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Edited Transcript of INCR earnings conference call or presentation 28-Feb-17 1:00pm GMT

Thomson Reuters StreetEvents

Q4 2016 INC Research Holdings Inc Earnings Call

Feb 28, 2017 (Thomson StreetEvents) -- Edited Transcript of INC Research Holdings Inc earnings conference call or presentation Tuesday, February 28, 2017 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Ronnie Speight

INC Research Holdings, Inc. - VP, IR

* Alistair Macdonald

INC Research Holdings, Inc. - CEO

* Greg Rush

INC Research Holdings, Inc. - EVP & CFO

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Conference Call Participants

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* Robert Jones

Goldman Sachs - Analyst

* Tim Evans

Wells Fargo Securities - Analyst

* Dave Windley

Jefferies & Co. - Analyst

* Erin Wright

Credit Suisse - Analyst

* Tycho Peterson

JPMorgan Chase - Analyst

* Courtney Owens

William Blair - Analyst

* Greg Bolan

Avondale Partners - Analyst

* Michael Polark

Robert W. Baird - Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen and welcome to the INC Research fourth-quarter 2016 earnings conference call. (Operator Instructions). I would like to hand the conference over to Ronnie Speight, Vice President of Investor Relations. Please go ahead, sir.

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Ronnie Speight, INC Research Holdings, Inc. - VP, IR [2]

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Good morning, everyone. The purpose of this call is to review the financial results for INC Research's fourth-quarter and full-year 2016. With me on the call today are Alistair Macdonald, our Chief Executive Officer and Greg Rush, our Chief Financial Officer.

In addition to the press release, a slide presentation corresponding to our prepared remarks is available on our website at investor.incresearch.com within the Events & Presentations section. An archived version of this webcast will be available for replay on our website after 1 PM today and there will also be a telephone replay available for the next seven days.

Remarks that we make about future expectations, plans and prospects for the Company, including those implied by our backlog and pipeline, constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors. These factors are discussed in the Risk Factors section of our Form 10-K for the year ended December 31, 2016 and our other SEC filings.

In addition, any forward-looking statements represent our views as of today and should not be relied upon as representing our views as of any subsequent date. While we might update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so.

During this call, we will discuss certain non-GAAP financial measures, which exclude the effect of events we consider to be outside of our core operations. These measures should be considered a supplement to and not a replacement for measures prepared in accordance with GAAP. We believe that providing investors these measures helps them gain a more complete understanding of our financial results and is consistent with how management views our financial results. For a reconciliation of the non-GAAP financial measures with the most directly comparable GAAP measures, please refer to slides 18 through 22 in our presentation.

As we will be limiting today's call to one hour, we request that participants limit questions to one each with an opportunity to ask one follow-up question.

I would now like to turn the call over to Alistair Macdonald. Alastair.

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [3]

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Thank you, Ronnie. Good morning and thank you for joining our fourth-quarter 2016 earnings call. After completing my first full quarter as CEO of INC, I wanted to provide a progress report on our financial performance and progress against our strategic initiatives.

First, we had a strong performance in many key financial metrics. We grew our net service revenue by 9% during the current quarter and by approximately 13% on a full-year basis compared to 2015. We grew our adjusted EPS by approximately 24% for the quarter and 30% for the full year. We also achieved two key milestones during the year, crossing $1 billion in net service revenue for the first time and ending the year with approximately $2 billion in backlog.

While we are certainly proud of these accomplishments, net awards for the quarter and related backlog build for 2017 were weaker than we expected. Specifically, our net awards for the quarter were down 3% to $289.6 million compared to $297.4 million during the fourth quarter of 2015 primarily due to a slight decline in new business awards resulting in a book-to-bill ratio of 1.1.

For the full year, growth in net awards was 4% resulting in a book-to-bill ratio of slightly less than 1.2 for the year. Our gross new business awards for the quarter did not achieve our expectations, particularly given the pipeline we had entering the quarter. The weakness in net awards for the quarter and the year were primarily due to lower awards within the top 50 biopharma companies, particularly those in the top 20, as gross awards from small biopharma continue to grow year-over-year by over 20%.

While we experienced a weaker sales quarter, we believe many of the opportunities are still in play for us as the decisions were delayed by our customers. While we were disappointed with our new business awards and our expected 2017 revenue growth rate, which Greg will discuss in more details, we continue to be optimistic about our long-term growth prospects given a robust pipeline for the next 90 days and for the year, a strong win rate during 2016 fiscal and the continued investments we are making to help further penetrate the top 20 biopharma and strengthen our offerings to the entire top 50.

With regard to the investments we are making, I'd like to provide a progress update relative to our strategic growth initiatives. During 2016, we expanded our FSP offerings to and within several key top 50 biopharma companies resulting in revenue from this offering now at a run rate of over 7% of our revenue. We believe broader scale in these services should support the continued expansion of our marketshare with large pharma customers in the future given their propensity to utilize more diverse outsourcing models.

In addition, we are adding depth in the areas of real-world evidence and (inaudible), one of the fastest growing subsegments of our market.

Lastly, we are further investing in other operational, therapeutic and business development resources that supports our customer proposal process and expect these investments will better position us to achieve our long-term growth targets.

From a therapeutic perspective, our presence remains strong in areas where clinical trials are particularly complex, which represented 74% of our backlog as of December 31, 2016. In demonstration of our therapeutic focus and expertise in oncology, we are proud to have been selected by the Leukemia and Lymphoma Society to manage the Beat AML master trial. We believe this novel umbrella trial marks the first time a nonprofit organization is working with multiple biotech and pharma sponsors to conduct a study. The trial protocol consists of up to 10 different treatment types seeking to create targeted therapies for acute myeloid leukemia.

Wrapping up, I wanted to take a moment to thank all of our employees, which now total approximately 6800, for their hard work and dedication during 2016.

Let me now turn it over to Greg Rush for more comments on our financials. Greg.

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [4]

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Thank you, Alastair and good morning, everyone. As a reminder, we are presenting our results on an adjusted or non-GAAP basis and have further normalized certain metrics to improve comparability. The normalized amounts are presented on slides 3 and 4 and the adjusted amounts, along with the detail of the normalizing adjustments, are presented on slide 17.

We grew our net service revenue by 9% to $263 million during the fourth quarter, up from $241.4 million for the fourth quarter of 2015. This was net of a foreign exchange headwind of $3.1 million resulting in a constant currency revenue growth of approximately 10%.

On a full-year basis, we grew our net service revenue by 12.6% to $1,030.3 million for 2016. Excluding a foreign currency headwind of $11.7 million, our revenue grew by nearly 14% compared to 2015.

For both the quarter and the full year, net service revenue came in at the lower end of our previous guidance range primarily properly due to the following factors. Cancellations and delays had a higher-than-normal impact on revenue in the fourth quarter 2016 despite the overall dollar value of cancellations being down in 2016 compared to 2015. Secondly, the impact of FX from the significant strengthening of the US dollar post-election negatively impacted revenue by approximately $2 million compared to our previous guidance in October.

Turning to gross margin, our gross margin remained relatively flat at 40.9% during the fourth quarter of 2016 compared to 2015. The fourth quarter of 2016 included a foreign exchange benefit of 140 basis points. For the full-year 2016, our gross margin declined from 40.3% to 39.7%, including a foreign exchange benefit of 85 basis points. The decline in gross margin on the full-year 2016 was primarily due to the increased use of contract labor associated with the accelerated work we highlighted throughout 2016, partially offset by a favorable revenue mix.

SG&A expenses decreased slightly from $42.3 million in the fourth quarter of 2015 to $42.1 million in the fourth quarter of 2016, declining from 17.5% to 16% of net service revenue. SG&A expenses declined on a year-over-year basis primarily due to the benefit from lower foreign exchange rates, which accounted for a decline of $1.8 million, lower incentive compensation for business development personnel resulting from lower achievement of gross awards targets compared to 2015 and lower outside services, which can vary significantly from period to period.

On a full-year basis, SG&A expenses increased from $154.9 million to $164.9 million while declining from 16.9% to 16% of net service revenue. On a year-over-year basis, the growth in SG&A expenses in absolute terms was driven primarily by increased headcount to support the overall growth of our business. This growth was partially offset by a benefit of $4 million from lower foreign exchange rates representing an impact of 20 basis points on SG&A margin.

Compared to our expectations, SG&A for both the quarter and full year were lower levels due primarily to a slower-than-expected ramp in headcount to support new business acquisition along with the factors discussed previously.

Our adjusted income from operations for the fourth quarter increased from $52 million in 2015 to $59.3 million in 2016 with the associated margin increasing from 21.5% to 22.5%. For the full year, adjusted income from operations increased from $195.5 million in 2015 to $223.2 million in 2016 with operating margin improving from 21.4% to 21.7%.

Adjusted EBITDA for the fourth quarter grew by 15.5% from $56.6 million in 2015 to $65.4 million in 2016 with the associated margin improving from 23.4% to 24.9%. For the full-year 2016, adjusted EBITDA increased by 14.4% to $244.5 million, up from $213.7 million for 2015 with the related margin increasing from 23.4% to 23.7%.

Foreign exchange had a positive impact of $4.3 million on adjusted EBITDA for the fourth quarter of 2016 representing an impact of 190 basis points on EBITDA margin percentage. On a full-year basis, foreign currency had a positive impact of $8.1 million on adjusted EBITDA or 105 basis points on an EBITDA margin percentage.

Adjusted net income increased to $36.9 million for the fourth quarter of 2016 from $31.4 million for the fourth quarter of 2015 and increased to $139 million for the full year from the $115.2 million in 2015.

Adjusted EPS grew by 24.1% from $0.54 in the fourth quarter of 2015 to $0.67 in the fourth quarter of 2016 and by 30.2% for the full year to $2.50 from $1.92 in 2015.

Slide 7 provides key metrics related to our cash flow and leverage position. During the fourth quarter of 2016, our operations produced $14.2 million of cash as compared to $63.6 million for the fourth quarter of 2015. Cash flow from operations for the full-year 2016 was $109.3 million, a decrease of $95.4 million compared to 2015. The decrease in cash flows for both the fourth quarter and the full year were primarily driven by the increase in our DSO to 24 days as of December 31, 2016, along with other changes in working capital.

Our DSO has continued to elongate due to customers' increased focus on milestone building terms along with the timing of achievement of those milestones during the fourth quarter, which were back-end loaded.

We ended 2016 with $102.5 million in unrestricted cash and total debt outstanding of $500 million. We did not complete any repurchase of our common stock during the fourth quarter. Accordingly, we have $85.5 million in capacity remaining of the $150 million share repurchase plan that was authorized by our Board in the third quarter of 2016.

Before discussing our backlog coverage on slide 8, I wanted to first establish the appropriate context for providing our revenue guidance for 2017, which is presented on slide 9. Keep in mind that our guidance takes into account a number of factors, including our existing backlog, current sales pipeline and importantly our expectations of net awards for 2017. Please note that net awards during the first half of the year are particularly important as they typically contribute a greater amount of revenue for the year than later awards.

Further, our guidance is based on current foreign currency exchange rates, current interest rates and our expected tax rate.

We expect our net service revenue for the full-year 2017 to range from $1.030 billion to $1.100 billion with the midpoint of $1.055 billion. This range represents flat to approximately 7% growth. This takes into account a foreign currency headwind estimated at approximately $15 million, which would have a negative impact to our full-year growth rate of approximately 150 basis points. Accordingly, our constant currency growth rate is expected to be between 1.5% and 8.2%.

As we have mentioned in the past, backlog coverage is one of the most important leading indicators of future revenue grow. As the bottom of slide 8 indicates, our backlog scheduled for the next fiscal year was $844 million at December 31, 2015 compared to $872 million at December 31, 2016.

In each of the previous three years, we have added over $100 million to our backlog coverage during the fourth quarter compared to an addition of only $50 million during the fourth quarter of 2016. Therefore, despite our backlog coverage for the subsequent fiscal year being up over 12% at September 30, 2016 compared to September 2015, our backlog coverage only grew by approximately 3% from December 31, 2015 to December 31, 2016.

The lower-than-normal growth in backlog coverage during the fourth quarter is due primarily to the unusually high impact of cancellations and study delays that I mentioned earlier. This trend continued in early 2017 as we experienced additional project delays further impacting backlog coverage and thereby creating an additional headwind to 2017 revenue growth.

Also contributing to the lower backlog build was a year-over-year decline in new awards during the fourth quarter and a relatively lower contribution of 2017 backlog from new awards compared to previous years.

Finally, since September, we have lost approximately $10 million of revenue for 2017 due to changes in FX rates, an impact of approximately 100 basis points on our growth rate.

In evaluating the revenue guidance that I provided earlier, it is important to note that our current backlog coverage would favor the lower end of the range. To exceed the growth rate the backlog coverage suggests, it is critical that we deliver very strong net awards during the first and second quarters.

Turning to the rest of our guidance, we expect to earn $1.94 to $2.10 per share on a GAAP basis. Lastly, we expect our adjusted diluted earnings per share to range from $2.63 to $2.75 representing growth of 5% to 10%.

We base our adjusted earnings-per-share guidance on, among other things, an expectation that interest expense will range between $11.5 million to $12 million, an effective tax rate of approximately 32% and adjusted EBITDA margins of approximately 23% to 24%. We expect our weighted average share count for the year to be approximately 55.7 million shares outstanding. Although it will vary on a quarterly basis.

Although we typically don't provide quarterly guidance, I'd like to provide some additional color on our expectations for the first quarter. Given the recent study cancellations and project delays, we expect first-quarter revenue to range from $245 million to $255 million. Since we will need to retain staff until the delayed projects start, we expect our adjusted EBITDA margin to be between 22% and 23%. We expect to earn $0.57 to $0.63 in adjusted diluted earnings per share during the first quarter. Our guidance for 2017 excludes the potential impact of any share repurchases that we may make in the future with the remaining capacity in our existing equity repurchase plan.

This completes our prepared remarks and we'd be happy to answer any questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions). Robert Jones, Goldman Sachs.

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Robert Jones, Goldman Sachs - Analyst [2]

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Greg, you laid out several components that impact the 2017 revenue guidance, but I wanted to just go back and see if you could help us think through the major pieces to bridge what you seemed pretty comfortable with when you updated us with 3Q, the long-term 10% to 12% top line and then what you are guiding to today obviously markedly lower than that. Could you maybe just isolate the major moving pieces about what changed from when you updated us on the 3Q to the update today?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [3]

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Yes. Happy to do that, Bob. As I mentioned in the call, every component of our guidance that could go one way or the other went against us in the fourth quarter to be honest with you. The first is cancellations/delays hurt us by probably -- sorry -- cancellations hurt us by over $15 million from what we thought and that's despite cancellations being down. So as you know, cancellations have various impacts, so you have to look beyond just the absolute dollar value.

The other thing is we had some delays that are still within our backlog, but don't impact net book-to-bill, but they probably hurt us by another $20 million. And then the last couple components, FX headwind, there's $15 million of headwind compared to what we said in October, so that's 1.5 points in our growth rate, that alone. We do have a tailwind from that in EBITDA, but, from a revenue perspective, that hurt us by about $15 million.

And lastly, it's hard to break it out separately, but new awards were below our expectations for the fourth quarter for sure and then the second component is the new awards that we actually did receive, they are contributing to a lower amount of revenue in 2017 than they typically do in a fourth-quarter setting. Part of that is because several of the studies don't start until mid-year in 2017, and typically a study will start within 60 to 90 days of an award. And if your awards are front-loaded in the quarter, they could be starting right at the beginning of 2017 and if they are back-end-loaded, they should be starting by end of first quarter or early second quarter.

So a lot of our big new awards in the fourth quarter are not starting until early in the second half or even late in the third quarter. So their contribution to 2017 revenue is not as big as it normally is.

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Robert Jones, Goldman Sachs - Analyst [4]

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Great. Just a follow-up, it seems like your success in the first half of 2017 is critical to you achieving your guidance. I guess could you talk a little bit about the pipeline and as you talk about delays or awards being less than you had expected, is it people just not making decisions or are you actually losing on bids that you thought you would win to competitors?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [5]

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A little bit of both. In all honesty, it's more the delays than it is the losing to competitors, but there were two large binary decisions in the fourth quarter that went against us. We did not win it. The other, we are still in play. We expect to hear on that one in the next month or so, hopefully earlier than that. But it was a delayed decision and as I think Alistair mentioned, business is particularly strong in the top 50. Below the top 50, we actually had really strong growth. Our pipeline is up substantially in aggregate and particularly up amongst the companies below the top 50.

So we are seeing a strong demand for our services particularly against the customers that are in our heritage, the small biopharma and biotech. And we are making the investments that Alistair mentioned to try to shore up and re-energize growth in the top 50.

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [6]

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Yes. I think we've had some good success in the FSP realm. That investment that we started to make last year in that area is enabling us to give more of a hybrid approach to bigger pharmas, that top 50 who look for that hybrid rather than just full service or just FSP. So we continue to work on that and I think it is worth pointing out as well that the cancellations and delays we've had are based on either reprioritizations of spend in pharma or the actual performance of the drug.

I think we are delivering good quality work. We remain very focused on service levels to our customers, making sure we get out, provide the right quality. I think if we carry on doing that, like Greg said, the pipeline is pretty robust. I think we get back to the performance that we expected and those binary decisions that went against us in Q4 we hope to be on the right side of those.

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Robert Jones, Goldman Sachs - Analyst [7]

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Got it. Thanks so much.

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Operator [8]

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Tim Evans, Wells Fargo.

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Tim Evans, Wells Fargo Securities - Analyst [9]

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Just a follow-up on some of that. So you talked about $15 million of cancellations and $20 million in delays. Can you talk about how widespread those are? Is it two or three clients, or is it broader than that and then were those big pharma clients or were they small biotechs? Any general profile you could give us would be helpful.

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [10]

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The delays in terms of things that were in our backlog was broad-based. It wasn't just one or two large studies. We did see multiple delays. I can't say it's five or six. I don't have that data in front of me, but it was more than a few customers, so it was multiple delays that just added up.

With regard to cancellations, there is nothing really unusual in that one, Tim. We didn't see a spike in cancellation rate. Our cancellations, as I mentioned, were actually down. They weren't down substantially; they were just down slightly, I believe. But the mix -- back in 2014, we had a cancellation on June 29 that immediately took out $20 million of revenue for the rest of the year because the study was supposed to start in July. Typically, when you get a cancellation, that's an example of a large study cancellation that had an immediate impact.

Most of the time when you get a cancellation, the bulk of the impact of the cancellation is in outer years and this time many of these studies were right on the verge of starting and so they have an unusually high impact in terms of revenue being lost. And in addition, you don't have much of a wind-down on some of the studies. So it's not like you get a burn of three to six months of shutting the study down. Many of these cancellations just haven't really started yet and then the study gets canceled due to reprioritizations, as Alistair mentioned.

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Tim Evans, Wells Fargo Securities - Analyst [11]

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I guess what I am trying to get at, to that point, you've got a bunch of studies that are getting canceled for reprioritization. Is this a big client of yours that's doing this and it's disproportionately affecting your backlog, or is this a big macro trend that we need to be attuned to?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [12]

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I do not believe it is a big macro trend because we are not seeing a significant dollar value of cancellations and, no, it's not one large customer. As I said, it is broad-based. A lot of these studies are from customers in our core that are smaller studies.

So the impact -- I'm fairly confident given that the cancellations in aggregate were not up year-over-year. In fact, we have seen a declining amount of cancellations. If you think about it, our backlog is bigger, substantially bigger than it has been in historical terms and the absolute dollar value of cancellations, not the cancellation rate as a percentage of backlog, but the absolute dollar value of cancellations is actually down. So I do not believe it is a macro trend. I do think that we just got hit hard by the type of cancellations that we were receiving versus the aggregate dollar value.

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Tim Evans, Wells Fargo Securities - Analyst [13]

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Okay. Thank you.

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Operator [14]

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Dave Windley, Jefferies.

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Dave Windley, Jefferies & Co. - Analyst [15]

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I'm, Greg, trying to look through -- Greg and Alistair both probably -- trying to look through some of the trends in your pie chart and your large biopharma revenue composition in 2016 declined. Biomass I think actually even declined in absolute dollars. That was accompanied by a decline in repeat customers, which is also a decline in absolute dollars and not as much change in your top-client revenue composition, but I guess I'm trying to read tea leaves here and I am wondering if the primary issue is that, in one or two of your top clients, you were losing share of wallet.

And I'm wondering what the cause of that is? Is it this need for FSP and you are a little late with those clients to develop that, or what competitively is causing you to lose traction in large pharma?

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [16]

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Good morning, Dave. I think that comment is fairly accurate in that we are late to the FSP market. Some of our larger clients last year, I think they would've declined. If we looked closely at those individual clients, they are more static. I know certainly one of the bigger clients that we have that I deal with, we were pretty much flat with them based upon their own outsourcing pattern. So they have been bringing some work in-house using FSPs of which we do some for them and also full service. So they are in a true hybrid. I think we actually looked at it once and we work in 11 different models with them effectively.

But I think we need, as we told everybody at the Investor Day last August, that we needed to invest in FSP, that we were going to invest in FSP. We have done that and we continue to do that and we are having some early success with it. So I think as we start to address the top 20 and the top 50 maybe even, we have to have that capability. We have to have it at some reasonable scale. That's why we are investing in it. That's why we are investing in real-world evidence as well. We think that is very important, particularly for the larger pharma who go on to commercialize their own products and they are both investments that we're making now and we expect them to pay off in the longer term.

But I think your statement are we slightly late to the FSP game, yes. We've looked at FSP assets in the past and weren't successful on them, so we were aware of it and aware of its kind of benefit in that top 50 sector and that's what we are addressing now.

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [17]

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The other thing that I think you see in the revenue, but to give you a forward-looking thinking, we always look at forward trends. I think historically the top 50 has been mid-50s revenue and in 2016, we certainly had expectations that it would be over 50% of our new business awards. And I believe rough generalizations, two-thirds of our awards or a little less were from below top 50 in 2016 and as Alistair mentioned in his prepared comments, most of our shortfall regarding expectations and new business awards were -- not most -- all of our shortfall was amongst the top 50.

And I think the bulk of that is two factors. Factor number one is many of our customers that our existing customers, where they are in the development cycle, was lower and we expect to see a rebound in those customers in 2017. So it's not a loss of wallet share, but, in certain of our customers, they certainly like a hybrid mix and their portfolio in our specialty areas, particularly [CNF], are rotating more to a flexible model or a FSP model that we don't have as strong an offering as some of our competitors at this stage.

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Dave Windley, Jefferies & Co. - Analyst [18]

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Yes. So my follow-up is maybe a multi-parter, but you commented in your comments about SG&A that the SG&A was I believe you said lower because of delayed decisions or delayed filling on some hires and I think particularly in business development, so I am a little curious about -- it would seem like that is an area that you would need to have redoubled effort on.

And then, second, you talk about delayed decisions. We are two-thirds of the way into the first quarter. By now, you ought to have pretty good visibility on things that were on the precipice at the end of the year. What does the bookings activity look like two-thirds of the way through the first quarter? Thanks.

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [19]

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We historically don't give that number at this stage, as you know, but I will tell you that those decisions are still open. So we have not seen as many of those closed as we would like, but those decisions have not been made on the positive side, thus still a large pipeline at this stage.

With regard to SG&A, you are right. One of the things that we believe that may pressure EBITDA margins and my guidance as to why I think it could be down, more likely down in 2017 versus 2016 is we have to make those investments. We did make many of those investments in the sales and BD and operations people to support bid defenses.

All of those investments have not been made as of yet, but we did make many of those and did bring those people on board midway through the fourth quarter, but it takes a while for them to build their pipeline and sales relationships and name recognition within INC. Many of them are veterans of the industry, but we've got to allow them their time to soak in at INC.

So those investments will take a little time to pay off, but we are making those investments and we did bring many of those heads, particularly in the BD area, on board in the fourth quarter.

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Dave Windley, Jefferies & Co. - Analyst [20]

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Okay, thanks.

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Operator [21]

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Erin Wright, Credit Suisse.

Erin Wright

Great, thanks. And a follow-up to that question. Can you speak to your capital deployment strategy more broadly? Any particular areas of focus for you from an M&A standpoint and generally how much of your focus on a daily basis is on potential M&A opportunities at the moment? Thanks.

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [22]

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I won't answer the amount of time, Erin, because if I answer and said I spend 90% today and then next quarter, I say 10%, you will know if an acquisition is close, but that was a good try.

Acquisitions are clearly our top focus. The areas that we are focusing in on are FSP is an example, particularly outsourcing of the monitoring aspect of FSP, which we do none of today. All of our FSP effort today is around data management, safety investigator payments and those areas.

We've got to add capability to allow our larger customers that want to do studies in-house a flexible option on monitoring to help supplement the workforce. That's a big area. Real-world late phase is another area that's probably harder to do acquisitions, but we are certainly making investments in that, capital deployment with internal investments, multi-million dollar investments that are planned in 2017 to do that. So those are the areas where our capital deployment is first and foremost.

In the short term, we are probably going to focus on debt repayment next versus share repurchases because we want to make sure we have a big enough wallet to go out and do acquisitions. We feel like we certainly will see that pick up in the next 12 to 18 months.

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Erin Wright, Credit Suisse - Analyst [23]

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Okay. That's fair. Figured I'd try. Can you also discuss the dynamics around the working capital accounts? Are you seeing longer payment times from customers or shorter payment times to investigators and were there any anomalies impacting DSOs in the latest quarter?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [24]

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There was a little bit of an anomaly. We had a customer -- you've got to look at -- a typical contract has two different tracks. It has revenue milestones that oftentimes don't necessarily line up perfectly with billing milestones. We did achieve several key revenue milestones late in the fourth quarter that did not allow us to bill until early 2017.

We had other milestones that we achieved late in the fourth quarter that allowed us to bill and those receivables, I think, have terms of 60 to 90 days and those two examples I'm thinking of specifically are both with top 50 pharma.

The biggest trend we've seen over the last 12 months is customers are focusing less on the days -- the invoices due from the dates, so whether it be 30, 45, 60 days, those terms aren't changing dramatically. The biggest trend we are seeing is milestone payment terms where the customer wants a certain number of [pages cleaned] or are a certain number of patients enrolled, different milestones that elongate the payment cycle.

So we did have an unusually disparate impact in the fourth quarter. I do expect the DSO to stay in the 20s over the next few quarters. Hopefully, it will decrease a little bit, but I don't see a significant expansion over the next couple of quarters from where it was and we did get hit a little bit negatively by those timings in the quarter.

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Erin Wright, Credit Suisse - Analyst [25]

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Okay. Thank you.

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Operator [26]

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Tycho Peterson, JPMorgan.

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Tycho Peterson, JPMorgan Chase - Analyst [27]

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Wanted to maybe dig into the delays. I appreciate the color you provided before on cancellations and it's understandable how portfolio reprioritizations can (technical difficulty) as failures may impact cancellations. But can you maybe give us a little bit more color on what drove the delays and what's the risk ultimately these projects don't come to fruition?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [28]

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The delays come from a variety of factors. I wish I could say it's factor one and it distinguishes itself, but a lot of it is delays with getting the protocol from the sponsor nailed down. Things are more complex and so the sponsor is changing the times that they reiterate the protocol and you've got to get that finalized before you can really get the study up and moving.

Part of it is, in the countries we are dealing with, regulatory approvals have resulted in delays and to a far lesser extent, some of it is our own operational delays, but the vast majority of it is with the sponsor or with regulators.

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [29]

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Yes.

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Tycho Peterson, JPMorgan Chase - Analyst [30]

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Can you maybe touch on the pricing environment in light of your comments around net awards being below expectation? Are you seeing more pushback on price from your customers?

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [31]

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No, I don't think we are. I think we are seeing people -- like Greg said, the complexity of some of the trials now is up and the algorithms that we used to put the pricings together on those drives out the same way as it always has done. We don't get -- we obviously monitor reasons why we lose projects. We haven't seen any appreciable difference in that percentage over the whole of 2016 let alone Q4.

So I don't think it's a price issue. I think the general behavior for the larger CROs on price is good. It comes down to operational solution as well. Your price is reflective of how efficiently you can get the project planned and then executed. And I know INC has always had a very strong reputation for that and we continue that. We understand the complexity in these trials. We know the best way to get to them. We have good access to data for sites and patients and how we access them and we use that on every chance that we can get.

Our goal is to get in front of a customer with the best operational solution and the price is a result of that. So I think we are still doing that. We are bringing in more talent around the therapeutic areas like we discussed earlier to help us produce better and better operational solutions. So I don't think we have seen any real -- there is no price war going on out there. It's pay a price for a fair project still.

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [32]

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The only other thing I would tell you within the top 50 in particular is -- and I want to be careful here because I don't know that this is a trend, and don't take this as a trend -- but certainly the environment at the end of 2016 with the political environment, as you know, there is a lot of uncertainty there and I think that created a focus on their pipelines.

I do think that overall in the market you may have seen a little bit of pressure from the demand from the top 50 across the sector. And whether that's a temporary blip, I don't know and I do think there's a focus amongst the bigger pharma to make sure that they evaluate the numbers of CROs that they are involved in. And so as we try to penetrate new customers in particular, it seems to be a little bit more difficult as the bigger CROs circle their wagons to protect their base. They seem to be doing that a little bit better than they may have done 18 months ago.

And if you looked into some of the other CROs' comments at JPMorgan, they certainly seem to be indicating that they are going to be much more aggressive in taking marketshare and I think we are seeing many of the bigger CROs, maybe because of that pressure in the top 50, in our core. They are coming down market more so than we have seen them in the past and so we are seeing a lot more of the big guys in our bids with the below top 50 than we did 12 months ago.

Again, I don't want to call out a trend to say that is going to continue to happen. One quarter doesn't make a trend. Two quarters don't necessarily, but after a year -- you talk to me at the end of the year and I will tell you if it is a trend or not. It's early days.

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Tycho Peterson, JPMorgan Chase - Analyst [33]

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Okay. And then two quick ones. Is the rotation out of CNF that you are seeing on the part of your customers, do you think this is transient or maybe a longer-term issue?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [34]

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No, I do not believe it's a longer-term issue. We've actually seen a spike in demand. I think our gross awards were particularly strong, but we also probably suffered the largest impact on cancellations in that group. I don't have that stat in front of me to prove that out, but I believe when we've talked operationally, we had a really good year in new awards in CNF. We also had a few cancellations.

One of the cancellations was -- one of the larger cancellations within CNF was not due to protocol or reprioritizing. Our customer had a great win with the FDA. The FDA said the drug in this other indication is performing well, it's safe and the cousin of that indication doesn't need to go through a clinical trial. You are good. And so the trial that we had won and were getting ready to start was canceled and it was an over $10 million study, so one of our larger recent wins that never got off the ground.

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Tycho Peterson, JPMorgan Chase - Analyst [35]

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Okay, and then just lastly, we have seen some of your peers change backlog definition, adopt a more conservative approach there. Any thoughts from your perspective as to whether that might make sense?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [36]

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I don't necessarily agree that it's more conservative, so I will tell you that it's different and you need to ask the question why they changed it, which is a different question altogether. But in managing a people business, you've got to understand what -- typically after you are awarded business, within 30 to 90 days, that contract is signed. And if you wait to engage and hire people until the contract is signed, you are not going to satisfy your customer.

So in managing your business, you've got to evaluate and ensure that you have staff ready to go and planned and backlog covered for what we would call soft backlog that has not gone to contract. If you are not managing that business, well, you are ultimately not going to satisfy your customers. So I guarantee you every one of our competitors that have changed that policy manage their business with that soft backlog. So why they don't tell you what that number is, you need to ask them.

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [37]

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Yes.

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Tycho Peterson, JPMorgan Chase - Analyst [38]

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Okay. Thank you.

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Operator [39]

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Courtney Owens, William Blair.

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Courtney Owens, William Blair - Analyst [40]

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So my first question is from a macro broader demand perspective, are you seeing or hearing concerns from clients that's more so related to the broader healthcare policy uncertainty that we are experiencing right now?

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [41]

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Certainly, in my conversations with customers, that hasn't come up. I'm sure that in -- I think it would be different by different customer sets. So the customer set that we tend to deal with and deliver work for, as you know, is predominantly outside the top 50. I think their development plans are pretty baked today, maybe aren't the customers that will commercialize the product themselves, which I think creates a difference in the way that they look at the overall macro healthcare environment. But that conversation doesn't come up.

We are hearing more from customers about commercialization in general, how we help them plan for that. I think the work that we're doing in real-world evidence has been key in that where we can actually help them deliver a lot of their evidence package through the deployment of a clinical trial rather than having to build it as they approach a commercialization milestone. So we do see a lot more conversation in that area and that's why we started the investments in that area in 2016.

There is concern out there. I think some of the large customers that we deal with, that concern is very relevant to them, but the majority of our customer set we don't see that. I don't know whether the political environment is causing these delays that we have seen a little bit in that sector. It could be, but I'm not a political commentator. I don't really get that connection yet between that political environment and the sector that we play in.

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Courtney Owens, William Blair - Analyst [42]

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Okay, great. Thank you. And then also changing focus a little bit, from a therapeutic perspective, are you seeing any pickups in areas outside of oncology in CNF right now? Thanks.

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [43]

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It's very cyclical, I think, outside of those areas. They are always pretty robust. Obviously oncology and CNF are pretty robust areas. I think, in 2016, we saw a lot of infectious disease work pushing on and we are very competitive in those areas.

We are seeing a lot more interest in real-world evidence, not a therapeutic area, but it's an area of -- a strong business for us as we invest in that. And I think our information in the immunology area was pretty strong last year mid-year, so -- and we evaluate those pipelines all the time. We are constantly looking at what work is coming in, what therapeutic area and actually what sub-therapeutic area because as these projects get more and more complicated as they target specific patient groups and those groups get smaller and smaller, you have to really drill down into sub-therapeutic areas. So it's a constantly shifting landscape.

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Courtney Owens, William Blair - Analyst [44]

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Got it. Thank you.

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Operator [45]

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Greg Bolan, Avondale Partners.

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Greg Bolan, Avondale Partners - Analyst [46]

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I appreciate all the candor on this call. I guess firstly on customer loyalty, Greg, I guess just going back through some past slides, just looking at that repeat customer number, seems to be dropping 92% in 2014, 86% in 2015 and now 80% in 2016. Is that just growth outside of the installed legacy customer base, or is there something else to take note of?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [47]

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I think it's mainly the mix of customers that you are seeing. Customers outside of the top 50 usually are, one, compound companies and so what you are seeing is this increase. I mentioned to one of Dave Windley's call that over half -- between a half and two-thirds of our new business awards were from customers outside the top 50.

By definition, there is a high probability that those customers are not going to be repeat customers in the future unless this compound is successful and they have a second indication. So I think that's the bigger impact.

The second is several of our large customers that are historically in the top 10 in our backlog we just did not win business with them this year either because of their portfolio or because of their rotation to more of a hybrid model away from full service.

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Greg Bolan, Avondale Partners - Analyst [48]

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Got it. And then I guess going back to I think Tycho's question on backlog recognition. You guys have one of the highest backlog burn rates in the industry. And I think, honestly, that's indicative of a very conservative backlog recognition pattern.

As we think about your guidance for revenues for 2017, obviously, you've pointed out first half is going to be very important, but is it fair to say that, from a constant dollar perspective, the level of coverage that you have, the level of -- I'm just going to say it -- conservatism in this guidance range, is it about in line with where you guys have been this time beginning of each year for the past few years as a publicly trading company? Is it a little bit higher just given a little bit of the uncertainty with regards to some of these more binary decisions that seem to be forthcoming? Any color on that would be great. Thanks.

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [49]

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Yes, as I mentioned in the prepared remarks, our backlog coverage is not where I want it to be, to be honest with you and I think I even pointed people to the lower end of the range of the guidance. I do think our backlog policy is conservative, but, if you think about last year, we had $844 million of backlog and we talked about that customer that asked us to accelerate work out of 2017 into 2016.

So if you look at that, the fact that we had [$44 million] I think of backlog coverage coming into 2016, coupled with the fact that we actually got a benefit in 2017 revenue from that acceleration of work, we had a backlog coverage of $872 million at December 31 and as I mentioned in the prepared remarks, we actually add further delays in January and early February that actually lowered that number.

So I don't believe that my guidance is conservative or aggressive. I think that for us to reach the top end of that range, we have to have a very strong Q1 and Q2 of new business awards and we have to avoid a repeat of Q4 in terms of impact of cancellations. If those two factors happen, we can hit the top end of the range. If they don't, we are going to be at the bottom end of the range.

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Greg Bolan, Avondale Partners - Analyst [50]

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Okay. That's fair. Thanks, guys.

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Operator [51]

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Michael Polark, Robert W. Baird.

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Michael Polark, Robert W. Baird - Analyst [52]

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This is Mike Polark on for Eric Coldwell this morning. I have two questions. First, I was hoping you could just comment generally on the labor market, access to direct staff, trends in compensation, any therapeutic categories that are particularly tight? And then related, curious if you are seeing any opportunities for direct staff or upper-level management or mid or upper-level management driven by some of the transitions that your large competitors are going through right now.

Then the second question, what's the adjusted tax rate in the 2017 guidance? I might have missed it in the slides. Thank you.

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [53]

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I will take the first multi-faceted question and Greg can take the one at the end. So talent, I think the talent market in 2016 was interesting. It was tight at the beginning; opened up in the second half. I think we've been able to recruit well into that both at senior levels, so bringing in what we call CREs, customer relations execs, so that's EDs, VPs, Senior VPs in the therapeutic areas.

We've been able to successfully attract and secure those folks and I think it was Dave's question about SG&A and the impact of those. Those people are either joining now or will be joining throughout Q1, Q2 depending on non-competes, non-solicits, etc. So we wait to bring those onboard and they are actively engaged with us now.

The CRA market opened up a little bit I think in 2016. I think a lot of the CROs, including ourselves, put a lot of effort over the 2015, 2016 period when it got really tight to develop our own CRAs and I think those programs have gone well. We are using the IAOCR accreditation pathway so we are training CRAs who come out and they are accredited so we know we get good quality from them and we are able to deploy them quickly.

So I think the labor market has eased a little bit. I think we are seeing -- as you -- the question around some of the disruption in our bigger brethren -- yes, we are seeing some impact from that. Yes, we are able to recruit well-seasoned, good talent from those organizations and bringing them in.

So I think INC has always been about our ability to attract talent and deploy it and put that talent in front of opportunities and build relationships with customers and that is certainly what we will continue to do. Greg, on the tax.

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [54]

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On the tax rate, we mentioned 32%. That's an approximate. It could vary up or down 100 basis points, but the midpoint of our expectation is around 32%.

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Michael Polark, Robert W. Baird - Analyst [55]

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Thank you. That's it for me.

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Operator [56]

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Dave Windley, Jefferies.

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Dave Windley, Jefferies & Co. - Analyst [57]

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Just wanted to come back to, Greg, your backlog recognition. I think you have effectively made the point in the past about a relatively conservative bookings and backlog recognition policy. And my sense has been that you've pretty strictly adhered to a not so much whether it's contracted or not contracted, I agree with you that makes less of a difference, but more of a difference as to how long it is from the time it's awarded to when you think it's going to start.

And I think there's also some elements of, as you grow as an organization and see a broader portfolio of opportunities and the size of those opportunities changes may also have an influence on this timing to start and the backlog burn rate. So my question to you is, as you grow and new projects are coming into your backlog and you made the comment in your remarks that some of this revenue is not starting until say mid to late third quarter, is it worthwhile to revisit your policy and tweak the policy to match what you are seeing coming in, i.e. tighten up the timeframe from award to revenue starting in what you recognize in backlog?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [58]

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Dave, I don't think so because, again, I use that and tell you my guidance and try to be consistent. What I do try to do, to your point, is to try to be very transparent with you and our investors as to if there is a change in mix. And so I was very purposeful in calling out the fact that some of those awards are starting a little later than normal because obviously from a perspective are those awards themselves more risky than an award that's going to start January 1? Absolutely.

And so I try to give not just quantitative information as to what our new awards are and backlog and book-to-bill, all of that; I've got to give you all the color as to some of the qualitative factors. And do we think those awards are solid? Absolutely. I wouldn't have booked them if I didn't. But by definition, if they are starting a little later in the year, they are riskier and that's the color commentary I tried to give you so that you all can understand that dynamic.

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Dave Windley, Jefferies & Co. - Analyst [59]

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So let me ask it just a slightly different way. I think one or two years ago coming out of the IPO, my sense, and I could have been wrong, but my sense was that you believed that your backlog booking policy was something that helped to establish difference between your burn rate and the burn rate of some of the larger peers that seemed maybe somewhat more generous in what they put in backlog. Your burn rate has now dropped 100 basis points in the last six or seven quarters and if I am right, it's going to drop again in the first quarter. So is the goal to put in backlog what will burn out at a consistent rate or is it to grow the backlog into a larger number?

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Greg Rush, INC Research Holdings, Inc. - EVP & CFO [60]

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The goal is to be first consistent with how we have always done it. So that's the first thing, so we are not changing anything from what we've ever done in backlog. The goal is always to put into backlog -- has always been, particularly before we went public and afterwards, is to use backlog to manage the business and determining when to hire people, what resources are needed and which functions, etc. That is why we do backlog.

We disclose all those other metrics because they are industry-standard metrics, bookings and backlog. I think we set the trend in the industry of backlog coverage. I think many of our competitors are starting to provide that number now.

But you are right, we do believe backlog burn is a measure of the quality that goes into backlog and also a measure of how efficiently you are executing on that backlog and I think our backlog has dropped a little bit and that's reflective of the delays. I think that is a bigger impact on the backlog than what the quality going into it.

In the fourth quarter, we did have some awards that went in that are starting later than normal, but we've put similar awards with a similar profile. We've always disclosed that our policy is if it is going to start within the year. The vast majority of our awards historically have started within 90 to 120 days and many of those even earlier than the 90-day mark. In the fourth quarter, we had several large studies that are starting later and we wanted to call that out.

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Dave Windley, Jefferies & Co. - Analyst [61]

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Okay. Thanks.

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Operator [62]

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I'm showing no further questions at this time. I'd like to turn the call back to Mr. Macdonald for closing remarks.

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Alistair Macdonald, INC Research Holdings, Inc. - CEO [63]

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Thank you, everybody. Thanks, ladies and gentlemen, for your attendance today and for your interest and investment in our Company and I wish you a very good day. Thank you.

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Operator [64]

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