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

I'm Juan Avendano, and I am joined by my colleague, Mike Ryskin. We're part of the life sciences tools equity research team led by Derek De Bruin at Bank of America. I focus on biopharma services, mainly CROs and CDMOs. I want to thank everybody on the webcast for their participation and please feel free to submit your questions through Veracast. It is my pleasure for me to conduct the following fireside chat with Charles River. We're joined by David Smith, their CFO; and Todd Spencer from Investor Relationships. David and Todd, thank you once again for being here.

Thanks for having us.

So to set the stage and for those in the audience who might not be familiar with the product portfolio of Charles River, can you provide a quick overview of the company and the role that it plays supporting customers across research, drug discovery, preclinical development, analytical testing and most recently, contract manufacturing?

Sure. So Charles River, we're a contract research organization, mainly in the preclinical space. We have over $3 billion of revenues and an addressable market of $15 billion, 18,000 employees across 20 countries and we operate through 3 segments. We have our Research Models and Services segment, which is something we've been involved in for over 70 years now, and as such, we enjoy 35% market share. We have our Discovery and Safety Assessment segment, which is our largest segment, and that covers about 50% of our total revenue. And there, we're helping to invent drugs and ensure that the safety profile of that drug is appropriate to take into the clinic into human in Phase I, II and III. Now we've invented or coinvented over 85 novel molecules or drugs that has the potential to be taken into the clinic. And we've been involved in over 80% of the FDA-approved drugs. So really a meaningful player in this space. Now Manufacturing, our third segment, is made up of a number of subunits, we have Microbial, which is a QC lot testing or lot release testing of products, particularly in the pharma industry. The pharma industry is FDA-mandated to make sure that they don't have any bugs in the system. And we have a very -- we have a product that enables them to get a fast turnaround to help them with their efficiency. Biologics, another QC testing, but this time to ensure that the manufacturing of the biologic is safe. Often, there are multiple steps when you're building out a large molecule like a biologics and the client needs to be confident that each step is being done properly, and that's where we can help. And then to your point, recently, we acquired Cognate which is in the CDMO space, the cell and gene therapy. Now our total revenues in cell and gene therapy is about 10% of our revenue, so about $350 million. It's a new emerging modality with very high growth rates. So we're really pleased to be in that industry. And the final comment I'd make is we are delighted to be in the S&P 500, effective from Friday.

So you guys heard the news come yesterday, I believe, and so congratulations on that. And definitely, to set the stage, given your product overview in several business segments, that was good. I guess Charles River, the company, seems to be in a very strong position. The company is seeing unprecedented demand across several business lines. What are some of the key trends that you're experiencing now that you expect to be sustainable or secular in nature, so to say, in years to come?

Okay. So a few things to call out here. So first on funding. If you look at quarter 1 this year compared to quarter 1 last year, we've seen an almost doubling of funding flows. So something of the order of about $40 billion. And last year was another record year with over $130 billion flowing in. So funding flows have been strong. Outsourcing also continues to expand. So in our Safety Assessment business, we have about 60 -- we're in a market that's about 60% outsourced. If you go back just before the last COVID crisis, that was only about 25%. Discovery is about 25% today. So there's room for more expansion in outsourcing. So while companies like ours do good work, there is a way that clients can continue to put less dependency on their in-house fabric and work with companies like ours. So biotech, we know is the engine for big pharma They don't actually have all the in-house capabilities and resources. So they rely heavily on companies like Charles River. We're also seeing there's emerging modalities. So we're all familiar with small molecules. We're now seeing that. Of the large molecules, biologics, half of the FDA approvals are in large molecules. And we're now seeing cell and gene therapy as a new emerging way to actually identify, and there's only a handful of approvals at the moment, but more will come. So if the science continues, my expectation is that we should see sustainability of that funding flow. If the quality of what we do continues, we should see more outsourcing and that's all beneficial. And even if funding flows was to dry up temporarily smaller companies have 3, 4 years' worth of cash on the balance sheet, they're incentivized to move their molecule through the pipeline. And whether you're a large client of ours or a small client, players are wanting a more of a one-stop shop. It simplifies the process if they can come to a company like Charles River that has a broad breadth of portfolio as opposed to working with a dozen or so different providers. So it makes it simpler. And finally, to your question about sustainability in years to come. I've mentioned -- well, I haven't mentioned, but we've got a portfolio effect. We saw last year with COVID and the pandemic that we were softer in some parts of our business, stronger in other parts of our business. We still had a very good year overall. So when you put that all together, I think that bodes well to Charles River, having sustainability in its work in the coming years.

And going back to last year, I mean management noted that Charles River was gaining share across some of your businesses during the pandemic. Fast forward to the present, a year now. Can you share with us whether the company has been able to maintain those share wins? How reversible are they? And what are the switching costs?

Okay. So a quick comment on the pandemic. So we were open, all of our sites were open during the pandemic. We were working on COVID-related solutions. So we were deemed as an essential business, which was good because not only did that mean we were open and could work on COVID solutions, but we were also working for all those other medical needs that we have. And it was inspiring for staff. It was inspiring for staff to come in even if they weren't directly working on COVID, they knew that we were part of an organization that was working on COVID. So our staff stepped up to the plate and they came in. And suppliers, too. When they heard that we were working on COVID, they made sure that we've got the supplies needed for the totality of our business. So we were open. So that was good. Now because we were open, our Research Models and Services businesses were able to win work from some competitors. So we saw a meaningful increase in principal investigators. These are the people that place the order at academics. And we're talking not just a handful, but principal investigators who have never placed work with us before, and that was partly because our competitors were struggling to service certain jurisdictions. And the same with GEMS, our Genetically Engineered Model business, clients were closing down their variants, and were asking us to look after the company while they were temporarily closed. Now we knew that we would be able to retain some of that GEM work and some of that principal investigator because our best marketing is when clients actually work with us. So of course, we put our best foot forward, encouraging them to sustain their work with us. And now here we are, Q2, almost coming up to a year later, we've seen a number of those clients stay with us. So that's good. So with DSA. I mean DSA, some of our clients closed down their sites temporarily because of COVID. We were open, and that helped with our reputation because -- it helps with outsourcing because some managers feel that they ought to keep the work in-house because when things get bad, they can depend on themselves. So here where we open and a lot of our competitors in the DSA space were open, and therefore, it helped with that conversation around outsourcing. Biologics, it's picked up some of the vaccine testing work, and we all know that COVID isn't going away. We're going to have variants. We're going to have boosters. And so we expect that work to continue going forward. To your question around switching costs, this is a science-to-science type relationship. And if we do good science, then there's no reason for the customer to walk, unless we got someone pressed. So what we find is that if somebody makes a mistake on the science then, of course, the scientists will want to go elsewhere or if we push the price too hard, the procurement department may encourage these scientists to go elsewhere. So it's an algorithm that we work very hard on, but switching is technically easy, but in the real life, as long as we get that good relationship, provide good science at a good price, we don't actually see much switching taking place.

Understood. Good. And so if we can switch gears a little bit and move on to capital deployment, we've had some investor questions on that. Do you expect the acquisition of Cognate, one of your recent deals, which is a CDMO business and can be capital-intensive, to diminish your ability to do future M&A deals? And with Cognate in the portfolio, how should we think about CapEx as a percentage of revenue on a normalized basis going forward?

Okay. So 2-part question. So the short answer to your first part is no, we don't expect it diminish our ability to do future acquisitions. So our leverage ratio at the end of Q1 was 2.3x. On a pro forma basis with Cognate, our leverage was still under 3x. Now we have signaled for a number of years now that we prefer to be under 3x. We're happy to lever up for the right acquisition and have often levered up to the mid-3s. But we've always got a flight path to see how we can get that leverage down. We normally say we'll get it down within a year, and we've traditionally done that within 6 to 9 months. So historically, we're very pleased with the way that we've managed our leverage. And as you can expect, we will work very hard to maintain that reputation. We also have a mentality that we're only as good as the last deal. So Cognate is a slightly different business to what we normally do. So we've got a lot of eyes and attention on Cognate to make sure that, that goes well. But no, I wouldn't say that it diminishes our ability to do M&A because as I said, we've got the balance sheet to be able to do that. To your CapEx as a percentage of revenue question, clearly, CapEx has gone up. We signaled that at the last Investor Day. It went up by $40 million, primarily because of the Cognate deal. But we've got strong free cash flows. We were able to maintain, at the top end of our guidance, our free cash flow to $435 million despite the fact that we had this $40 million extra CapEx. And part of that is because we had a really strong Q1. Q1 last year was a record breaker for Q1 at $40 million. This year, we had $140 million. So we really smashed through our record in terms of the free cash flow. And in terms of this year, we would expect our CapEx to be under 7% of revenues, which is the signal that we gave at our last investor conference. As to the future, we will say more at the end of the month, on the 27th, when we have our investor conference, and we'll talk a little bit about where we think CapEx will go. But what I would like to say, although it's a CDMO business, this is not a typical stainless steel type CDMO business. A lot of what we do is in 10-liter plastic containers, often on a desktop. So it's not as capital-intensive as people might initially say to do cell therapy. And we'll give some visuals in our May conference to sort of have people see and feel the sort of capital needs that this business has.

Good. I appreciate the differentiation on your present CDMO acquisition versus what people might have a notion about. There was some good color there. An incoming question now that we're talking about the cell and gene therapy space. How have the recent acquisitions impacted your blended end market growth rate now that you've acquired -- with the cell supply businesses and now Cognate?

So how do we -- sorry, can you repeat that?

How have the recent acquisitions in the cell and gene therapy space impacted your blended market growth rate?

Okay. So we have signaled that HemaCare and Solero would be about a 30% growth rate going forward. A little soft this year because it requires donors that come through the door. And of course, because of COVID, you can understand that donors are a little hesitant to come forward. But once we've got COVID a little bit behind us due to the vaccines, we would expect that to continue. I mean, structurally, we think that, that should continue to get a 30% clip rate in the future. [ Hopefully ], we've signaled at about 25%. So our -- the cell and gene therapy acquisitions that we've recently done are sort of 25% to 30%. So that will benefit the growth rate of RMS because that's where HemaCare and Solero sit. And we will say a little bit more in a couple of weeks. If we can just encourage a little more patience, we'll give the longer-term guidance at that point. And of course, while these businesses are relatively small today with those sort of growth rates, it's not long before the compounding impact really makes these businesses a meaningful difference to the both RMS and Manufacturing segments.

Sure. Got it. And going back to a remark that you made early in the conversation, so all in, the cell and gene therapy business is about 10% for Charles River. That's off of, at the end of 2020, 10% of revenue?

It's at the end of 2021. It would be about around 10% of revenue. Because we've only just acquired Cognate and Solero and HemaCare we've only had for a year. But about 10%. And that also includes the legacy cell and gene therapy that we already do. So it's not as if this is the first time we've done cell and gene therapy. We do a lot of that in Biologics already, and we do a fair bit in Safety Assessment as well. Although I would say in DSA, the cell and gene therapy is a little underweight compared to other things that we do in that space. So there is an opportunity to build that out.

Good. And staying on the topic of M&A. And so after the acquisition of Citoxlab, I think that management might have noted that Charles River was likely done with acquisitions in the Safety Assessment space. Is that still the case? Or can you shed some light on the company's strategy when it comes to safety assessment?

Yes. So that follows a little bit from the last comment that we're a little underweight in Safety Assessment in cell and gene therapy. So there could be a tuck-in small deal then. But if we step back a moment, we did WIL Research in 2016, MPI in '18 and Citoxlab in '19. So we picked up 3 of our competitors, who are number 3, 4 and 5 in terms of size, and that catapulted us into the largest provider of Safety Assessment. We're now 50% bigger than the next competitor. And at the time we did Citoxlab, we did say that -- we felt that, that enabled us to have the geographic reach and the specialty reach that we didn't feel we needed to do anything meaningful in Safety Assessment going forward. So we are continuing to build that out on an organic basis. So there's still upside because to my earlier point, there's still more that could be done in outsourcing. And if we continue to provide great service, good science at a sensible price, we should expect to see Safety Assessment at that 60% outsourcing climb. And we would, of course, hope to win share from our competitors if we can provide a differentiated offering, which we feel that we're in a good place to do.

And another one that is being flagged. And so I mean going back to a comment that you made about becoming a one-stop shop and how a feeling that is for biopharma customers. And so Charles River, you're helping biopharma customers and research customers in drug discovery, preclinical toxicology development and now in contract manufacturing services, do you feel that in order to become that ultimate one-stop shop, do you eventually need to become involved in clinical development?

Right. So short answer, no. We still feel there's a lot of opportunity and targets available in the space that we're currently in. Just taking Cognate for instance, in cell therapy it has a small viral vector technology. We could build that out with time. So it's better that we take something that we do and build that out and just get stronger in our wheelhouse than it is to move over to, say, the clinic. Also, the -- within large pharma, the management team within R&D is often split between the clinic and preclinical, which includes Discovery. And the reason for that is the clinic is a very different type of business. It's about working with hospitals, it's about human data, et cetera. Very different to what we're about, which is about inventing drugs and getting you to the position that the FDA will approve you to take that into human into Phase I. So we're not hearing from clients that they see a need to have their clinic and preclinical combined. And I guess we'd have to explore what type of synergies exist in a marriage between 2 units like that. So at this stage, we feel there isn't a need -- well, we won't say never, but we don't see the need at the moment to go upstream to clinic, downstream to the clinic. We still think there's lots of targets that we can do and build out the offering that we have and continue to provide greater and greater service offering, particularly in Discovery to our clients.

Great. And staying on Discovery, if we may. Charles River has partnerships with several companies looking to enable drug discovery through artificial intelligence, technology platforms, including Atomwise, Distributed Bio, which you acquired, and most recently Valence Discovery. Can you talk about why the partnership strategy makes sense for Charles River? And what will have these partnerships played in the development and growth of your Discovery Services?

Sure. So there's lots of technologies out there, right? Some are so early that you can't be certain that they're going to work. And the last thing we want to do is do an acquisition, pay good money for something that clients actually say, "Well, thanks but no thanks, not useful to us." So the partnership strategy is a way that we can get closer to these emerging technologies. We offer them our largest sales force, we train up our sales force and help them sell. Often, we prenegotiate an exit price that we can buy them out, like we did with Distributed Bio. So they get a feel for that they've got a real exit. Now that's why we set up those programs the way we have because we can get client feedback to say, yes, we like this. This makes sense. We want more, and therefore, we can then think about acquiring them. Now specifically to your AI or artificial intelligence-type question, this is really useful in drug invention from a way of looking at the way that the potential drug will interact with the target. So it's a good way of looking at efficacy. Does it work? And definitely, we see a future in AI, in building out the ability to identify molecules that have a high propensity to work. However, then it shouldn't get confused with safety. And that the -- a drug may interact and be very effective with a target, but who knows what side effects it will have when it's put into the human body and can -- and that drug can cascade right across. So I don't think we're going to see AI in the -- maybe in my lifetime, maybe certainly in my career, having a meaningful impact on being able to talk about side effects. So safety, our research model business, I still think has a future because there's no getting around using, unfortunately, an organism to check that there are no unintended consequences of that particular drug.

I appreciate your insights there. Moving on to recent development. So last week, it was reported that the U.S. would support waiving patent protections for COVID-19 vaccines. Can you give us your thoughts on this matter? And do you think that this could disincentivize ongoing and future COVID-19 drug development work?

Okay. So obviously, we all want to protect IP. Our businesses wanted to protect their IP. Clearly, we're in the business of helping them invent IP and protecting it. And clearly as investors, we want to make sure people get a good payback on that. Now there've been a lot of shots on goal with COVID-19. I mean there was people saying we've never invented a vaccine within 4 years. And here we are, we've managed to get that out and into human populations within a year. And that's because there's been so many shots on goal. And many of them have been funded by governments. Modena, AstraZeneca, governments put in a lot of money to make that happen. And so I think it seems appropriate that we want to get this vaccine across the globe because it has, as we all know, a major impact on the total economy. And so clearly, the pharma industry as a whole will benefit from the fact that hospitals can get working on other medical procedures, where the economy has cash to invest in investment side is. In terms of whether it would disincentivize other COVID-19 drug development, there's a lot that's already in the pipeline. And a lot of this is still sold within the Western world anyway. We're talking about passing the IP over to countries that might not -- who might not be able to afford to buy the COVID-19 from the Western world. So my personal view is I don't think it's going to disturb the way we do this because this is now something that's going to be needed probably forever. It's like the flu injection, we're going to need to have variance, et cetera. And I think we're going to see a few players get very good at keeping up-to-date with the new variants.

And staying on recent developments, any thoughts on the potential tax implications from the proposed Biden infrastructure plan?

So we -- so clearly, this is emerging. We don't -- none of us know the details yet. Obviously, we're working hard with our outside providers to keep close to it. Clearly, we have a -- we're a global organization, so we're looking at global tax changes. Our effective tax rate is in the low 20s. Like all U.S.-based companies, we're expecting that the tech liability will go up a notch. And when we do our investor call, I'm going -- I've got another 2 weeks before I need to make a final decision to -- how to position that with our long-term guidance. But clearly, tax is going to go up. That said, our earnings per share compound average growth rate the last 5 years has been 15%. Where it looks, if we're exiting this year at about 20%. So I think our earnings per share can accommodate an increase in taxes, but we'll say more about that in the May conference.

Yes. And so you have that upcoming Analyst Investor Day on May 27. I mean you've hinted at perhaps revisiting the long-term guidance. I know you want to save the best for that event, but anything else that we should be looking forward to in general for the event?

Yes. So the event is clearly going to say a lot about cell and gene therapy and the new acquisitions because we haven't had an investor conference since we bought HemaCare, Solero and of course, recently Cognate. So -- and of course, Cognate, there's a lot of interest in that business, and we wanted -- and when we talk to different people, people at different levels of understanding about what is Cognate, what's its competitive landscape, et cetera. So we're going to use it as an opportunity to try and bring everybody up to a similar level of knowledge. We'll have presentations from the company management team, et cetera. So that's one of the key note items. The next one for those of us that are interested in the financials, long-term guidance. So I'll be giving an update on the sales, the margins, earnings per share over maybe a 3- to 4-year time line. The last time we did our investor conference, we did 2 years, but we really wanted to emphasize the margin. Now we want to get back to where the peer group is giving sort of slightly longer than 2 years, 3, 4 year's sort of guidance. And to our earlier point, I'll try and put that guidance with some thoughts as to what we think Biden's tax reform might do. So we won't leave you hanging in there.

It looks to be a quite useful event. I'm looking forward to that. I guess, my closing question. As we said at the beginning of the presentation, Charles River is in a very strong position. Given the positive backdrop, what is the biggest [ question ] to the company? What could go wrong?

Right. We're always focused on execution. I mean we're talking double-digit growth rates. We're talking thousands of recruits that we're hiring each year. And we're -- have to be really thoughtful on how we hire, how we train, how we retain good scientists and all staff really, given that we've got this strong robust demand environment. So we're not worried that we'll get it wrong, but we do need to stay focused to ensure that we continue to provide great science, great service, responsive to clients, always protect that DNA, the DNA that has helped Charles River double in size, and as we said at the beginning, become a member of the S&P 500. So we really do want to make sure we can protect that. So it's an internal execution type risk that, if anything, keeps us awake at night.

With that, David and Todd, thank you very much. For everybody on the webcast, thank you for your participation, and we would appreciate your support in the upcoming II voting season. This is the end.

Thank you.