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

Hey, everyone. Good morning. Thanks for joining us at the Morgan Stanley Healthcare Conference. I'm Tejas Savant, and I cover the life science tools and diagnostics sector here at Morgan Stanley. I'm delighted to have Charles River join us this morning. And representing the company is Jim Foster, Chairman, President and CEO. So welcome, Jim.

Nice to be here.

Before we get into the Q&A, I just wanted to quickly rattle off my safe harbor. Please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. And if you have any questions, please do reach out to your sales rep.

So with that, thanks for joining us again. To set the stage, Jim, can you give us a snapshot of Charles River 5 years ago versus the Charles River of today? How has the company evolved in your mind? And what are some of the key accomplishments over the last couple of years that you're most proud of?

Great question. So we've doubled the size of the company over the last 5 years from a revenue point of view. We've enhanced the profitability and we have dramatically enhanced our portfolio. Don't know what the acquisition count would be over the last 5 years but probably 15 to 20 companies we bought. So we bought several players, sort of second-tier players in the Safety Assessment business, which makes us the world's leading player. We bought several businesses in the Discovery space. We've really built a significant business there. We've enhanced our Biologics business, and of course, we've done 4 acquisitions now in the cell and gene therapy space. So the portfolio -- look, the strategy has been, for a long time, to have the broadest gauge portfolio possible, nonclinical at the moment, so far, nonclinical portfolio; to provide products and services, mostly services, but also products as much of pharma and biotech that want to and need to utilize those products and services. So we've become a very critical part of the whole drug development universe. And I would say without us, and without us, none of the 4 vaccines, for instance, would -- COVID vaccines would have gotten to market, just as an example. And of course, we worked on 80% of all the drugs that are approved over the last 4 years. So it's a strategy we will continue to invest aggressively from an organic point of view but also through M&A to continue to expand portfolio scientifically and geographically so that we can be a more holistic provider.

Got it. Two interesting things that have come up. I mean, recently, one of it, you actually mentioned when you said perhaps expanding into clinical. And then the other question we often get is, is Charles River's interest in the CDMO side of things restricted to cell and gene therapy? Are you interested in the space more broadly? How do you think about sort of those 2 aspects of the story?

Well, those are the 2 areas where we could make a big move, I think that's pretty obvious. We had the clinical business and we had a CDMO business, both relatively small. On the clinical side, we didn't think the clients care. In other words, we didn't think the clients actually wanted someone to do the preclinical and clinical. That could change, which is why I always leave the door open. But hasn't so far. Never had a client say, "You know what, you're not getting the preclinical work because you couldn't do the clinical or vice versa. I'm not going to let you do the clinical work unless you understand the drug from a preclinical point of view." So that never happened. On the CDMO space, which we try to avoid, I actually try to avoid it because it's a pretty crowded field and there are some gigantic players. And we like to be the leading player in whatever we do, if possible. We are in most of our businesses, as you know, but not all. There was a pretty overwhelming demand by our client base. We really want you to be in the cell and gene -- particularly, once we bought those 2 cell product companies, "We really want you to be in the CDMO space because you're providing us the cells, then you're going to test the product. Your Biologics business is going to test the product after you manufacture it. But we have to go elsewhere to manufacture, and we're going to lose time. And so we'd like somebody to understand the molecule really well." So a lot of demands and the clients said, "There really aren't enough players. They aren't all that great. We really would like you to get into this field and improve it." So we feel that the cell therapy manufacturing side is kind of a thoughtful niche move on our part. We are already a major player. I think we could be the principal player and lead player in cell therapy. And the gene therapy side, I would say, is restricted more toward the gene-modified cell therapy aspects and providing the products, and products for others to do straight-up cell -- sorry, gene therapy manufacturing like plasmids and the viral vectors, all of them. Although I wouldn't close that door entirely, I would say it's not -- it's not the major focus that the gene therapy space feels more crowded and that there aren't any more major players. And I think we can really have a significant business in the cell therapy side. So that's why we move there. And so that was based on client demand. Unless the client demand changes on the clinical side, we probably will stay out of it.

Got it. Fair enough. Quick question on the macro picture. R&D budgets are on sort of extremely healthy footing here. The one question we get is how much staying power is there, if there's a bit of an air pocket for a couple of quarters? So wanted to get your take on that. And secondly, beyond just the budget aspect, outsourcing penetration, where do you see the most opportunities for Charles River to ramp up that penetration and perhaps even gain share from a lot of that long tail of private CROs that are doing niche work?

Yes. I think we're taking share all the time, both from current competitors who don't have the capacity or the depth of science or the sophistication that we do. And obviously, there's a whole bunch of de novo work all the time. There's several hundred new biotech companies every year, which are becoming increasingly small or smaller in terms of the headcount, what they want to spend on internally. And so I think this is a long, steady climb. I think on the safety side, we've said for years that we think that share could be 80-plus percent of what's outsourced. I actually think it could be 100%, subject to the caveat that there's some second-tier pharma companies, particularly European ones, that probably will always do things internally. So probably we'll never get quite to 100%. But I think the client base has shown and our work has shown that there's no need for the clients to do it themselves. In fact, we do it faster for a lower price point and I think better science than they do it. And so -- and they're quite adept at supporting the work even if they don't do it all internally with the FDA and other regulatory agencies. I don't see any air pockets coming anytime soon in funding. That's been the question du jour of us for at least a decade now, it's kind of, well, this can't continue forever. So what are you guys going to do when biotech funding dries up? Fair question. It's not drying up. In fact, it's becoming more pronounced, more intensified, more aggressive money coming directly from the capital markets and from big pharma directly and less work being done internally. So unless the modalities don't work, I guess that's possible but unlikely. Let's say, it actually don't work unless people aren't getting better or aren't being cured. And the companies don't become real companies or -- and/or the drugs don't get bought by larger companies, I don't see any logical rationale why this won't continue to be a fertile place for investors to put their money in.

Got it. On the 2Q call, Jim, you mentioned sort of booking work into next year on the Safety Assessment side. Are you having to turn down projects because of near-term capacity constraints? And has COVID, in general, been a net positive for you here in terms of winning share?

I don't think COVID's been a big issue at all on the Safety Assessment side. Maybe a little bit in Discovery, mostly when things were really shut down. So probably got a little bit of a pop from some new clients in Discovery, maybe a few in Safety but not much. So I would say that, that hasn't been a big issue for us at all. I think that...

I guess my question was more along the lines of, Jim, have competitors now sort of have to take a step back? And has that opened up some opportunities for share gain or perhaps some of your customers shut down Safety Assessment and so on?

Probably, probably. And I think most of our competitors just talk about Safety, which is our biggest business, a much smaller. I don't think it's definitely not as well financed and they have kind of a trivial amount of capacity to begin with. So I think -- and I'm okay with this. I think the capacity is probably pretty tight from a client's point of view. Clients are booking safety studies, where they were at the end of the second quarter, definitely continuing to book into next year. As long as they book into next year and don't go elsewhere and don't go inside, that's a good thing for us. Better visibility, better predictability, better ability to plan both for headcount and capacity, so we like that. Also, in the inevitable event that some studies slide, slip, we call it slippage because the drug isn't ready and/or a few of them cancel, it's nice to have work in the queue to fill in. We probably can't accommodate -- just to go to your beginning, we probably aren't accommodating every bit of business. But we're probably passing on things that clients don't want to pay us appropriately or work is not complex enough. And the fact that we're booking things into next year, I do think, is a commentary on the fact that lots of clients will wait. So -- and it kind of feels like the capacity utilization and available capacity and the leverage that we have, the amount of time the clients are waiting, feels good, actually. We're getting more price. We're having more collaborative conversations with clients. We're on the same side of the table in terms of being privy to their plans for next year and the year after. as opposed to here's a study, do it, then you don't hear from them until the next study. So we really like the way it's evolved.

Got it. And Jim, in terms of just the cross-selling opportunities between Safety and Discovery, where does that sort of stand today? It's about -- I think it's about sort of 45%, 50%-ish. How high do you think that could go over time? And is there sort of a natural ceiling there because clients just prefer, some of them at least, to keep the discovery portion in-house?

So I would say that there's no logical reason -- while every study that's externalized for discovery purposes. So the client, let's say, does a very, very early discovery and we do the latest-stage discovery. If the drug continues to look promising and continues to be developed, there's no logical reason I can think of that you would go elsewhere to do your tox work, except if we're full, you, for whatever reason, had a bad experience with us and don't want to work. In some rare occasions for some of the big pharma companies who still do tox themselves, I suppose, they may have a preference to do some of the work internally for whatever reason. But besides that, I think there's very few reasons why we shouldn't be able to retain it. And from a speed point of view, from a development point of view, from a competitive point of view, I think for the clients to move quickly from our Discovery work and for our Safety work to begin to book a slot and know that the minute we go in Discovery work, we're going to hand it off, I think it's actually pretty essential. So I don't think there's any artificial limit or cap on what percentage that's going to be. And of course, a lot of where we are now is merely -- I mean, Discovery is still a relatively new business for us. We've been in it, basically, about a decade. We did a bunch of acquisitions. The business has pretty good scale now and deep science and good [ internationalization ]. I think it's just been clients knowing that we do it, having the drugs prevail and understanding that we can also do their safety work for them.

Got it. Switching to manufacturing support here and specifically cell and gene therapy, Jim, something you mentioned in your opener as well. Paint a 5- to 10-year picture for us in terms of what Charles River's involvement in the cell and gene therapy space looks like. As the industry matures, I mean, you only have a handful of commercial scale products today. As more of those come through the drug pipeline and scale up, will you scale with them?

I mean, it's going to be a very big business for us, so it's more than 10% of our revenue right now. The cell and gene therapy demand is growing at least to 25%. That could intensify even more if and as these drugs prove to be successful, beneficial, as you said, there's -- I think there's only been 8 approved even though there's 3,000 in development. It's going to bring with it a lot more work. And most of the -- or much of the work is coming from small biotech companies who have no internal capabilities. So if you do the math and your math capabilities far exceed mine, if you take kind of our current growth rate and you drop on top of that kind of 25% growth rate for cell and gene therapy, it will grow disproportionately fast, which means we'll have a disproportionately greater -- become a disproportionally greater percentage of the whole. So yes, it will continue to be a major area of focus, a major area of investment and probably continue to be an area of further M&A investment as well.

Got it. And as you think about sort of Vigene and Cognate, I mean, can you walk us through your plans for CapEx there? I mean obviously, at the company-wide level, you spoke about sort of 7% in CapEx in '22. What proportion of that do you envision being tied to the businesses?

I don't know the exact proportion. We never break it out. You can sort of think about the proportion of CapEx being similar to the proportion of each business as a part of the whole. So we spend more in CapEx in Safety than anything else, for instance. So that's pretty obvious. The CDMO space is not trivial from a CapEx point of view. Having said that, the cell therapy part of CDMO space is way less capital-intensive than other parts of the CDMO space. And we are sizing it, anticipating that the 7% includes further investment in the CDMO space as well. So we like our capacity now. We have a fair amount of unused space in that business. We have plans for further space in that business. We obviously hope that our clients who are now in the clinical phase, that several will move into a commercial phase, which will mean larger amounts of work, more steady revenue base, perhaps greater profitability just because of the scale. So we're quite confident in our ability to accommodate the growth rate, given that 7% number that we just threw out in the second quarter.

Got it. This just came in over e-mail actually, I mean. On the plasma side within Cognate, how do you compete with some of the larger players in the market, Jim? And -- or is the market sort of supply-demand imbalance so acute that it frankly doesn't matter at this stage?

There's definitely a supply-demand imbalance. So the demand is dramatically exceeding the supply, which is a great place to be as a provider. There are bigger players than us, one in particular, but there are bigger players than us. I think that we will compete on a quality basis. The quality of our plasmids is quite high. We'll compete on a geographic basis and where we're providing them. We'll compete because of the Charles River's name and the connectivity with plasmids with the rest of our portfolio, vis-à-vis the ability to buy more products and services from the same provider. So it's definitely not a crowded field. It's a relatively small number of players, given the amount of demand, although it's kind of an imbalance in terms of the scale. But we have both the financial wherewithal to make significant investments to grow that business to continue to be a more meaningful part of our cell and gene therapy portfolio.

Got it. On future M&A within cell and gene, I mean, there's 2 directions in the sense that you can go in, right? One is adding new capabilities and the other is perhaps expanding into new geos. That's something you've mentioned in the past around sort of co-locating with your customers and the importance of that. How are you thinking about those 2 buckets? And any thoughts on just valuation here for cell and gene therapy targets, given all the interest in the space?

So we, for sure, will grow this business geographically. I don't think that's optional. Like our whole portfolio, proximity is often very, very important to clients, all things being equal, assuming the science is great. We, for sure, will do that organically because that's in our control. And I think we can accelerate it and scale more quickly if we do some M&A like we did with Vigene and Cognate. So we hope to do both. We can't predict with any certainty our ability to get targets, M&A targets. We have to prevail. We have -- the price point has to be rational and we need to really respect the management team. Obviously, the valuations are full in this space. But if you've got a business growing at 25% or 30% with escalating operating margins, that's really not a problem. We have very, very rigorous financial models that we put all of these acquisitions through. We don't wing it. We don't guess. We don't push our models to the limit. We don't take a lot of risk in terms of holding ourselves up to miss them. I think our track record for the last, I don't know now, 5 or 6 years has been pretty good. I don't want to jinx it. We're very thoughtful about it. So everything else has to line up and the numbers have to work. Science has to be great, and the management team and the culture have to be like the rest of Charles River. I do think we have a lot of first-mover advantage. So we have conversations with clients, with prospective sellers earlier than most of our competitors. We also can close deals faster than most of our competitors. And by the way, most of the competition for deals right now is financial and not strategic, oddly enough. And while they have a lot of money chasing not a lot of deals that obviously don't have any synergies, and they don't really move as quickly as we do. And while we may lose some deals, I think that we have a really good chance of prevailing. So look, we've done, whatever it is now, 55 or so acquisitions since we took this company private. It's been the principal distinguishing feature in our portfolio versus the competition. It's held us in good stead, so we will continue to do M&A to the extent to which we find good targets.

Got it. A couple of quick ones on the rest of the manufacturing business, Jim. I mean, how are you thinking about competition in this space within Microbial Solutions? There's a couple of entrants with perhaps a more fully automated workflow and promising higher throughput that have made inroads into that market. How is your positioning there? And then on a near-term basis, with the resurgence in Delta, have you seen any sort of near-term headwinds around customer site access at all?

So no near-term headwinds, and I don't anticipate that will change. So we're getting access in both live and virtually, so things are getting installed, all good. We've got some technologically based competitors, both in the endotoxin part of the business and in the bioburden part of the business. Some of those are bigger customers -- sorry, companies than we. The technologies are interesting. On the endotoxin side, this recombinant Factor C technology is, I guess, promising, but at the moment, regulators are not allowing it because it's not comparable to basic LAL, and there's some risks associated with that. And we don't have any competitors right now that provide products in both -- in endotoxin, bioburden and ID. So we also can tell the client not only that they have a contamination but what that bacteria was. We have this huge library that allows us to do that. So look, we -- that's the -- probably the only business in Charles River that we do pure R&D. We have a lot of IP. I think we're multiple generations ahead of some of our competitors, particularly in the endotoxin field. Very high-growth business with incredible operating margins. And yes, we are cognizant of the competition but I think we're doing quite well against that.

Got it. Switching to RMS, Jim. On the research model side, obviously, China is probably the most important growth driver there for you. Is that sort of the demand broadening out? Or is it you guys taking share from local players that's the most important dynamic for you?

Definitely both, probably more just new business. So massive investment by the Chinese government and a whole host of new biotech companies and kind of improving and enhancing the pharma industry, meeting basic building blocks to do the research like research models; well financed but very unsophisticated local Chinese competitors who tend to get into trouble really early with contaminations and don't really understand what it's like to have a live inventory and how you manage that inventory and how you ship those animals and keep them healthy. So we're enjoying a whole wonderful growth rate there, somewhat closely tied to building new facilities, so moving to the middle of the country, so west and south and China, I think it's [indiscernible] said, so both. And I think that's a long-term trend.

Got it. And then on the services side of things, what's sort of fueling the growth there for your GEMs business?

Just the increasing importance of genetically engineered models to basic discovery to give you just better translatable information from the early animal work that is likely to prove to be true in clinical trials, getting very, very sophisticated and elegant animal models with multiple genes that have either been knocked out or embedded so they express certain disease states. So -- and the models have become increasingly more sophisticated. And the work kind of work we do, it's just not the type of work that our clients would readily do or be comfortable doing or it could add a lot of value. And so as the importance of the models become more pronounced, our services have been more important. And COVID definitely was an accelerant to the GEMs business, where people were flat-footed and thought, "My God, we're going to be shut down. We don't know what to do with the animals and we can't count on ourselves going forward, again." And so we definitely got a little pop there, which I think will continue.

Got it. A couple of quick ones here that came in again over e-mail. Do you see enhancing your big data/AI investments as an imperative for maintaining growth? And if so, can you just elaborate on what you're doing there?

I think directionally and intellectually, it seems obvious that AI and machine learning will be an important part of the drug discovery paradigm to learn from things that you've done before and design better trials, both preclinical and clinical and probably accelerate the process. You probably see that more in the discovery phase of drug development. We're going to place a bunch of bets, I don't know how big a bunch will be, but a bunch of different bets in aid, specifically in AI, machine learning, bioinformatics, 3D modeling and with very cutting-edge technologies in these small companies that allegedly are disruptive. And we'll see whether the technology really works. We'll see whether the clients actually like it, validate it, will utilize it or just think it's kind of interesting academic work. I think it will have some beneficial impact. I don't think it's going to be a big change anytime soon, but we're going to definitely participate in it with the opportunity to buy these companies, which is the way we structure most of these deals if a technology looks promising.

Got it. One last one on just your long-term growth targets. I mean, you outlined sort of a path to low double-digit organic growth. What are the most important swing factors in your mind, Jim, as you look at sort of 10% versus 13% growth? And given these -- the acquisitions of Cognate and Vigene that you mentioned sort of growing at a robust double-digit range, significantly higher than low double digits, is it fair to say that we should see upside to that number once they anniversary out?

I hope so. We're growing 13% to 15% this year. That's a pretty good number organically. We're going to continue to add capacity, both human capacity and space and continue to do more M&A, I believe. So look, we're poised to grow the business as quickly as possible without impairing the quality of our science and with also being able to improve our operating margins faster than we are on the top line. So we'll see. I don't want to get ahead of ourselves in terms of changing that, but we're certainly comfortable with both that short- and long-term guidance right now.

Got it. And one final one that came in again over e-mail here. On the margin line that you just mentioned, sort of the importance of improving margins over time, you've got some of these acquisitions weighing on manufacturing margins. You've also got sort of, I guess, a significant bounce back within RMS versus last year. As those dynamics normalize, how do you feel about sort of the margin trajectory heading into '22?

We feel positive, as we said, in, whatever we gave, 3.5-year guidance, so we continue to improve our operating margins. I think we said 50 bps a year. I Feel Very confident that we can do that. Pricing is strong. Capacity is well utilized and the businesses that are headwinds now should continue to improve over time, both with scale and operating efficiency. So yes, we feel quite positive about it.

Got it. Just to wrap up, Jim, are there any other aspects of the story that you feel are sort of particularly underappreciated by investors? What are you most excited about sort of heading into '22?

We continue to be excited with the fact that our role in drug development is increasing; that we are a more critically important provider to a whole host of companies, both large and small; that we have the opportunity to continue to enhance and improve and expand our portfolio to be an even more holistic provider. We like the strategy, it's working well. We like the relationship we have with our clients and the confidence that they have in us. We also feel pretty good about our ability to not only find deals for M&A but to integrate them well. So yes, we're really optimistic about '22.

Awesome. That's a great place to leave it at. Thank you so much for your time this morning, Jim, and I hope you enjoy the rest of the conference.

My pleasure. Always a pleasure. Thanks so much.