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

Great. Well, welcome, everybody, to the Charles River Labs fireside chat. With us today, we have David Smith, CFO. If you have questions, please e-mail them to me at [email protected] or use the question tab in your conference portal.

So with that, let's kick things off. Well, welcome, David. And the first question is the typical question. Can you offer us an update on the business environment? How things are trending compared to the conditions you contemplated in your upsized revenue guidance for 2021?

Yes, sure. So the latest guidance we gave was 13% to 15% organic sales growth, which is actually up from the 9% to 11% that we started the year with. And even when you back out COVID, we're nicely into double digit. And that's translating into earnings per share growth of 24% to 27% and free cash flow of over 30%. So we're really pleased with the year so far. The way I'd articulate why we're getting such healthy sort of metrics is partly because we've got a really strong demand environment. The biotech funding remains strong, stronger -- has been strong for several years now. And the driver behind that is really, there's several ways into drug development nowadays, small molecule, large molecule, cell and gene therapy is a new area, which we're really reaping some benefits from that. Clients are speaking positively, and that's translating into strong bookings and proposal activity. People are actually scheduling into 2022 because they want to make sure that they don't get delays. It's all about speed. And with the CRO market pretty much utilized, people are keen to make sure that they've got the space available. So when we seeing these bookings across biotechs, the globals, it's across pretty much the whole gamut of what we offer. It's not as if it's in pockets. So it's a pretty much all boats are rising type environment. And again, we're getting price. I mean you've seen that we're posting double-digit growth rates organically. This previously where we're sort of a high single-digit organic growth rate organization. So we were getting price at that time. So I think it's a reasonable statement to say that we're getting price when getting to double digits. And the final thing I would say in terms of the demand environment is to do with outsourcing, Safety Assessment, 60%, 65% may be outsourced. We think that, that can get towards 100%. So there's still more headroom to be able to go in that respect. And an interesting fact that -- before my time, that Todd gave me the other day was when we did an Investor Day in 2008, we were saying that about 25% was outsourced at the time. So I did a little bit of math. That average is at about 3% per annum. So that's obviously helping in our growth dynamics as well and the Safety Assessment [ during ] the release. And finally, COVID, that's helping with outsourcing. We were open throughout 2020 when many of our clients were closed. So those clients that felt that we should keep things in-house because that's a safer way of dealing with our development pipeline, while we were available when maybe they weren't. So I think that's changing some dialogue within clienteles that outsourcing is here to stay. And finally, Discovery is about 25% outsourced. We've been building out a nice portfolio, then we're seeing nice traction on the services. So all those dynamics are coming to play to give us that -- those nice metrics that I started the answer with.

Okay. And we'll touch on this further in the discussion, but that 3% outsourced -- incremental outsource penetration and safety assessment you've seen per year. Is that accelerating in the future as a result of the pandemic? And it's a broader question around structural impacts of the pandemic, but very specifically, I'm curious what impact it has on that 3% per year outsource penetration?

Yes. So I wouldn't want you to say -- feel that it's a sort of a linear progression. It's not really a metric that's easy to get your hands on and have an accurate data point as to the exact amount that's outsourced at any point in time. We know that broadly, we said approximately 25% in 2008. And we're saying broadly somewhere 60%, 65% today. How that's moved across time, difficult to say. What I would say, though, is about the COVID incident where clients were temporarily closed when we were open. For some clients who thought that it would be safer to have that resource in-house, I think that's changing the dynamics of the conversation. So I think people are -- having seen and witnessed what CROs like ourselves were able to do during this period, I think the answer to that, actually, we are robust. We are solid, during typical times we will be available to the customer. That is probably going to help accelerate the conversation for those clients that felt it was better to have it in-house. We are seeing some companies have completely closed down their safety assessment for instance and completely outsourced it. And there are others at the other end of the spectrum who still feel it's better to have it in-house. But I think what we've seen in the last 18 months will continue to encourage the outsourcing. And I can see us continuing that trend towards the 100% that we think is possible in the medium to longer term.

And have you seen incremental companies in the last 18 months completely close down their safety assessment? Or was that a broader comment over time, you've seen that?

That's a broader comment. We've seen that, and we can't talk about it. AstraZeneca is a client of ours who did just that. Once upon a time they did it all in-house. And they came to a point where they felt actually there are companies like Charles River and others who have a good suite of offerings right across the gamut, and felt that they didn't need to do that in-house and therefore shut down their internal fabric. And we do that work for them. And you've seen other companies sometimes toy with the idea of keeping a little in-house, outsourcing the others. They're certainly not expanding their facilities. So we'll see with time -- those remaining clients that are doing it in-house. I think we'll see them use more and more of our services. They are already using it for specialty services. Now there are services that we can do that they don't do in-house, of course, they outsource for that. We could give them a good experience, good price, it encourages them to consider outsourcing more and more. And we've seen that nice trend, which is what I was articulating with the data that I just shared with you.

And then again, on the business environment, can you remind us how sensitive you'd expect Charles Rivers' bookings activity to be to -- fluctuations in capital markets. So Q2 was a bit slower for capital raising for biotech than Q1 and Q4. Does that influence your business at all?

Not really, not on the short-term time frames that the community we're talking to today, I know you look it on a shorter time frame, but in the economics of our business, the funding flows is directional. So at the moment, you get different outsourced groups. We've done some calculations ourselves, you get a range of 2 to 4 years of cash on the balance sheet, some are high, some are lower. But broadly, they've got the cash because of the continually strong funding that we've seen in recent years that if there was a short-term correction, they still have the cash to be able to feed the work that we're doing. So no, we never see quarter-by-quarter change in the funding flow, doesn't have a meaningful -- any impact on us because the cash is in the system.

Okay. And your comments that you'd be in double-digit revenue growth in 2021, even without the COVID work you're doing, is it fair then to frame the magnitude of the COVID revenue contribution in 2021 as a low single-digit number?

Yes, we've actually called it out. It's about -- it's over 200 basis points impact. And broadly, that's because of the impact of Q2 in RMS, which is where most of the, if you like, the tailwind that we've got. Q2 last year in RMS was a very difficult quarter for that unit. It helped demonstrate the power of a portfolio that Charles River has because DSA manufacturing helps support us throughout the year. So if you look at the year numbers in isolation, you might not notice that we had a really chronic program in RMS for Q2, that's obviously bounced back this year. And that's obviously given a rise in the organic growth rate because it is an organic problem. But [indiscernible] 200 basis points. So even when you take that out, we're still double digit.

And remind me how you expect that 200 basis points of revenue to trend over time?

The -- on the -- for next year, a 200 basis points on the COVID-related impact will go away because RMS has rightsized itself in 2021. So you've got a sensible comparison for '22 to 2021. So from that perspective, not an issue going forward. The wider answer is that we are benefiting in biologics because there are work that we've been doing in the vaccine, COVID-related aspects, and we can see that being a need in the foreseeable future. But that depends on where the boosters are needed, et cetera, how that pans out. And I know there's still a debate as to whether the boosters will be used just for the elderly and those at clinical rig or whether it will be rolled out to a wider population. But we are benefiting in the biologics a little bit there. But the wider but -- without distracting us from this question, the wider biologics growth rate is really to do with the selling gene therapy. It's not really been driven primarily with that team alone. So even if that goes away, we still feel that biologics is in a strong position to continue to have some good and spectacular growth rates in the foreseeable future.

And I want to move on to cell and gene therapy, but before we do so, you mentioned structural impacts and Safety Assessment outsourcing as a result of COVID. Are there any structural impacts to the RMS business or manufacturing support that you would expect to see as a result of this pandemic?

Yes. So RMS was a lot of academic customers, et cetera, have closed. And as a consequence of their closure, the demand on research models fell considerably in Q2 last year. We saw them open up rather quickly. We've seen them remain open. I don't perceive that there will be another chronic lockdown. If there is, well, we'll have to see how those clients react. I would imagine many companies have now found a way to stay open even if there was another lockdown. But we're not -- we don't see another lockdown on the horizon. And even if there was, I think the clients have found -- will probably have found a way to stay open, right? So we don't see that one potentially repeating itself. The other area that we had some headwind was in Microbial. We were unable to access sites to put in new machines. And I had a bit of a haircut on the double-digit growth rate that Microbial had foreseen forever. And in Q2 this year, we were able to report that it was back into double digit growth. So what we've got is in Microbial, you install the machine. Once the machine is installed, the clients will then buy a consumable. So Microbial still did well during 2020, but not as well as a -- not a double-digit growth. Because, of course, we're still selling the consumable aspect of that business. So now we're able to prove that our staff have had vaccines or they can -- testers whether we've got the viruses, we're walking through there onto their premises. So it's becoming easier for us to install the machines. And as a consequence of installing machines, we've seen Microbial return to double digits. So again, I think now with new testing opportunities, I don't see that reversing gear going forward either.

Okay. Quickly on Microbial before we move on since you just mentioned it. How long can double-digit growth continue? Where do you think you are from a penetration standpoint in that market?

We think there's a long runway. I mean, our, if you like, key selling point, is that we can find a bug in the system and you're manufacturing within hours, whereas a lot of the competitive technology it can take days. So if you created your product and you're sitting in a warehouse waiting for that to be released, you have to wait a few days before you've actually got the confirmation that you didn't have a bug when you were manufacturing it. With ours, it's days. But there is a cost to switching from your legacy systems to our systems. So there's a lot of opportunity out there. So we still feel there's, certainly in the foreseeable future, great opportunity double-digit growth to continue. As we educate clients about the benefits that we have and they then make the switch -- sometimes clients will make a switch on one site, they'll try it out, like it and then make the switch on other sites that they've got.

Okay. And has there been any change in the competitive environment in microbial that's crossed your radar or no?

Nothing that we feel we can't handle or have a ways to address. So at the moment, we're feeling good about that franchise. It's FDA regulated as well. So there's a barrier of entry. The manufacturing of the cartridges, et cetera, is not easy. So that's a barrier of entry. So we feel as if it's a nice franchise, nice protection. And as long as we continue to provide good quality services, that should continue.

Okay. I have a question here from the audience. Demand for Safety Assessment services is very high. Can you speak to the industry's supply response?

Supply response. I mean, the industry as a whole is buoyant. It's not as if we're doing well alone. We know that capacity is well-utilized by us and by our competitors. We -- just talking about capacity for a moment, we have been a high single-digit growth rate in Safety Assessment for some years, and we've been building out capacity there, well within the sort of the numbers. So it's not as if you notice that we're building out that capacity. We've moved to double digits. So clearly -- or we've moved to double-digit this year, we're posting for the long term, approximately 10% in DSA. So there's more capacity to build out. But we're not building new greenfield sites. We are able to make use of existing sites. We've got some sites where there's a shell and that shell is empty and we can move into that shell. We've got some sites where we have land adjacent and we can build there. And the consequence of the benefit of that is that you've already got the protocols. You've already got the management team. You've already got the know-how. It's already vetted by customers. We get customers coming in on a very regular basis, checking the processes that we have. So they're comfortable with those sites. So all we're doing is really expanding them. So we don't see the need to build a new greenfield site in the foreseeable future. It's cheaper just to build on the sites that we've got. We're right across the globe. So we've got a nice, good reach for those clients that like to have it local because they can just pop in, not during COVID, they were using video. But normally, they would pop in and have a look at the way that the protocols are being dispensed, et cetera. So we're -- no one's out there building out supersites as we did back before the last credit crunch. So I think there's a sensible response to the demand curve that we're seeing. And it's good that there are others out there that are providing good quality services because the game in town, as we mentioned earlier, is if we're all providing good quality, there's no reason for clients to have it in-house. This is something that could be fully outsourced. And so we and others are providing good services. They will continue at sensible prices at prices that they can't do it internally as efficiently, which is true. It will encourage more of them to shut down and make use of not just us but others.

Okay. So moving on to cell and gene therapy. Could you remind us the importance of the cell and gene therapy field to both your business and your growth outlook?

Yes. So we have been doing cell and gene therapy. It's not as if the new acquisitions that we've done sort of last year, this year, is new. We've been doing cell and gene therapy in Safety Assessment. I would argue that it's underweight compared to what we might be able to do in Safety Assessment, but we're continuing to expand there. So we were looking at the wider cell and gene market with that internal expertise. We looked at some -- had some outside expertise as well. And the conclusion is we do feel that cell and gene therapy is a mechanism drug development that's here to stay. So in addition to small molecule, large molecule, we felt, okay, strategically, we need to be into the cell and gene therapy space. So last year, you saw us buy HemaCare, Cellero, which is basically a way of patients coming in, we can take bloods and we can then spin that and we can pull out the components that are used in research. And this year, you've seen us buy a couple of CDMOs. And I think it's important to distinguish when some people hear CDMO, they're thinking, "Oh, they're thinking of small molecule and large molecule CDMO space," which is different to cell and gene therapy CDMO space. First of all, there's less than 10 products actually approved on the market, right? There's 3,000 in the preclinical space -- sorry, in the pipeline, 2/3 of which in the preclinical space. So there's an awful lot coming through the pipeline and more and more will be approved by the FDA and move into the manufacturing space. So what we've bought is a couple of units that are primarily at this moment in time dealing with the clinic, the preclinical work, they're not actually manufacturing for dispensation to patients yet, right? But that will come as more and more FDA approvals take place. And so we see that this is a emerging CDMO type space where there is no clear leader in that space. We could be one of if not the leader in that space in 5, 10 years' time, whereas we could never do that in the small molecule, large molecule space, that's already saturated. So you take Cognate for instance, which is cell therapy, right? There's WuXi, there's Lonza, they are in this space, too. There are of similar sizes in terms of the revenue, right. So you could say it's a 3-horse race in cell therapy. So we think that we've got in at the ground in terms of the cell and gene therapy space. We've also got biologics, which is doing cell and gene therapy in terms of validating the processes, validating that what you believe that you're producing to either go into the clinic for testing or into manufacturing into the patient. And that sort of QR -- the quality control testing, QC testing that we do in biologics, we can bring to support the work that's coming out of the CDMO space that we just bought, Cognate for instance. So there's something that we're bringing to the table. And then if you move further upstream, you've got Safety Assessment that's doing the testing, and then further upstream to that, you've got the HemaCare and Cellero which is producing the research tool. So what we're seeing is a really good interest from our customers who have been saying it's great to see somebody pulling the different pieces together so that it makes it easier for the clients to go for a one-stop shop. At the moment, they have to buy the pieces from all over the place, a little bit like Safety Assessment 20 years ago, right? But now we see that we're the larger provider of Safety Assessment. There's really very little that we don't do. And even in Discovery, which was pretty bouncy and lumpy when we started, we've been consolidating the discovery space, bringing in different technologies, et cetera, to the point that it's -- it's sort of balancing off now and clients know that we do discovery. And if they want to do some discovery they say, "Well, let's at least call Charles River because they may have the solution," right? Whereas 5 years ago, some of them didn't even know that we did discovery. Same thing with cell and gene therapy. We want to get to the point where customers know, "Hey, Charles River does cell and gene therapy. We have this issue. Let's call them and see whether they've got a solution." And I think that's where we're going with our strategy.

Okay. I think you did a good job of describing your right to win in that market. How would you describe how differentiated the CDMO assets are that you've acquired? How differentiated can an asset be in this space? What does the moat look like beyond cross-selling opportunity with your QC and some other parts of upstream portfolio?

So as I said, I've already called out that Cognate, there's only 2 other competitors, we're all a similar sort of size. I mean you have to remember, this is an emerging space. So the competitive opportunity here is providing a wider suite of offering. So without calling out a couple of competitors, their offering isn't necessarily as wide as what we're doing, nor have they necessarily signaled that they intend to be big in this space. We've been quite clear. We intend to do more in cell and gene therapy. We already do cell and gene therapy in other parts of Charles River. Those scientists can talk, cross-collaborate. It's kind of the 1 plus 1 is more than 2 kind of scenario. When you start putting the pieces together, it gets easier to understand the complexity of it and to convey that to clients and help clients -- we've got more scientists involved, there's more opportunity for cross education, et cetera, as we go through what's quite a complicated field, right? So there, we're in a good position. Now it's harder in the -- the plasmid or the vector space, there are bigger players in that. So that's where you've got -- in the vector space, you've got Thermo Catalant; in the plasma space you've got Aldevron. They are bigger players. But these are ingredients. So what we've got with Vigene is the ability to get the ingredients that are part of the cell therapy development that we've got in Cognate. So the jigsaw pieces is coming together as we build these -- pull in these acquisitions, cross share the skills, et cetera.

Okay. How would you describe your appetite to compete with the bigger players in vectors and plasmids?

Well, we bought a company in that space. So we're clearly going to give it a good shot. As an outside group had said to us, they may be big, but that doesn't mean that they're perfect and that there is space for a fast follower. So we will see whether we can provide a better quality offering. Also, you have to bear in mind that we have many, many services. And there are particularly with large -- with larger clients, not necessarily the smaller ones, but with the larger clients, sometimes they reduce the number of suppliers that the scientists can use. So we have some of that says, "Look, you can use 2 or 3 suppliers," right? And of course, we're often on that list because we offer so many services to the scientists. So the other thing we're seeing is that when we acquire a company, and this is pretty traditional, when we acquire a company, the clients that they have often end up buying services from elsewhere within Charles River because we connect in the sales force, we can cross-sell by saying, "Oh, well, actually, you know this problem? Well actually, why don't we introduce it to somebody else in Charles River that can maybe help answer that question that you've got?" And the final thing I would say, this is about science to science, right? If you've got good scientists who are, if you like, respected by the client's scientists, that there's a good relationship between those 2 groups. Then as long as the pricing is sensible, they won't want a third [to do it]. If we can provide good quality science as we have done, then that can be an ingredient to success, even in this competitive environment that we're in. And it's not as if we're not used to strong competitors, Covance used to be larger than us. 20 years ago, we didn't do any safety assessment. Covance was the big dog, right? We're now 50% bigger than them over that 20-year journey. So it is possible to displace the big dog if you do it well.

That's a fair point. So to wrap up the cell and gene therapy discussion, can you remind us what proportion of your revenue is cell and gene therapy services and products and at what rate you see that growing?

Yes. So it's 10% of our revenue as we speak. And the CDMO acquisitions are expected to grow at north of 25%. And the HemaCare, Cellero are expected to grow north of 30%. So let's be conservative and say CDMO will be growing at 25% as a collective or more. So relatively small revenue today, but at a 25% multiplier, it's not long before that can grow quite well. And indeed, just a quick side note on that, which I think is relevant, is you could look at Charles River and say, we used to be a high single-digit growth organization. And now we've moved -- legacy business is now double-digit because the 13% to 15% organic sales that we talked about this year doesn't include the CDMO acquisition because they're not part of organic yet, won't be until we anniversary those next year, right? So we've got -- even if we had a headwind on our legacy business, you could argue that the CDMO businesses are providing a bit of a hedge in that their growth rates are such that could maybe offset some of that headwind that we see in the legacy businesses, which is why we feel comfortable we can post double-digit growth rates out to 2024 in our long-term guidance, because you've got these nice businesses that we bought, which will become more meaningful to the growth as time passes.

Would you anticipate any headwinds in the legacy business?

No. So we're not anticipating any -- I mean, if you ask me what could go wrong, I mean we could have a chronic economic downturn. We could have maybe a group of drugs are found to be not faulty or whatever. I mean these are black swan type events that are outside of our control. So by definition, I can't control a black swan event. But we -- everything we're seeing, the funding flows, the client dynamics, the creativity of scientists. The other thing I would say, academia and hospitals are getting very good at spotting areas of opportunity and translating that into economic benefits. So I -- we feel there shouldn't be a disruption, but you can never say never.

Okay. Well, with that, we're out of time. David, thanks a bunch for your time today. Thank you, everybody, who dialed in, and everyone, have a great day.

Thank you. Thank you very much for your time, too.