Charles River Laboratories International, Inc. (CRL) Earnings Call Transcript & Summary

Good morning, everyone. It's time for our next session, which is Charles River Labs. I'm John Kreger, the research analyst here at Blair who covers Charles River. I am required to inform you that you can obtain a complete list of research disclosures or potential conflicts at williamblair.com. With us today from Charles River is David Smith, the CFO; Todd Spencer, the head of IR, will also be joining. What we're going to do over the next 30 minutes is go through a fireside chat with questions that I will direct to David. If any of you on the line have questions, please, there's a function that you can submit them to me and I will do my best to pass them along as time permits. Before we get into questions, I'm going to turn the mic over to David for some prepared remarks. David?

Okay. Well first of all, thank you, John. So we had a particularly strong first quarter, pleasing on a number of fronts. Sales grew at a healthy 8.2% organically, and that's despite COVID and a stocking order in manufacturing that we had that made the year-over-year comps particularly challenging. Our margin at 19%, up 270 basis points from the prior year and non-GAAP earnings per share at $1.84, which is up 30% from the prior year. So COVID began to impact us in the last few weeks of March in research models. A whole host of academic research centers in the U.S.A., in Europe began to close and swiftly, and the usage of our research models dried up. So we recast our guidance accordingly, expecting revenue impact from COVID to be about $135 million to $250 million. We revised our organic revenue guidance to 1.5% to 4.5%, primarily due to research models, a little bit on DSA and almost nothing on the manufacturing segment. Implemented some cost reduction initiatives from $55 million to $90 million, and that range will depend on which of several scenarios we trend towards. And we gave some key assumptions on these different scenarios during our last earnings call. And when you put all that lot together, our earnings per share was lower but less painfully than otherwise might have been the case, namely now at $6.75 to $7.10, which is down $0.60 at the midpoint. So we paused M&A, but between the cash on hand that we have today and the revolver, we could draw on $1 billion for M&A and still have sufficient working capital for day-to-day operations. All of our operational sites are open, and most of our staff are working either from home or in our labs and have done throughout this period. And we have over 40 clients, where we're supporting solutions for COVID, which is a real beacon for both staff and suppliers in trying to support the community and our customers, which we're very proud of, really making a difference there. So looking at April and May, proposal volumes and bookings remained strong in DSA, as we previously stated. And what's interesting is that academia is actually opening up faster than we expected, especially in mainland Europe. So while academia was fast to close and we expected a much slower uptake on reopening, it's encouraging to see this shift is taking place already. So in short, we remain optimistic about our guidance. And as we find C level and begin to get more comfortable with COVID and how shall I say it, better understanding that and the impact it has on our business, we're beginning to think about our M&A strategy and what we might be able to do in the medium to longer term.

Thanks, David. That's a great update. Maybe just one quick follow-up to that same point. So you've now been dealing, as we all have, with COVID-19 for the last 4 or 5 months. As you kind of reflect on the impact that you just went through, what surprised you, particularly how your clients reacted? And I don't think you mentioned supply chain. How did the supply chain hold up? I mean, where -- did you have any surprises, positive or negative on that front?

So okay, okay. Whether surprise is the right word, we'll see. But certainly, with black swan events, you're never sure how they're going to unfold. And so for instance, initially, we didn't know how many staff would be able to get into the labs. And I'm pleased to be able to say that most employees actually have been coming into the labs. And it's helped because we quickly enhanced our health and safety measures. But even in normal times, many of our staff wear gloves, masks, gowns, et cetera. Some of our rooms have airflow management systems and filters that help safety. So that was relatively easy for us to sort of step up towards. I also think that professionalism of our staff, the importance of what we do has helped. And of course, as I mentioned earlier, the fact that we're working on 40 customers on COVID-related programs, that really is a natural call to action. So while it's a relatively modest amount of incremental work that we've had on COVID, it has a -- quite a marked impact on behaviors, and I'll come to that when we talk about supply chain as well. So the clients have been good and not just from the point of view that where they've had difficulties in running their own sites and where they're working from home, we've picked up some more work as they passed it to us so that's encouraging. But where they've been helpful is the remarkable number of notes, videos even, appreciating the thanks to the fact that we're able to move their programs forward. And I'm not just talking about COVID-related programs, I'm talking about the normal programs as well. And to your point about supply chain, we got off quickly with respect to procurement, engaging with our suppliers. And indeed, supply is one big part of the COVID solution. So we've told them. We've told them that we're working on a number of solutions. I'm not aware, I can be called on this, but I'm not aware of any other preclinical provider that is working on as many solutions as we are. And so suppliers have actually found solutions to their own problems in order to get kits and equipment, et cetera, to us. So that, you could argue, is a surprise. I didn't expect the supply chain to be as robust as it was until I kind of understood that, why wouldn't you want to be part of the solution to COVID? And of course, our other clients are benefiting as well because we're able to get the kit. So the resilience of the business being, I would say, outstanding, the dedication from employees, clients and the supply chain all have helped keep our operational sites open.

That's great. It sounds very encouraging. You did a nice job summarizing the updated guidance from your first quarter call. If I remember correctly, you talked about a number of different scenarios as you were recasting your guidance for '20. Now that we've had another month past, are you sort of landing on one of those scenarios, in particular, in terms of how you think this will play out? And I guess related to that, are you starting to incorporate or see any signs of a second wave later in the year?

Okay. Second wave in terms of COVID?

Yes.

Yes, okay. So 2-part question. Okay, fine. So well we went to our earnings call in May so we were able to talk about April, and we had a very strong April for DSA. Good proposal volumes, good bookings and pleased to say that, that's flowing into May as well. So we're seeing a good strong start as we anticipated on DSA. In terms of research models, we're beginning to see Europe, in particular, opening up, particularly in mainland Europe, beginning to see some green shoots in the U.S. as well as academic research centers begin to open. So that is a better prognosis than where we were even a month ago, where we were expecting academia to remain shut until the summer beginning to open up in the fall. Let's not get ahead of ourselves, there's still a lot to go. I don't want to leave the impression all of our customers in research models are open, they're not, but it is going better than we expected. So I think it's still too premature to say where on those various curves we will end up as we go through the year, particularly in respect to your sort of part B of your question in respect to, could we have a sort of boomerang in terms of COVID coming back? And so that leaves us with a need to keep our range a little wider than we normally keep it because we can't be certain where we might end up. But so far, things are looking pretty good in a miserable COVID sort of environment that we're all living and working in.

Great. Let me do 1 or 2 more on COVID and then we'll pivot to something else. With the surge of activity in both therapeutics and vaccines for COVID-19, and I understand this is going very, very quickly, how is that impacting the work you're doing on those programs? I would typically think most of that's happening sort of pre-IND, but in this environment where everyone wants to move faster, are some of the pre-IND things being skipped or are you sort of doing that in parallel? Will they circle back? How are you handling that?

Right. So first thing to say is remember that vaccines are for healthy people, though we certainly wouldn't want to see any compromise being taking place in the safety aspects. And indeed, if you look at the 40-plus customers that I mentioned that we're working on COVID with, the vast majority of those fall into safety assessment. So we're doing safety profiles to make sure that whatever we take into human later on is appropriate. The time frames though are compressed. Clearly, as you would expect and anybody listening would hope, we're making sure that we are prioritizing COVID-related work, that our team turns that round fast, gets the information to our clients, and as you would expect, they're turning that round fast back as well. So when we get to the data sets that they can take to the FDA, I would be -- I would expect the FDA would fast-track that package of information so that we can take it into human trials, et cetera, too. What's also encouraging is that not that we are directly involved with that, that people are taking the risk or companies are taking the risk to open up the manufacturing plants in anticipation of FDA approval. So that will also constitute the speed with which drugs get into people. But to come back to what Charles River doing, just to characterize the type of work that we're doing, much of what we do is in our wheelhouse, safety type work, et cetera. In biologics, there is some additional assays that we're running, specifically for COVID. And one that I personally find particularly interesting, which I'm happy to share is that we've actually got something going on in biologics in our Pennsylvania site, which is looking at the reusability of N95 masks. So when we're taking -- looking approach to COVID, it's not directly compounds, there are some other aspects that we're working on too.

Great. Might be too early for this but I'll ask it anyway. Any thought about in the medium to long term, any fundamental changes that might happen to your business as a result of the pandemic? Just kind of, are you -- do you think there might be ways in which clients think differently about how to access and use Charles River?

Right. So I guess our best marketing tool is when we actually do work for customers. And we have picked up some new clients which you could argue is temporary but I guess that depends on the experience they have. That temporary work that we're doing for them may prove to be longer term. So for instance, we've got clients that have traditionally not used us, but because they've closed down or not using their own labs, they've come to us. So there's an opportunity there. GEMS is a good one, genetically engineered models. Clients often have those. They have the common lease in-house. But rather than call them, they send them over to us. We're housing them, and what we're trying to do is make sure that's a smooth journey. And when they call down on those genetically engineered models to bring them back in, we want to make sure that's a smooth journey, too. So that may also color their thinking and their management views on outsourcing. Competitors, clearly, we're trying to win share from them. We know that some of them have cash problems. Some did not have robust contingency plans. I think I'm very proud of what we did and have done, and I think the fact that we are open demonstrates that our contingency plans were good. We know that some of our competitors are unable to ship to certain locations. So again, when clients are looking at who they're going to work with, they may remember this period and how we responded. And one of the, I guess, arguments you can make around transformational moments, whether that be a recession or a pandemic, is it can fundamentally force the industry to rethink. Like the last recession, I think that was a catalyst for much more outsourcing to take place. Too early to say what the consequences will be from COVID, but I do think that we are conducting ourselves extremely well. And as I mentioned in my opening remarks, a lot of thank yous coming in from customers. So that all bodes well.

Great. Sounds good. Let's switch gears a little bit. Precrisis, there is -- I would say, there is a -- the hot topic was cell and gene therapy. And of course, you guys did the acquisition of HemaCare not too long ago. So can you just kind of step back, what role does Charles River play in cell and gene therapy today? And how would you like that to change over the next 2 to 3 years?

Right. Okay. So we have about $150 million of revenue in cell and gene therapy today. That includes HemaCare, by the way. But we do work. Some of our research models, humanized models are used in cell and gene therapy. In discovery, we already make use of human primary cells in Holland and in the U.K. In safety, often, there's a sort of a combo study. You do sort of combo pharma-oncology as well as traditional safety studies. Biologics, new assay developments and cell banks and so on. So there's a fair chunk of work that we already do. But I would concede that we are underweight relative to the sort of market share we have in other parts of our businesses, there's more that we could do. But of course, since we already do it, it's relatively easy to build on that capability, to market that we do it and attract more work in. But that wouldn't preclude from doing M&A. I mean, it's a really attractive market. The growth rates are spectacular in cell and gene therapy. So we could see M&A like we did with HemaCare, where we do something on the product side. There might be something that we would do that maybe you would classify more of a niche CDMO-type work, not that we would do the direct manufacturing. But it might be something that sort of bleeds out a little bit into that sort of space. So yes, we are attracted into this space and the future will see where we end up in terms of both a combination of M&A and that organic growth.

Great, great. You mentioned on the first quarter call that HemaCare's donation center had been temporarily closed. Has that reopened now, and are you constrained at all in serving HemaCare's clients?

So that opened mid-May as a short answer to that. We were still able to ship product even when the donor center was closed because we had inventory. So I guess we have -- if you look at the full year, there's a bit of a headwind because the donor room was closed for a period. There's still a little bit of a headwind because not all customers are back to work and therefore ordering from us. However, now that we've got the room open and that clients with obviously the lockdown beginning to ease, more and more of those should be returning back to work, we should see that business begin to pick up. And certainly, there's nothing that's happened in the last few months that would impact its ability to grow at north of 30% that we were predicting when we first acquired it.

Great, okay. Let's pivot to discovery. I know Jim over the years has talked about this as being kind of a large area with a pretty long runway for you, but I know it's been difficult to convince clients of the merits. So where does that stand? Have you had any success in sort of kind of reaching a tipping point in discovery?

Right. So okay, good question. So discovery, you could argue, is a decade or so behind safety assessment in terms of the way it's progressing into the market. And of course, discovery is still one of the largest -- the last areas of biopharma that they still view as core. Notwithstanding that, we do have some work that we do with big pharma as well as smaller biotech. But that's one of the reasons why only about 25% is outsourced. It's a -- and it's a fragmented market. It's difficult to go to lots of different providers to do your various different components of discovery. Of course, if you're a small virtual company, you have no choice. But if you're a large pharma that already has that in-house, why would you want to go through the pain of dealing with many different companies to get the sort of services that you need? So our strategy has been to build up a discovery engine, very much like we used to do safety assessment. In 1999, we didn't do any safety assessment. Now we're the largest provider of safety assessment. That didn't happen overnight. That was a journey that we went through. Same with discovery. We're strong now in oncology and CNS, complex biology. We do medicinal chemistry. And what we're trying to build is sort of this integrated platform. And I think there are a few external providers like us that have such a comprehensive platform now. We can go from target identification all the way through from literally inventing the drug. And we have coinvented over 80 drugs that moving -- some of which are moving through the clinic. So yes, we're trying to make it easier for customers to be able to outsource the work by having a sort of a one-stop shop. And you have to remember that discovery is a bigger market than safety assessment. And while we could argue that safety assessment might get to almost 100% outsourced, I would concede that we probably won't get to 100% outsourced in discovery, that there will always be a call that's done in-house. But it's a larger market. And if that outsourcing was to double from 25% to 50%, that's doable, then we would be part of that journey. But more importantly, I think as we build out the capabilities of discovery, people become aware of the quality that we can provide. I think even if the outsourcing didn't change, I think we'd begin to get more and more market share. Certainly, we feel that we've got a critical mass now in discovery and it's beginning to stabilize. You've been following us for some years. You will have known, and go back 3, 4 years ago, it was a very choppy unit. That has stabilized. And I think that's all part of the journey that we're going through.

You mentioned theoretically, safety could get to 100% outsourcing. Where do you think that is today?

55%, maybe 60%.

Got it, okay. Interesting. Good stuff. Did you see any delays on the discovery side, particularly as clients were coming to grips with the pandemic? Or did those programs pretty much continue as expected?

There were some delays. We called that out on the last earnings call, particularly large sort of big programs. I think you've got to remember when you're doing discovery, if your -- it's a combination of the parts. And we might be doing a piece that if your lab isn't open, then you can't turn around quite so fast. It's okay if you do the whole thing but it's less easy if it's a team. And a lot of what we do is part of a wider team. We try to position ourselves as an integral part of the client team. We are not just providing you X, we are providing you our thinking, our thoughts, advice. More often than not, we will sit on the panel with a client and actually sit as scientists to scientists and work through, is this worth investing more money in or not? And we will tell the client, no, it's not worth investing if we don't think it is because we're in it for the long term. We're not in it to get a quick win. We're in it to show that we are proper scientists providing proper thinking and that we've got skin in the game in the relationship. So a little bit of the slowdown in discovery is because we have all that nimbleness between us and the clients. That doesn't mean that there's still a lot of work that we are doing, particularly packages that we can provide.

Great, great. Okay. Let's pivot a little bit to biotech funding, always a popular topic. From our vantage point, it seems like it's holding up very, very well. But curious what you're seeing, particularly among your smaller, less well-funded clients? Are they reporting any challenges to you in terms of raising money? And does that sort of trickle down to cancellations or delays in terms of what's being passed on to you?

Right. You're quite right. I mean, this is a question that comes up repeatedly. I've been doing this job for several years now, but your angle is slightly different in that you're asking is a bit about what are our clients saying about biotech funding, which is an interesting angle. And our biotech community are in it for the long term. They don't seem to be focused or worried about short-term fluctuations in the markets. That's possibly because as a cluster, they have about 3 years of cash on hand. There's always exceptions to that rule because we're talking about thousands of companies. Some will have less, some will have more. Some are well managed, some are less well managed. But certainly, in the conversations that we're having, price -- the funding isn't something that's coming up on a regular basis. In fact, if you look at the first half of last year, where biotech funding got off to a very slow start, it wasn't a question that was coming up with clients. VC funding, as you called out, seems to be going well. IPOs are beginning to pick up. Pharma will always be there as a bank. They have to pay to buy that product in. In terms of just a slightly different remark I'd make, I think what the industry has shown over this period with COVID is that it's important that we have a strong industry because we've never had so many shots on goal trying to resolve the COVID problem. So my thesis is that it would be harder for politicians to mess around too much with drug pricing. So I think that, that opens up a new dynamic as to where will the conversation on drug pricing go. But in terms of clients at the moment, their conversation is around, are you -- "What sort of scientists are available? Oh, most of your scientists are there, so I'm going to get quality scientists and you're open. And when can I start? Oh, I can start pretty much now. Oh, by the way, I have to ask you about pricing." So they're not leading with the pricing conversation, and that suggests to me that they're not worried about the funding. Otherwise, I think the canary in the mine is when they start asking about pricing on a regular basis. And if they start opening up with that, then you know that they're worried about the funding environment.

Great. Sounds encouraging. We've got about 5 minutes to go and we haven't really talked broadly about manufacturing. So let's pivot there. And maybe start, you've got a lot of various businesses that fit into that segment. Step back for us and just strategically talk about where you want to play there? Where do you see an opportunity and where do you think you're differentiated? I know you said you don't want to be in the CDMO business per se.

Yes. I think biologics is a big sector, and biologics is going to continue to grow. And you know and many on the call will be aware and I'll remind everybody, we made that investment in one of our sites in North America in biologics. And we had that double running cost, and that was a bit of a drag on the margin, et cetera. But it was worth that investment because the future is bright in terms of more and more biologics are going to be approved by the FDA, and we needed to have that space and that infrastructure to make sure that we could support that journey. So we continue to organically invest in biologics. It is a fragmented market. I think everybody is keen to hold on to their assets. So for instance, we're not keen to sell our biologic unit because it is an attractive market. So if opportunities arise, we would certainly be interested in seizing those opportunities. But they're not -- there's not that many players but it is somewhat fragmented. We're probably #2 at the moment. We're not that far behind being #1. And if we continue to do the right moves in biologics, there's no reason why we can't expand that. And of course, microbial goes from strength to strength. Avian is a smaller part of our manufacturing unit. It's pretty much a saturated business. It's a good cash flow, but I don't see much potential for it to take more market share. We already own most of that particular franchise. I mentioned earlier that we might look for niche type activities that we could consider in the CDMO space. So that might be something that we could see in the near term.

Excellent. Sounds good. Okay. Let's wrap up with maybe some financial ones. Back at your Analyst Day almost a year ago now, you guys certainly made a pretty strong commitment to getting to 20% EBIT in '21. Now of course, we've got this pandemic to deal with. So how do you think about that? Does that set that time line back or are you still committed to getting there next year?

So I wouldn't say it set the time line back, and we're certainly still committed to getting to the 20% by 2021. And indeed, if it wasn't for COVID, I think on the back of our Q1 numbers, the question that you might have put to us, is could we get to 20% in 2020? Of course, with the headwind that we've got, particularly in research models, that will temporarily pull us back a little bit from getting to that -- from the possibility of getting to 20% this year. But certainly, yes. Structurally, we don't see a problem today. The only caveat I'm going to put in to, can we get to 20% by 2021, we don't fully know, to one of your earlier questions, what might be the sort of second wave of COVID, how might that play out in the business and the world at large. But from what we see today, structurally, there's no reason why we can't make it. But I just put that little caveat in that we still got pretty much a year to go. And we don't really know yet what COVID has in store for us all.

Excellent, okay. We've got 2 minutes. So David, I'll just -- I'll ask one more and then we can wrap it up. And that is kind of a follow-on to what I just asked. If you think across your portfolio, where do you see the largest opportunities to improve returns over time?

So just a follow-up to the margin question. DSA has good potential for margin accretion. We want to get into the mid-20s on a sort of a full year basis, not just on a 1-quarter basis. Acquisitions, for instance, Citoxlab is still a drag. It's certainly not got to the margins that we have in our legacy safety assessment business. And we will be -- recall, we made some big investments in people, both in compensation at the low entry-level staff, hiring, et cetera, and that's behind us. And you've seen yourself, Q1 was pretty clean from a DSA perspective. And you've seen the margin accretion that we got out there. So I think we've kind of proven that we can do it in DSA. We just need to get COVID behind us and march on from there. And the second area is in corporate. Our unallocated corporate costs as a percentage of revenue have been coming down about 50 basis points year-on-year. And there's no reason why we can't continue to do that as we do the right things in back office and get that scalability. So we'll see some margin accretion there. So those are the 2 areas that we've called out. But of course, we have got margin opportunity in manufacturing. And people often ask, "Well you're mid-30s, why did you move that from mid-30s up?" Well we are taking that margin accretion, we're reinvesting it in the business so that we can continue to enjoy the double-digit growth that we have in manufacturing. And so that's -- so don't take the fact that we've not pushed the margin in manufacturing as a negative thing. Think of it as a way of sustaining that double-digit growth to the top line.

Excellent. That's a great summary. And I see with that, we are right at 10:30 Central, so let's cut it off. David, Todd, thank you very much for your time, and thanks to all the listeners on the line. Have a good day.

Thanks for having us.