Earnings Call Transcript - LH Q3 2022

Operator, Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Labcorp Third Quarter 2022 Earnings Conference Call. Operator Instructions. At this time, I would like to turn the conference over to Mr. Chas Cook. Sir, please begin.

Chas Cook, COO

Thank you, operator. Good morning and welcome to Labcorp's Third 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 our press release and an Investor Relations presentation with additional information on our business and operations, which include a reconciliation of the non-GAAP financial measures to the GAAP financial measures discussed during today's call. 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, acquisitions and other transactions; 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.

Adam Schechter, CEO

Thank you, Chas. Good morning, everyone. It's a pleasure to be with you today to discuss our progress and our performance in the third quarter. I'll start with a few high-level comments about the quarter, then provide a brief update on the planned spin of our Clinical Development business before turning to our quarterly results and progress against our strategy. Diagnostics performed very well with Base Business revenue growth of 3.7% over the last year and a 4% CAGR versus 2019. With Ascension in the fourth quarter, we expect full-year revenue growth of 6% to 7%. Drug Development Base Business fundamentals remain strong, and our expected full-year CAGR of almost 8% since 2019 is consistent with how we expect the business to perform. There are what we believe to be temporary issues that impacted our Drug Development performance in the quarter, which I'll discuss in more detail when outlining our results. Turning now to the spin of our Clinical Development business. We are off to a strong start since announcing the planned spin back in July. We were quick to establish a spin management office made up of dedicated people and external advisers with significant spin transaction experience. In addition, working with advisers, we're in the process of identifying members of the executive team, the CEO and the Board of Directors of the new company. And finally, we are making good progress in finding their transition service agreements and preparing the audited financial statements. With the progress to date, we are targeting completion of the spin with an accelerated timeframe of mid-2023, subject to the satisfaction of certain customary conditions, including those related to the tax-free nature of the separation and the SEC process. Upon completion, we will create two strong independent companies through a tax-free transaction. We are excited by the opportunities this spin represents for the Clinical Development business. The new company will have the enhanced strategic flexibility and operational focus to grow, invest, pursue its priorities, and address market opportunities. Further, we believe both Labcorp and the new Clinical Development business will emerge from this transaction with the ability to better meet customer needs, drive sustainable and profitable growth, and deliver attractive shareholder returns. We plan to provide more information on our progress, including key leadership appointments, in the coming months. I'll now turn to third-quarter performance. In the quarter, revenue totaled $3.6 billion; adjusted earnings per share was $4.68; and free cash flow was $270 million. Base Business organic revenue for the enterprise, excluding COVID testing revenue, is up 1.4% year-over-year on a constant currency basis. This demonstrates the strength of our underlying business, particularly in Diagnostics, in a very challenging operating environment marked by rising labor costs, labor shortages, and other inflationary pressures. In Diagnostics, Base Business revenue increased about 4% year-over-year due to an uptick in demand in both routine and esoteric testing. We continue to see momentum in our hospital system business, and later, I'll give an update on the Ascension integration, which is off to a very good start. In Drug Development, quarterly Base Business revenue in constant currency is flat versus the prior year. This is driven by a tough year-over-year comparison with less COVID-related work and the impact from the conflict in Ukraine. In central laboratories, there were timing-related challenges when looking at kits out, those that we sent to investigator sites, and kits returned, those that investigators sent back to us to be analyzed. We believe investigators ordered significantly more kits than normal in the third quarter last year to overcome supply issues. This was in addition to the kits for COVID trials. The pace of investigators returning kits has not rebounded as quickly as we expected. We believe this is largely due to COVID-related impacts and the macro environment, and that will return to normal levels over time. Both demand and orders in central laboratories continue to be very strong. In early development, we have strong demand for trial work as well as adequate capacity. However, the impact from our business was due to labor constraints. We are hiring as fast as we can, but like in many parts of the economy, finding labor has been difficult. Drug Development Base Business margins for the quarter were 15%, an expansion from last quarter but lower than anticipated due to the revenue in central laboratories and labor shortages in early development. We continue to see a healthy order flow and backlog in Drug Development, and the segment ended the quarter with a 1.25 trailing 12-month book-to-bill. Across Diagnostics and Drug Development, our margins were negatively impacted by rising labor costs and other inflationary pressures. We are taking cost actions, and we're focused on improving margins. In addition, LaunchPad savings continue to help offset the impact of near and expected midterm headwinds. COVID PCR testing volumes continued to decline during the quarter, totaling 2.2 million tests performed and averaging 24,000 per day. As we enter the winter amid concerns about rising COVID, flu, and RSV cases, we're maintaining adequate supply and capacity to accommodate current and future testing needs. Also, our scientists stand ready to respond as new variants arise. I'll now move to our enterprise strategy against which we're executing well by harnessing science, innovation, and technology, and capitalizing on key opportunities to help us deliver for all stakeholders. Earlier this month, we announced the completion of transactions that established our comprehensive laboratory relationship with Ascension. Our strategic collaboration includes an agreement for Labcorp to manage hospital labs in 10 states and to acquire certain lab assets. At its core, the collaboration expands access to Labcorp's comprehensive capabilities and laboratory services for communities served by Ascension. I'm pleased to report that the transition and the integration are going well, and we are now performing thousands of tests across the health system. This was a big undertaking, and I'd like to thank employees and leadership from Ascension and Labcorp who made the changeover as seamless as possible. In addition to the Ascension agreement, we're focused on accelerating our hospital and health systems business. We completed our acquisition of the outreach lab business and related assets of New Jersey-based RWJBarnabas Health during the quarter, and that integration is also progressing well. Our hospital and local lab acquisition and investment pipeline is very robust, and we see major opportunity now through 2023. Turning to oncology, we're furthering our position as a leader in this space through the addition of new testing and screening capabilities. We continue to see benefits from the Personal Genome Diagnostics and omni portfolios, including their leading liquid biopsy, tissue-based diagnostics, and kitting solutions. We have the broadest portfolio and capabilities in oncology diagnostics today, and we are well positioned for growth. We are also pursuing relationships that accelerate our growth and enhance our portfolio. This quarter, the company formed a strategic partnership with MD Anderson Cancer Center Foundation in Spain to increase access to early-phase oncology clinical trials. We also entered a collaboration with Becton, Dickinson, and Company to help match patients with critical and potentially life-changing treatments for cancer and other diseases. In addition to our progress in oncology, Labcorp is relentlessly focused on innovating and delivering our customers valuable solutions across all areas to help them achieve their goals. We enhanced our neurology offering in the quarter through the launch of pan-neoplastic and other neuro autoimmune panels. Together with our previously announced test for brain injuries and neurodegenerative disease, these panels round out our portfolio and give us a leadership position in neuro biomarkers to support customers. The company has seen growing demand for our at-home testing and collection options through Labcorp OnDemand, and our consumer product pipeline is strong. Our FDA authorization, combination COVID, flu, RSV at-home collection test continues to be important with the rise of respiratory virus cases expected this fall and through the winter. Lastly, Labcorp's commitment to its employees continues to be recognized. We were recently named by Forbes to its list of World's Best Employers, and we also earned a top score on the 2022 Disability Equality Index. In summary, our base business fundamentals remain strong, and we are well positioned to deliver sustained long-term value and growth. With that, I'll turn the call over to Glenn.

Glenn Eisenberg, CFO

Thank you, Adam. I'm going to start my comments with a review of our third-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. Revenue for the quarter was $3.6 billion, a decrease of 11.2% compared to last year due to lower COVID testing and the negative impact from foreign currency translation. This was partially offset by organic Base Business growth and the impact from acquisitions. COVID testing revenue was down 70% compared to COVID testing last year, while the Base Business grew 0.7% compared to the Base Business last year. Organically, in constant currency, the Base Business grew 1.4%. Operating income for the quarter was $469 million or 13% of revenue. During the quarter, we had $65 million of amortization and $54 million of restructuring charges and special items, primarily related to acquisitions, the proposed spin of the Clinical Development business, facility rationalization, and other LaunchPad initiatives. Excluding these items, the adjusted operating income in the quarter was $589 million, or 16.3% of revenue compared to $907 million or 22.3% last year. The decrease in adjusted operating income and margin was primarily due to a reduction in COVID testing and the impact from acquisitions. The benefit from organic Base Business growth and LaunchPad savings was essentially offset by higher personnel expense and other inflationary costs. The tax rate for the quarter was 16.2%. The adjusted tax rate was 22.8% compared to 24.4% last year. The lower adjusted tax rate was primarily due to benefits from increased R&D tax credits. We now expect our annual adjusted tax rate going forward to be approximately 24%. Net earnings for the quarter were $353 million or $3.90 per diluted share. Adjusted EPS were $4.68 in the quarter compared to $6.82 last year. Operating cash flow was $374 million in the quarter compared to $767 million a year ago. The decrease in operating cash flow was primarily due to lower cash earnings. Capital expenditures totaled $104 million, down from $118 million last year. We continue to expect full-year capital expenditures to be approximately 3.5% of Base Business revenue. Free cash flow was $270 million in the quarter. During the quarter, we invested $459 million on acquisitions, paid out $65 million in dividends, and repurchased $400 million of stock, representing 1.5 million shares. At the end of the quarter, we had over $800 million of share repurchase authorization remaining. We continue to believe that our shares are undervalued, and our share repurchase program is an important part of our capital allocation strategy. At quarter-end, we had $400 million in cash, while debt was $5.3 billion. Our leverage was 1.7x gross debt to trailing 12 months EBITDA. Excluding COVID testing earnings, our leverage was 2.5x, in line with our targeted range of 2.5 to 3x. Now I'll review our segment performance, beginning with Diagnostics. Revenue for the quarter was $2.2 billion, a decrease of 15.7% compared to last year due to organic revenue being down 16.4%, partially offset by acquisitions of 0.9%. COVID testing revenue was down 70% compared to COVID testing last year, while the Base Business grew 3.7% compared to the Base Business last year. Relative to the third quarter of 2019, the compound annual growth rate for Base Business revenue was 4.3%, primarily due to organic growth. Total volume decreased 10.3% compared to last year as organic volume decreased by 10.9%, partially offset by acquisition of 0.6%. The decline in volume was due to COVID testing as Base Business volume grew 3.1% compared to the Base Business last year. Price/mix decreased 5.4% versus last year, primarily due to an organic decline of 5.5%, partially offset by acquisitions of 0.3%. The lower organic price/mix was due to COVID testing. Base Business price/mix was up 0.6% compared to Base Business last year, benefiting from a higher esoteric test mix. Diagnostics adjusted operating income for the quarter was $440 million or 19.9% of revenue compared to $775 million or 29.6% last year. The decrease in adjusted operating income and margin was due to a reduction in COVID testing as lower COVID volumes caused margins to decline to approximately 50% for the quarter. We expect this margin level to continue through the rest of the year, which would put the full-year margin at approximately 60%. Base Business margins were flat versus last year as organic growth and LaunchPad savings were offset by higher personnel expenses and other inflationary costs. Now I'll review the performance of Drug Development. Revenue for the quarter was $1.4 billion, a decrease of 3.7% compared to last year, primarily due to foreign exchange translation of minus 3.4%. While acquisitions contributed 0.5% of growth, organic Base Business revenues declined 0.7% compared to last year due to the negative impact from lower COVID-related work and the Ukraine-Russia crisis. Excluding these impacts, organic Base Business revenue grew 3.8%. The central lab business continues to be the most impacted by lower COVID-related revenues and the impact from Ukraine-Russia crisis. Central lab Base Business revenues were down 9.8%. However, excluding these items, organic constant currency revenue was up 4.1%. While on a comparable basis, early development was up 8.6% and Clinical Development was up 2.3%. In addition, Clinical Development was impacted by the loss of an FSP contract outside the U.S. earlier this year, affecting third and fourth-quarter revenue growth. However, recent wins, including a large Phase IV market access program, will support a return to higher growth in 2023. Reported Drug Development revenues grew at 6.1% on a compounded annual basis compared to 2019. Adjusted operating income for the segment was $211 million or 15% of revenue compared to $226 million or 15.5% last year. The decrease in adjusted operating income and margin was due to the reduction of COVID-related work in the Ukraine-Russia crisis. Excluding these issues, margins would have been up approximately 100 basis points compared to last year as the benefit from organic growth and LaunchPad savings were partially offset by inflationary costs and the negative mix impact from acquisitions. We ended the quarter with a backlog of $15.2 billion, and we expect approximately $4.7 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 year-to-date performance and fourth-quarter outlook and assumes foreign exchange rates effective as of September 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 6% to 7.5% compared to 2021. This is a decrease at the midpoint from our prior guidance of 275 basis points, primarily due to the slower pace of central lab kits shipped and kits received, early development labor constraints, lower COVID testing, the delay in the Ascension transaction, and currency. This guidance now includes the expectation that the Base Business will grow 3% to 4%, while COVID testing is expected to decline 57% to 59%. We expect Diagnostics revenue to decline 10% to 11.5% compared to 2021. This guidance reflects a 25-basis-point increase at the midpoint as the benefit from Ascension will be mostly offset by lower COVID testing demand. Diagnostics Base Business revenue is expected to grow 6% to 7%, an increase of 150 basis points at our midpoint due to Ascension now being reflected in the segment outlook, while it was in our enterprise guidance prior to closing the transaction. At the midpoint of our Base Business guidance, the compound annual growth rate compared to 2019 is 5%. Note that Ascension will be dilutive to Diagnostics AOI margin of approximately 100 basis points in the fourth quarter, but we expect margins to improve going forward as they are fully integrated. COVID testing is now expected to decline 57% to 59%. We expect PCR volume to be between 15,000 to 20,000 tests per day in the fourth quarter. We are currently tracking at approximately 15,000 PCR tests per day. We expect Drug Development revenue to decline 1.5% to 2.5% compared to 2021. This is a decrease at the midpoint from our prior guidance of 450 basis points, primarily due to the slower pace of kits shipped and kits received in central labs, labor constraints in early development, and further currency translation headwinds. We expect the Base Business to decline 1% to 2% compared to 2021. Foreign currency translation negatively impacts our growth rate by 280 basis points. In addition, the growth rate is constrained by lower COVID-related work in the Ukraine-Russia crisis. At the midpoint of our Base Business guidance, the compound annual growth rate compared to 2019 is 7.7%. Our guidance range for adjusted EPS is $19.25 to $20.25, a narrowing of our prior guidance range of $19 to $21.25. At the midpoint, our guidance is lower by $0.38 due to lower COVID testing. In the Base Business, the decreased revenue outlook for Drug Development is being offset by additional cost control measures and a low effective tax rate. Free cash flow guidance is now $1.25 billion to $1.4 billion, down from our prior guidance of $1.7 billion to $1.9 billion. The decline in the cash outlook is due to lower projected cash earnings and higher working capital requirements. The lower cash earnings include the expected decrease in adjusted net earnings, the proposed spin and acquisition-related costs, as well as the timing of cash tax payments. The higher working capital requirements, which are timing-related, primarily relate to Drug Development receivable collections as the company continues to work to improve days sales outstanding. Said differently, DSOs remained flat over the past quarter, but our guidance had assumed improvement in the second half of the year. In summary, our Diagnostics business continued to perform well, while our Drug Development business fundamentals remain strong in a challenging environment. We expect to drive continued profitable growth in our Base Business for the fourth quarter, while COVID testing volumes are expected to decline from the third quarter. 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.

Operator, Operator

We will now take questions.

Jack Meehan, Analyst

Adam, I wanted to discuss the Drug Development business. Could you share what's changed regarding the business trends since the second quarter? Labor shortages have been a significant topic. Can you quantify or provide a metric regarding the level of pressure you're experiencing now compared to July? Glenn, you mentioned an FSP cancellation. When did that happen, and can you provide any details about its scale?

Adam Schechter, CEO

Jack, I’ll start. If you examine Drug Development as a whole and consider our updated guidance, the midpoint indicates full-year growth of approximately 7.7%, nearly 8% compounded annually since 2019, which aligns with expectations for the business. However, the significant change is the unexpectedly large impact from kits in central laboratories. Last year, investigators ordered more kits than usual due to supply shortages, including butterfly needles and test tubes. Typically, we deliver kits within 2 to 3 days, but these issues led to delays, resulting in investigators hoarding kits and ordering more than they needed. This hoarding complicates tracking usage versus inventory. Meanwhile, we were distributing many kits for COVID trials, which were rapidly returned, masking the return rates of kits for non-COVID studies. Currently, in the third quarter, the number of kits dispatched is about 30% lower than in the same quarter last year, which is significant. We earn revenue for each kit sent out, but more importantly, the return rate has not yet reached 2019 levels, and most of our earnings come from the tests performed on the samples returned to us. We anticipate this is a temporary issue, possibly linked to ongoing COVID challenges in regions like Europe and labor constraints at sites. We believe the kits will eventually return, and trials will continue to enroll. The delay in flagging this issue stems from observations made earlier this summer when returns were beginning to pick up, but they leveled off quickly and have not increased since. Additionally, we are facing challenges in recruitment, especially for frontline and specialized lab personnel, and training them takes longer than for many other roles, delaying productivity. In our early development segment, orders and capacity look promising, but we struggle to initiate all necessary studies swiftly because of the labor shortage. We are actively hiring, including efforts in Madison, Wisconsin, where we have a large lab and have deployed buses promoting career opportunities to expedite our recruitment process. Now, I’ll hand it over to Glenn for the next question.

Glenn Eisenberg, CFO

Jack, we noted that the FSP's loss of the contract affected our quarterly results. While the contract was lost earlier this year, its winding down did not significantly impact our first half results. The real effect was felt more in the third and fourth quarters. For this quarter, we estimate that we would have accounted for about $22 million from this contract last year. This represented roughly a 3% headwind for the Clinical Development business, with approximately half of that being a headwind for the Drug Development segment. However, as we mentioned, we are quite pleased with the recent awards we received. Looking ahead to 2023, we believe that the lost contract will be compensated by other orders we are acquiring.

Adam Schechter, CEO

Exactly. The thing I'd add to is, overall, we feel good about the business fundamentals in both Diagnostics and Drug Development. The RFP inflow is strong. Our wins are strong. Even our ability to offset, as Glenn just said, the loss of that FSP with new wins and a large market access win that we have. So the fundamentals are strong. We believe these are temporary issues.

Jack Meehan, Analyst

Great. And then as a follow-up, it's that time of year, everyone is focused on 2023. So I was wondering if you could just talk about puts and takes on EPS for next year. I think the COVID math, that 60% margin, suggests that could be a $5 headwind. I'm not sure if you agree with that. I think there's also probably some good guys with growth in Ascension; I look at The Street forecasting $18. Just any color on forecasting would be helpful.

Adam Schechter, CEO

Yes. I'll give you some color; I'll ask Glenn to jump in. And we'll provide more complete guidance, obviously, in February. But first of all, what we're focused on: we want to execute the spin as fast and as effectively as we possibly can. So we are focused on that. We've accelerated to the middle of next year, and we're doing everything we can to move quickly there. Second, when you think about Ascension and not just Ascension, some of the other hospital deals are really big and important to us. We're focused on integrating them, and they're going to represent strong growth opportunities, and they're going to represent significant revenue growth opportunities. What we're focused on in Diagnostics is the inflationary pressures that will remain, and we've got to find ways to reduce costs and to improve our margins. These hospital deals are going to impact our margins negatively in the beginning. And over time, we'll be able to take costs out. When you do these hospital deals, the most important thing is business continuity for the hospitals at that time. In addition to that, we have PAMA headwind, obviously. We're working to see if there's a new way to think about PAMA, which is SALSA. We're not putting on our base case at the moment. But by February, we should have a very good idea of where we are there. And then we have other things that Glenn can talk about.

Glenn Eisenberg, CFO

Yes, at a high level, when considering the challenges as we head into 2023, we anticipate a significant decline in COVID testing, which we will clarify when we provide our guidance in February. This year, we achieved approximately 60% margin on COVID testing, but with a projected 24% tax rate going forward. A major factor to consider is the impact of PAMA, which we estimate could range between $80 million to $100 million. By the time we offer our guidance, we should have clarity on whether PAMA will affect next year's numbers. Additionally, we face headwinds from current inflation and labor constraints. However, we see more positives than negatives. The demand in our Diagnostics business has shown steady growth in volume each quarter and throughout the months. We expect this trend to continue into the fourth quarter and 2023. Although we anticipate a decrease in high-margin COVID testing, this shift may benefit our Base Business in Diagnostics. As for Drug Development, demand remains strong, but the issue lies with kits, which have not yet returned to pre-2019 levels. The expectation is that demand is solid, the backlog is substantial, and the return of kits should normalize. Additionally, we expect labor capacity issues to improve. With a continued focus on cost management, LaunchPad initiatives, and strong free cash flow generation, we are optimistic about our acquisition pipeline and capital return strategies. Overall, we feel positive about our position as we enter 2023, balancing top-line growth and margin improvement, while acknowledging potential headwinds from PAMA and the annualization of Ascension. Nonetheless, we remain hopeful about our capital allocation efforts as we move forward.

Operator, Operator

Our next question or comment comes from the line of Erin Wright from Morgan Stanley.

Erin Wright, Analyst

So where are we now in terms of business utilization across the Diagnostics segment compared to the pre-COVID baseline? And what are you seeing right now in terms of mix? Are there any sort of structural changes that we should be thinking about longer-term? And just a follow-up on 2023 and how you're thinking about base organic diagnostic volume heading into that time period. Do you anticipate that we see a complete normalization in utilization trends? Or is it a build to that? And why or why not would that happen?

Glenn Eisenberg, CFO

Erin, this is Glenn. I'll start on that one. So again, one of the really positive things that we have seen is that the volume levels have recovered within Diagnostics that we continue to see good growth this year, obviously, over last but also compared to 2019. And we're tracking from a volume standpoint, call it, a little bit over 1% kind of CAGR compared to where we were. So clearly, more room for growth, which is why as we enter into 2023, we feel that volumes will continue to pick up as we go through more of the recovery. When you look on the price/mix side, which again has also been positive, tracking to kind of more historical levels, plus or minus kind of 1% growth. We talk about there's always kind of the pricing pressures that we see, but we get positive on price/mix because of mix. We continue to see our esoteric and routine businesses growing, but esoteric, growing at a faster pace, which helps our mix acquisitions that tended to help our mix as well. And actually, when we think about now the large lab hospital management agreement we have with Ascension, as you know, we treat that as price as opposed to volume. So you'll see a pickup from that aspect as well as that becomes in the numbers and annualized. But acquisitions overall, we continue to see a slight improvement in our tests per session. So a lot of positive momentum on the price/mix side as well as the volume side.

Adam Schechter, CEO

And Erin, this is Adam. So I feel very good about the Diagnostics volume, and we're heading into next year with real strength. Our focus next year is going to be a lot of how can we improve margins and reduce costs. So that will be a big focus for us because we realize that the volume is going to grow extraordinarily well with these hospital deals. And we just have to make sure we get the margins to improve as fast as we can there.

Kevin Caliendo, Analyst

Can we discuss the impact Ascension is having and how we should understand it? You provided some figures for the fourth quarter regarding volumes and margin pressure. Are the costs associated with the startup one-time, or is this a lower-margin business that will negatively affect margins in the future? I know the deal closed in October, so should we consider this a full quarter, or will the effects be more pronounced going forward? How should we assess the impact?

Adam Schechter, CEO

I'll give you some context, Kevin, and I'll ask Glenn to jump in. First of all, we just closed the deal on September 30. Typically, that business is lower-margin business to start with. When we take over these laboratories, the most important thing that we do is ensure that the physicians can order and we can perform the test seamlessly if not better than what they had before. So we don't take out costs, we don't change systems, we don't change supply chain in the beginning. We just transition over the work with minimal disruption. And then over time, we use our scale and our capabilities to reduce their cost and improve the margins. So this is more about making sure that we do this the right way. This is a massive undertaking, and we want to make sure that there's no disruption to the patients and the physicians first and foremost. So the margins are very low in the beginning. And then over time, they get better. They never reach our historical margins in Diagnostics because it's always going to be to some degree lower, but it will certainly get better over time. And then I'll ask if Glenn has any additional context.

Glenn Eisenberg, CFO

Yes. The only thing I'd like to add is that when we consider the hospital system deals, which Adam mentioned, they are financially attractive. The return on invested capital has a different profile. The in-hospital lab management agreements we have are mainly fee-based, which serves as a headwind to our overall revenues. The outreach labs we acquire have margin profiles that are similar to or enhance the overall margin for the Diagnostics group. However, due to the size of Ascension and the scale of the in-hospital lab management agreement, this represents a higher percentage of in-hospital than a typical hospital system deal we would undertake. We noted that this could result in around a 100-basis-point negative impact in the fourth quarter. As Adam mentioned, we expect margins to improve as we integrate this into our operations in 2023 and beyond, reducing the headwind in 2023 as margins increase beyond what we experienced in the first quarter.

Kevin Caliendo, Analyst

So the net effect, you didn't really call it out as a headwind or a tailwind for '23. Should we assume that from an EBIT perspective, net-net, it's neutral then?

Glenn Eisenberg, CFO

So from an EBIT perspective, call it, the first quarter. So the fourth quarter, first time we have it is kind of neutral. It will be positive from a profitability standpoint next year. So again, as you look at our financial criteria for acquisitions and these partnerships, we look for them to be accretive to earnings year 1, earn the cost of capital by year 3, and have a very attractive IRR. And Ascension is no different. The first full year of ownership, positive to earnings and cash flow accretion. We'll earn our cost of capital at least by year 3 as an overall transaction. So we're excited about it, but with acknowledgment that from a return on revenues, it will be dilutive to diagnostics markets.

Rachel Vatnsdal, Analyst

So just following up on the Drug Development side. So you talked a bit about the kit stocking dynamic. Last quarter, you said that that was a $30 million revenue headwind. So can you just quantify how much of a headwind it was this quarter? And then what's assumed within guidance for kit stocking heading into 4Q and early next year as well?

Adam Schechter, CEO

Yes. So I'll take the second part first, Rachel. So we're assuming that the kits coming back to us do not improve for the rest of this year. We've not seen improvement, therefore, for the rest of this year; we're assuming no additional improvement from where we are, which is slightly lower than the 2019 levels. In terms of kits out the door, they're actually at 2019 rate as we sit here today. And when I say 2019, I think 2019 and I put projected 4% or 5% growth on that each year. And when you get to this year, where you would expect us to be if we grew 4% or 5% CAGR since 2019. So kits out the doors look good, and they're back to where they need to be. We want to get some more time under our belts to see as the kits start to come back to us faster, and we'll provide more information for 2023 where we give 2023 guidance. But for the rest of the year, we've taken out significant growth and kits back to us.

Glenn Eisenberg, CFO

Yes. So Rachel, to your comment, clearly, it continues to be at roughly that level on what we would call COVID-related. So roughly half of the cost impacting us from a revenue standpoint would be the kits. So call it, around $25 million impact during the quarter year-on-year. And similarly, the lower vaccine and therapeutics related to COVID would have the same amount of impact on the revenues for the quarter.

Operator, Operator

Our next question or comment comes from Mr. Derik De Bruin from Bank of America.

John Kim, Analyst

This is John speaking for Derik. You executed a significant number of share buybacks in the quarter and are maintaining your focus on hospital and local lab agreements. Are there any other areas you are considering before the Covance spin? Additionally, I would like to know if you are observing any trends in bad debts and your expectations in that regard.

Adam Schechter, CEO

I'll answer the first part. So if you look at our capital allocation, we continue to be committed to our dividend. We continue to look at these hospital and local laboratory deals. They help us with our growth in our core. They're accretive first year to return the cost of capital quickly. And then we continue to believe we are undervalued. So share buybacks will continue to be a big part of our capital allocation, and we still have over $800 million that are available to us.

Glenn Eisenberg, CFO

And John, on the bad debt, again, not seeing really any change. Again, Drug Development, we normally don't have any bandwidth issues in the Diagnostics side. It's been at a fairly steady state. I would say, probably see a little bit of an increase now that the HRSA for the COVID testing. So when you look at our 50% margin that we did in the quarter, let alone expected in the fourth, there's a little bit of that associated with it. But as a general rule, bad debt continues to be consistent with what we would have experienced in the past.

John Kim, Analyst

Got you. And just one more. Has the turnover for frontline workers stabilized? Or do you see any additional need to reinstate retention program bonuses or anything like that?

Adam Schechter, CEO

I would say it continues to be an issue with labor almost everywhere that I look in the economy, and frankly, around the world. I don't think it's getting worse. I just think it continues to be the same. So at this point in time, we're doing a lot of work on what we can do to retain people, attract people. We're facing very similar issues that other healthcare companies, but also even more broadly than that are facing.

Glenn Eisenberg, CFO

Yes. And John, when you look at our difference between our reconciliation in our financial statements that we said and we do break out retention. And you'll see, as Adam said, we continue to use that where needed. But overall, not a material issue.

Adam Schechter, CEO

Thank you all for being here today. There is much to be excited about as we look to the future in the coming year, and we are committed to making continuous progress. We understand what needs to be accomplished, and we will achieve it. I want to extend a warm welcome to our associates from Ascension, and I would like to express my gratitude to our employees worldwide who are dedicated to their vital mission of improving health for everyone.

Operator, Operator

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