determine the best treatment options. The test is also expected to be used to support clinical trials. For patients with metastatic non-small cell lung cancer, we're collaborating with Lilly and using Labcorp's OmniSeq INSIGHT genomic test to help physicians make more informed and personalized treatment decisions. Moving now to new and ongoing partnerships and acquisitions. During the second quarter, we acquired select outreach business assets and agreed to provide ongoing technical support to Prisma Health's hospital laboratories. We completed our acquisition of select clinical outreach business assets from AtlantiCare in New Jersey. We reached an agreement to acquire the clinical outreach business and related assets of RWJBarnabas Health, also in New Jersey. And the previously announced relationship with Ascension is progressing through normal regulatory approvals. We continue to have a very strong pipeline of health system and regional acquisition possibilities, and we look forward to announcing more in the future. In summary, we continue to deliver solid results, improve our performance and execute on our strategy to create long-term value for all stakeholders. We're encouraged by momentum heading into the second half of the year and by the strategic opportunity for Labcorp's growth and impact in the future. With that, I'll turn the call over to Glenn.

Thank you, Adam. I'm going to start my comments with a review of our second quarter results, followed by a discussion of our performance in each segment and conclude with an update on our full year guidance. For reference, we've also included additional business information that can be found in our supplemental deck on our Investor Relations website. Overall, the company performed well in the quarter. Revenues for the quarter were $3.7 billion, a decrease of 3.7% compared to last year due to lower COVID testing and the negative impact from foreign currency translation. This was mostly offset by organic Base Business growth and acquisitions net of divestitures. COVID testing revenue was down 42% compared to COVID testing last year, while the Base Business grew 1.2% compared to the Base Business last year. Organically, in constant currency, the Base Business grew 1.6%. Operating income for the quarter was $526 million or 14.2% of revenue. During the quarter, we had $66 million of amortization and $64 million of restructuring charges and special items, primarily related to acquisition and integration costs, facility rationalization and other LaunchPad initiatives. Excluding these items, adjusted operating income in the quarter was $656 million or 17.7% of revenue compared to $840 million or 21.9% last year. The decrease in adjusted operating income and margin was primarily due to a reduction in COVID testing, higher personnel expense and other inflationary costs, partially offset by organic Base Business growth and LaunchPad savings. The tax rate for the quarter was 24.7%. The adjusted tax rate was also 24.7% compared to 25.1% last year. The lower adjusted rate was primarily due to the geographic mix of earnings. We continue to expect the adjusted tax rate for the full year to be comparable with last year at approximately 25%. Net earnings for the quarter were $359 million or $3.87 per diluted share. Adjusted EPS were $4.96 in the quarter compared to $6.13 last year. Operating cash flow was $572 million in the quarter compared to $487 million a year ago. The increase in operating cash flow was due to higher cash earnings and favorable working capital. Capital expenditures totaled $143 million, up from $97 million last year, primarily due to timing. As a result, free cash flow was $429 million in the quarter. During the quarter, we invested $100 million on acquisitions, paid out $67 million in dividends and repurchased $400 million of stock, representing 1.7 million shares. At the end of the quarter, we had $1.1 billion of share repurchase authorization remaining. Now I'll review our segment performance, beginning with Diagnostics. Revenue for the quarter was $2.3 billion, a decrease of 4.7% compared to last year due to organic revenue being down 5.7%, partially offset by acquisitions of 1.2%. COVID testing revenue was down 42% compared to COVID testing last year, while the Base Business grew 3.9% compared to the Base Business last year. Relative to the second quarter of 2019, the compound annual growth rate for Base Business revenue was 4.3%, primarily due to organic growth. Total volume decreased 2.7% compared to last year as organic volume decreased by 3.1% partially offset by acquisition volume of 0.4%. COVID testing volume was down 45% compared to COVID testing last year, while Base Business volume grew 3.4% compared to the Base Business last year. We continue to see Base Business volumes improve as we're now up 0.6% on a compounded basis compared to the second quarter of 2019. Price/mix decreased by 2% versus last year, primarily due to an organic decline of 2.6%, partially offset by acquisitions of 0.8%. The lower organic price/mix was primarily due to COVID testing as the Base Business was relatively flat. Base Business price/mix benefited from esoteric growing faster than routine testing but was negatively impacted by payer mix. Diagnostics adjusted operating income for the quarter was $516 million or 22.9% of revenue compared to $663 million or 28% last year. The decrease in adjusted operating income and margin was primarily due to a reduction in COVID testing. COVID testing margins were down compared to last year due to lower testing demand while the company continued to maintain capacity. In addition, margins were negatively impacted by COVID testing payer mix. Base Business margins were lower due to higher personnel expenses and other inflationary costs, partially offset by organic growth and LaunchPad savings. Going forward, we expect the second half Base Business margins to be up year-over-year due to improved demand and labor efficiency. Now I'll review the performance of Drug Development. Revenue for the quarter was $1.5 billion, a decrease of 2.9% compared to last year, primarily due to foreign currency translation of 2.6% and lower COVID testing of 0.6%. Organic-based growth was negatively impacted by lower COVID-related work, the Ukraine-Russia crisis and lower pass-throughs. Excluding these impacts, organic Base Business revenues grew in the mid- to high single digits. Base Business revenues compared to Base Business last year declined 2.3%, but was up 0.4% on a constant currency basis. Early development experienced good growth as did the clinical business, which was constrained by lower pass-throughs. Central labs was down year-on-year but up 6.7% on a compounded basis versus the second quarter of 2019. The decline year-over-year included the impact from lower COVID-related work and the Ukraine-Russia crisis. We expect central labs revenue to be up in the second half year-over-year based on the strength of its backlog. Drug Development segment revenue was up 8.8% on a compounded basis relative to the second quarter of 2019, primarily driven by organic growth. Adjusted operating income for the segment was $213 million or 14.7% of revenue compared to $221 million or 14.8% last year. The decrease in adjusted operating income and margin was due to a reduction in COVID-related work, the Ukraine-Russia crisis and inflationary costs. These impacts were partially offset by organic Base Business growth and LaunchPad savings. In addition, personnel expense was lower due to cost reduction actions and variable compensation. In the second half, we expect top line growth and continued cost reductions to drive margin expansion such that the full year Base Business margin will be comparable to 2021. We ended the quarter with backlog of $15.2 billion, and we expect approximately $4.8 billion of this backlog to convert into revenue over the next 12 months. Now I'll discuss our updated 2022 full year guidance, which reflects our first half performance and outlook and assumes foreign exchange rates effective as of June 30, 2022, for the remainder of the year. The enterprise guidance also includes the impact from currently anticipated capital allocation with free cash flow targeted to acquisitions, share repurchases and dividends. We expect enterprise revenue to decline 2% to 6% compared to 2021. This is a decrease at the midpoint from our prior guidance of 50 basis points due to the change in currency. This guidance now includes the expectation that the Base Business will grow 5% to 7.5%, while COVID testing is expected to decline 50% to 60%. We expect Diagnostics revenue to decline 9% to 13% compared to 2021. This is an increase at the midpoint by 250 basis points driven by our updated expectations for COVID testing. COVID testing is now expected to decline 50% to 60%, while our Base Business is expected to grow 4% to 6%, unchanged from our prior guidance. At the midpoint of our Base Business guidance, the compound annual growth rate compared to 2019 is 4.5%, primarily driven by organic growth. We expect Drug Development revenue to grow 1.5% to 3.5% compared to 2021. This is a decrease at the midpoint of our prior guidance of 475 basis points. The decline includes 130 basis points change from foreign currency translation as well as the impact from lower COVID-related revenues and lower pass-through revenues. Compared to last year, the guidance range of 1.5% to 3.5% growth includes the negative impact from foreign currency translation of 230 basis points. This guidance also includes the expectation that the Base Business will grow 2% to 4% compared to 2021. Excluding lower COVID-related work and the Ukraine-Russia crisis, the constant currency growth rate would be in the high single digits compared to 2021. At the midpoint of our Base Business guidance, the compound annual growth rate compared to 2019 is 9.3%, primarily driven by organic growth. Our guidance range for adjusted EPS is now $19 to $21.25, an increase at the midpoint of $0.50 compared to our prior guidance. This increase is primarily due to the impact from COVID testing. Free cash flow guidance remains unchanged at $1.7 billion to $1.9 billion. In summary, the company had a solid quarter. We expect to drive continued profitable growth in our Base Business for the remainder of the year, while COVID testing volumes are expected to decline relative to the first half of this year. We expect to continue to use our free cash flow generation for acquisitions that supplement our organic growth while also returning capital to shareholders through our share repurchase program and dividends.

We will now take questions.

This is Ricky Goldwasser and Erin Wright from Morgan Stanley. So Adam and Glenn, congrats for moving forward with elements of the strategic program. The question I have is, as we think about the clinical business, can you give us some context as to the margins that are associated with that business and how it compares to what's staying with kind of like the core Labcorp or central versus early development? And then I have another follow-up after that.

Sure. First of all, thanks for the question. And I'll give you some context, and I'll ask Glenn to give some additional context. The first thing is that the clinical development market is a very exciting market. It's probably about more than $25 billion in potential revenue. So it's a very large market, and it grows very quickly. And if you look at the business that we're spinning out, historically, it has about an 8% CAGR. And what we expect for the future is that it will have high single-digit organic growth. So it is a fast-growing business in a very large market. That's part of the reason we think it makes sense to spin it out at this time. When you look at the margins, we don't give the exact margin yet. And the reason why is because we still have a lot of shared services, and we have to break out those shared services to understand what the full margin picture will look like. Historically, what we've said is that we've seen margin improvement in that business year-over-year for multiple years now. And as we look to the future, we said there'd be margin expansion; we've always said that the clinical development business has the greatest potential for additional margin expansion.

Yes. The only thing I'd add, Adam, is that, Ricky, as you know, when we've done the enhanced disclosures, we provide the full Drug Development segment, obviously, revenue down to margins. When we gave the enhanced disclosure of the three businesses that comprise it, obviously, clinical being one of them, we didn't provide the margins essentially for the reason that Adam had said, that we have a lot of shared resources. They're not necessarily stand-alone businesses. They're part of the segment. I think directionally, it's fair to say that when you look at the margins of the businesses, they all have different characteristics. And in the case of the clinical business, it is the one business that has, frankly, over 20% of its revenues that are pass-through revenues. So obviously, that would constrain the margins of that business relative to the other businesses that wouldn't have that. But as Adam said, it's a very profitable business and a business that each year, we've seen margin improvement continue, and we expect that to continue going forward.

Congratulations on the deal announcement. I might just ask you, in the Base Business, Drug Development, one of the things throughout this year is how the margin is planned to step up over the course of the year, and you had good margin improvement from, I think, 11.6% in the first quarter to 14.7% in the second. But you're also reiterating that you think you'll be similar to last year, which I think is 15.2%, implying further step-up. What allowed you to show the 300 basis points of margin improvement from first quarter to second? And what further gets you that back half margin improvement that's embedded in guidance?

It's Glenn. I'll start with that one. When we look at the first quarter, the margins were low, and we explained the reasons for that. We felt positive about our comment that for the full year, we expected margins to be similar year-on-year, partly due to the run rate at the end of that quarter. We did observe that by the end of the first quarter, the margins were now comparable to last year. In fact, they would have been higher compared to last year if we excluded the COVID testing we conducted last year. As we consider the second half, we still anticipate continued top-line growth along with many of the cost reduction initiatives, such as LaunchPad, that began late in the second quarter. We will now see the full quarter benefit as we move into the third and fourth quarters. With the top line and the cost reduction strategies we have in place, similar to the end of the first quarter and as we concluded the second quarter, we are at a run rate now that supports the higher level of margins we need to see in the second half to maintain our belief that our full-year margins will be comparable on a Base Business level to what we achieved last year.

This is Taji Phillips on for Brian. So just going back to your most recent news about the announcement of the spin-off, can you provide some color on your thinking and the strategy moving forward? Specifically, given that clinical business is typically a strong pipeline for central lab work, how do you see that dynamic playing out between the two independent companies after the spin-off?

Yes. Thank you for that question. And as we look at the strategy overall, I mean, the reason it makes sense to do the spin and to do it now, it really is going to give strength and strategic flexibility and operational focus so that we can pursue the specific market opportunities and customer needs in each of those areas. The market for our laboratory services is different than that of the clinical trials. It gives us the focused capital structures and capital allocation strategies to drive the growth that we're looking for. And I think it also provides shareholders with more target investment opportunities. We are going to have arrangements between the companies that will enable us to make sure that the new business will have access to some of the data and the insights that we get from the diagnostics, which is a big part of the advantage that I think the Drug Development business has. In terms of looking at the central laboratory business, what's interesting is our central laboratory business, the vast, vast majority of our business comes from companies outside of ours. In fact, it's only about 15% to 20% of the central laboratory business that comes from the clinical trials that we're running. So I think we actually will have expanded opportunities to do even more central laboratory work as we open it up and we're no longer only related to one Phase I through IV organization.

Big announcement this morning. So I had two questions for you. First is on the timing, why announce it today versus back in December? What's changed over the last seven months? And then second, how did you decide where you wanted to draw the line? I see the rationale to hold on to the clinical testing piece. But specifically, I wanted to hear your thoughts on why it makes sense to hold on to safety assessment.

Yes, thank you for the question, Jack. I appreciate it. We conducted a strategic review for most of last year and at the end of December, we announced five key initiatives. These included implementing a dividend, launching a significant share buyback program, initiating the LaunchPad initiative, providing long-term guidance, and committing to increased disclosures, all supported by timelines. I believe we have successfully met every commitment on schedule. Importantly, we determined that our current structure was in the best interest of our stakeholders at that time, while also acknowledging that post-review, the Board would continue to explore ways to enhance value, including potential transactions, and engage with external parties. Currently, we are experiencing strong growth across all our business units, which gives us confidence in their profiles. We believe that spinning off our units will enhance value and provide both companies the opportunity for sustainable growth. Having focused capital structures is crucial as there are numerous business development opportunities available, and our approach to these may differ between the two businesses. Regarding the COVID environment, the situation at the end of last year and the start of this year was quite challenging with Omicron, and we concentrated on ensuring we could conduct as many tests and drug development studies as possible, making it an inappropriate time for any distractions or disruptions. Overall, we feel that now is the right time to take action. In response to your second question about drawing the line, it’s evident that the laboratory business has very different capital structure and equipment requirements compared to the clinical development business, which primarily relies on personnel outside. Having a global footprint for diagnostics will allow us to expand diagnostic testing worldwide. Additionally, in the realm of companion diagnostics and personalized medicine, much initial development occurs early on, and establishing laboratory services will support our global reach in personalized companion diagnostics, which is increasingly important and has distinct growth profiles and capital requirements. We have been very deliberate in deciding what to retain in the laboratory versus what to separate for clinical development.

Maybe just quick ones on the Covance business. Can you just talk generally about kind of the cancellation environment? It seems like it's been a little mixed this quarter across CROs. Are you seeing any uptick there? And then secondarily, in terms of the spin, will you guys consider kind of strategic options over the next year in terms of kind of selling it to a larger player? Or is it kind of set on kind of the tax-free spin?

Yes. Thank you for the question, Patrick. And when you look at the RFP environment in drug development, it remains very healthy. In fact, if you look even our central laboratory, we had a decline this quarter because of the COVID-related work. But we're confident in the growth in that business for the Base Business going forward because of the orders that we see and the book-to-bill that we have. So we have not seen an increased cancellation environment. We continue to see a very strong environment for all aspects of the Drug Development business as we move forward. With regard to the spin, we've looked at all the different options. And based on all those options, we believe a spin is the right thing to do. Of course, there may be other things that people come to us. But I think we've shown as a management team, we're open. We listen. We really analyze whatever comes our way. But based on everything we know as we sit here today, we think the spin is the best path forward for really capturing both customer and shareholder value.

This is Kieran Ryan on for Pito. Starting with the Diagnostics business. It looks like base margins came down again depending on what assumption you want to use around COVID margins, but your key competitor was talking about some margin contraction on COVID revenues due to a higher mix of retail tests as well as some reimbursement pressure. So I was just wondering if that's something you're seeing as well and then also just how you think about that retail channel opportunity and balancing those extra volumes with the margin side.

Yes. No, thank you for the question, Kieran. The first thing I'd say is we think the Diagnostic business is performing very well. The Base Business revenue grew 3.9% versus the prior year, and the Base Business volume was up 3.4% compared to last year. The growth was coming from both routine and esoteric testing. In fact, if you look at the Base Business CAGR, it was 4.3% versus 2019. So you see good, strong underlying performance. When you look at the PCR testing, you'd see the decline. You saw a decline from first quarter to now. In fact, we did about 31,000 tests per day on average. When you do fewer tests, it has some impact on the margin. We've also seen a payer mix switch. We used to have the uninsured firm, HRSA. We no longer have that. That was higher-margin business than the retail sector. We've seen more of our business move to the retail sector, where also it challenges our margins a bit. Margin right now for PCR testing is about 60%, but we'll continue to do everything we can to manage that. We see the retail sector as an opportunity. But frankly, we're really focused on our Base Business. We're really focused on the hospital and the local laboratory acquisitions that are before us. And to me, that's the long-term growth that we see. So we'll continue to do what we can in PCR testing, but long term, we're really focused on getting that base business to perform well, and I think you've seen that in the quarter.

Yes. The only thing I'd add to that, and Adam commented that it's still at a very attractive margin. So we've commented in the past that last year, we were kind of in the 70% margin, so obviously very attractive. But to still be at 60% speaks to the fact that, one, volume levels are down, we continue to keep the labor force to make sure that we have the capacity because we don't know if there'll be future spikes. So obviously, from a labor efficiency, we're absorbing that. And obviously, as Adam said, too, as we do more in the retail setting, it has a mix. But again, as we look to the outlook for the year, and part of the reason for the improved outlook in our earnings guidance that we have is that we're actually performing more COVID testing than what we had expected, and that's why we continue to keep the excess capacity available for the unknown.

I apologize for joining late, but could you discuss the expectations related to the recent acquisitions and their contributions to M&A? Specifically, I would like to know if the performance of these acquisitions has had a larger impact on margins than anticipated, particularly regarding the ramp-up of the Personal Genome Diagnostics business. Any additional insights on M&A contributions and their effects on margins would be appreciated.

Yes. In response to your question, when we announced the acquisition of PGDx and also the impending acquisition of Ascension, we mentioned that both deals were very strategic and we believe will yield a strong return on our investments. However, both acquisitions, particularly in the beginning, will negatively impact our margins. The closure of PGDx, which is mainly affecting our drug development segment, is putting some pressure on our margins. Therefore, when we discuss our margins year-on-year, we expect them to be similar to last year, despite the pressure from the PGDx acquisition. In Diagnostics, the margins from our acquisitions are generally mixed. Large hospital systems, especially with in-hospital lab work, tend to exert some pressure on margins. Overall, we anticipate that Diagnostics margins will remain relatively flat compared to our base. Once Ascension is finalized and included in Drug Development results, we expect some margin pressure. Overall, our outlook for company margins this year, compared to our Base Business margins, is flat. Margins will slightly decline due to the dilutive effects of PGDx and Ascension. Other acquisitions in the pipeline are more traditional tuck-ins, though they include hospital systems as well. However, we believe that the outreach component will not significantly impact our revenue returns. It's important to note that regarding EPS, only the PGDx acquisition is expected to be dilutive this year, while Ascension and the other acquisitions will help offset that. Therefore, from an EPS perspective, we see a relatively neutral impact, while from a margin perspective, there will be slight dilution.

So digging deeper into that earlier margin question, when Covance was last public and would split margins out, it looks like clinical and central lab combined for roughly 23% EBIT margins. So should we assume that central lab is materially higher and that clinical will also be around there given the expansion since then and the Envigo acquisition? And then also on the same side of that, should we also think about how early stage margin has expanded from that 12.5% EBIT margin level in 2014?

The acquisition of Covance occurred some time ago, and since that time, there have been many changes due to acquisitions and business growth. We have not specified the individual components because of how we operate the business; it is integrated with shared resources and cost allocations. Therefore, when we separate the clinical development part of the business and establish it as a stand-alone entity, we will provide detailed information about its profitability and margins, including a retrospective analysis for the past three years with audited financials. Directionally, we've indicated that while the clinical side is quite profitable, it is influenced by pass-through revenues. When we acquired Covance, we were under 605 accounting regulations, which resulted in over 20% of today’s revenues not being included in their margins, thus constraining the overall margin. Nevertheless, it remains profitable, and margins continue to grow. We will be in a much better position after the financial separation, where we can identify specific costs related to that business. Overall, it maintains an attractive level.

Just a quick two-parter on the spin. Maybe first, just following up to Rachel's question, given the close is targeted for second half '23, when do you think you might start to be able to untangle the web and disclose more in terms of the margin profile in that business? That's part one. The second part is, given market conditions and your strong balance sheet, the next year seems it might be an active M&A environment. Obviously, you've been active in the past year as well. Anything about your process to prepare for and spin the asset that would constrain capital deployment activity on either side of the business?

I will go ahead and start, Matt. We're looking to initiate the spin in the second half of next year. There are many processes involved in spinning off a company, including ensuring that the exchange is tax-free, working with the IRS, and preparing audited financials. We are effectively creating a standalone company that was previously integrated into a larger organization. We've announced our intent to strategically spin off the business and will continue to provide additional relevant information as it becomes available. Once decisions are finalized and accounting is established, we've given a good sense of our direction. On a positive note, our balance sheet is very strong, and we are committed to maintaining Labcorp's investment-grade status with the same targeted leverage ratios we've had in the past. We are currently below those targeted ranges. We've been increasing our share repurchase program and the amount of mergers and acquisitions, while maintaining a strong balance sheet to support our capital allocation initiatives, including starting a dividend. If we were to model the company without the clinical business, we would still meet our targeted leverage range. This indicates that we won’t be limited in pursuing acquisitions for both companies as they are part of Labcorp today. Regarding the spun-off company, while we haven't detailed its capital structure, we can assure you that both businesses will be well-capitalized, enabling them to pursue growth strategies through internal investments as well as acquisition opportunities.

I apologize for earlier. First question, I noticed a couple of things were larger this quarter. The unallocated cost or the corporate cost line was much higher than normal. Can you talk through that? Also, the CapEx number grew quite substantially this quarter. Can you discuss what drove both of those?

Sure, Kevin. First, regarding the unallocated corporate costs, which increased by $29 million year-over-year, we previously mentioned two changes in how we treat corporate unallocated. The first change pertains to Drug Development, where part of its bonus tied to enterprise results is now reflected in corporate unallocated. In other words, all incentive compensation for Drug Development that's connected to its business is recorded within that segment, ensuring that when we compare our Drug Development performance to peers, it's all related to that business. This contributes to the overall increase, and until the effect annualizes, you can expect to see a year-over-year increase. The significant figure is largely due to the strong enterprise performance, partly driven by higher-than-anticipated COVID testing. The second change in methodology involves including our investments in oncology and R&D within corporate unallocated, specifically those that are not linked to current revenue streams. This centralization allows us to manage R&D holistically as an enterprise. Additionally, with the acquisition of PGDx, which has a substantial R&D cost component compared to our historical data, there’s also a year-over-year impact since this expense didn't exist before the acquisition. If we exclude these factors, we've accounted for almost all of the year-over-year increase. For modeling purposes moving forward, you can expect our unallocated corporate expense to be around 1.5% to 2% of Base Business revenues in a typical environment. Concerning CapEx, we noted a higher level of spending this quarter compared to last year. We anticipate that for the year, our capital expenditures will align with the typical expectation of about 3.5% of our base revenues. While quarter-to-quarter figures may fluctuate due to timing, we are currently on track with our planned capital spending for the year.

I want to thank everybody who joined us today. Labcorp continues to be at the forefront of science, innovation, and technology, and we continue to deliver on our strategic priorities. As always, I also want to thank our more than 75,000 employees around the world for their tireless work carrying out our mission to improve health and improve lives. We look forward to talking with all of you soon.

This concludes today's conference call. You may now disconnect.