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

Okay. Jim, I think we're live. Good morning, everyone. My name is Eric Coldwell. I cover health care distribution and pharmaceutical services at Baird. It's our great pleasure to once again have Charles River with us. Hopefully, next year, we'll be in a live format and not virtual, but that remains TBD. We're really excited to have Jim today. Charles River, for those of you who don't know, is our longest-standing buy rating. It's one of our absolute favorite companies. It's been a real pleasure to see this company grow and mature over many, many years. And we're going to keep the introductory comments to a bare minimum because there's a lot of Q&A to go through today. And Jim, I just want to say thank you again for joining us.

I'll start it off with this. Client demand, obviously, in recent quarters, has not been a question. Quite the contrary. Your performance and execution have been very good. The market still is always on the lookout for potential headwinds and risks. So I'd like to cover a few categories to make sure we're not too swept up with the excitement of what's been happening here in recent periods. First one, human capital. I think it's maybe the #1 topic, certainly top 3 on everyone's mind. Staffing challenges in so many industries, wage inflation across so many industries. I'm hoping you can give us some context of your experience, where you're seeing the greatest challenges with staffing, recruiting, wages, benefits, et cetera. And I'll add to that, Jim, that back in 2018, you took a proactive step to raise wages primarily for lower-level, less technical employees. But I am curious if the current market dynamics might lead to a similar situation or whether the steps you took a few years ago got you closer to where the current market rates are and, therefore, perhaps less of a headwind today.

Always good to see you, Eric. And always great to be at your conference, albeit virtually. Headcount is the principal focus these days and a rate-limiting factor. So we have sort of a combination of factors that are happening at the same time. One is that workforce is tight. Available labor is tight. And we have actual operating performance that is substantially exceeding our operating plan. And hence, whatever it's been, 3.5 raises on the top line, guidance raises. And you know us well enough that while it may not appear to be this way, we don't try to be overly conservative and crush our numbers. We try to be realistic and make them. If we beat them, great. But business is just improving. The demand is improving. Our portfolio is improving. The number of clients that need our services is increasing. Competition continues to be who and what they are. And so we spend a lot of time on physical capacity. That's more planning and cash. We can effectuate that relatively accurately. And I think we've demonstrated our ability to do that without impairing our operating margins, but staffing is more complicated. So I would say, as a general proposition, that we're doing well. We obviously still raised our guidance to 13% to 15% organically in the midst of these challenges. So we believe we'll deliver those numbers. We hired a lot of people in the first half of the year and we'll continue to do so. We're spending much more time and money on adding full-time recruiters, on spending more time on ESG issues that are important to the millennials, on career development, on keeping turnover as low as possible and, therefore, retention as high as possible. And with regard to comp, we are continuously assessing and tweaking our comp levels. So unlike 2018, which you referred to, where we had sort of a major sort of bolstering of our comp in North America and China actually. While I suppose it's always possible, we don't see that happening. And so we have made some alterations to our compensation already, and we'll continue to do so in different geographies. And we have 110 sites now. So there's a lot of geographies to prosecute. Whatever we have done or intend to do is already embedded in our guidance. So I think we're doing well. We're adding more people all the time. We will continue to -- we'll roar right into '22 with aggressively adding people just because the demand will be at least as good as it is now. And we have -- and we also have the added issue of unskilled labor needs to be trained for relatively long periods of time. So they're not effective and additive to the workflow for several months.

That's great. Thank you for the response. The next area I wanted to hit on, Jim, was raw materials. We've seen shortages in raw materials, commodities, inputs to a number of items that you use in your facilities and products that you make might be exposed as well. There's been disruptions with freight, logistics, shipping, you name it. To what extent have you had some of these experiences and where -- maybe if you could give us some anecdotes of things where you've had challenges on supply chain. And then also kind of enough -- kind of off the head here, have you thought about investments yourselves and making investments in raw materials, components, suppliers, distributors? Are there any entities in the supply chain you actually think of taking control of because they're such a critical component that you need to run your business that it might make sense to, at some level, even vertically integrate it?

So our procurement organization has grown significantly over the last decade and it's a much more professional, thoughtful group. And so even without COVID, I think we've been doing a really good job in supply chain and accessing the critical things that we need and getting multiple bids for them and buying, where possible, across the world, so we get the benefit of scale. And so we found ourselves in very good shape as supply chain tightened or was hampered by COVID and have continued to work through that with pretty much no disruptions at all that I'm aware of. One important resource are large animals, which I think maybe you were referring to in the back half of your question. I think access to large animals, which are increasingly more important, particularly in biologics, safety work, is a complex framework of suppliers. And so what we've done there is meaningfully expanded our supply sources. By that, I mean countries of origin, numbers of suppliers in those countries of origin. And in at least one situation that I'm aware of, we have a joint venture with one of those businesses, so we have greater access. So I think we're doing well. We are preparing now, getting prepared for '22. And so that strikes me as the most complex component. Obviously, not something that's physically -- I mean, it's a biologic component. It's much more complicated. But I think we're doing well. So I think our procurement group is handling potential shortages quite well.

Thank you, Jim. And you're right, that was on the back of my mind. So facilities is the last area I want to hit on. You guys are constantly investing in facilities. I know there's frequently additional shelf space built out and you're optimizing plants. You also sometimes, as you did a couple of years ago, built a new site in Philadelphia in your biologics testing unit. We are hearing, and I think you've made comments about this openly on last -- recent calls and other conferences, that tox demand, safety assessment demand is an area of incredible shortage from a supply standpoint and high demand. And we're hearing of a number of sites being booked out pretty deep into 2022 at this point, second quarter. Maybe in 1 or 2 cases, even third quarter. I'm just curious, what's the balance between rationally adding sites and facilities and building on existing campuses and not getting ahead of your skates versus having to say no to clients and say -- and having to tell them, you can have this site or this team but you have to wait 6 or 9 months? Where is the balance in that? And how do you find that balance? And then as an add-on, I have had some investors start to wonder, given the incredible biotech financing and the demand that we're seeing in the space which seems to be recurring and sustainable, would we run into a situation where perhaps some companies in the space decide to make a bigger investment and go out and greenfield a new 300,000-, 400,000-, 500,000-square foot facility somewhere and we run back into that environment that we had in 2005, '06, '07 before the financial crisis? I think there's a lot packed into that question, but it is a big topic because I think we all believe you could grow faster if you have more open sites today, but then we also want to make sure you're being rational about how you roll these sites out.

I don't see any scenario under which clients will build new tox space either in existing facilities or expanded ones. On the contrary, we are able, so much better than they, to do the work quickly at a lower price point with greater results and greater historical knowledge that it makes no sense at all, even the biggest drug company that obviously can afford it. So I think that's more than unlikely. I think that's the scenario that we won't have in this. There's a few holdouts. Mostly European drug companies still do a fair amount of tox internally, that employ every person in a particular town, and that really hasn't changed much. But besides that, not going to happen. So yes, we have the balance and attention, positive attention actually, between client demand and available capacity. And I like lots of the aspects of attention right now. By that, I mean, clients really have to be thoughtful, they have to plan, they have to prioritize as opposed to saying all the drugs are a priority. No, we really need you to start this one in 2 months, but if the one -- something can wait until 6 months, we're okay with that. Let us tell you which one it is. So we like that. We like having a bigger backlog because there's always slippage in this business, as you know, test articles just not available on time. And so they have some other things available to slot right in without any disruption is extremely important and powerful for us. We're definitely getting -- continue to get sustained and then perhaps even enhanced pricing power from this situation. For so many clients, it used to be the first thing that they talked about. It's all about, can you accommodate me? When can you start my study? I need this done now. How quickly can you get me the results? Oh, by the way, what's it going to cost? So I'm not saying it's not important. It will always be somewhat important, but less so. So it feels very rational, feels much more collaborative, it feels much more like we're on the same side of the table with our clients, which is what we always aspire to. By the same token, the balancing act, and you've been with us a long time, we can't go back to '08. I made those decisions personally, where things were so frothy that we built a whole bunch of space and so do our competitors all at the same time. And then the financial crisis happened. So I don't think we're going to have an industry-specific crisis, I really don't. Can't imagine. I don't think we're going to have a drug safety -- a drug pricing issue like some sort of exogenous thing. By the way, COVID wasn't an exogenous thing for our business, but something like a financial meltdown could happen. So if the music stopped today, which, of course, it won't, but if it stopped today, we'd be pretty full. Pricing would hold. Margins would hold. Top line would hang around. We would stop recruiting as many people. So we're going to continue to add space across our whole portfolio, in particular, safety, because it's our biggest business. We're going to try to call it right in terms of what incremental capacity do we think we need, assuming that demand is even greater next year. We just have to call that right. We have to pretty much call that right today. We have to call it right for '23 for CapEx that we drop in '22. But we're able to accommodate the demand this year. Yes, maybe we're not able to accommodate all of it. Maybe we're not able to accommodate people who are overly price-sensitive or don't appreciate our science, there's probably some of that. But I think by and large, we're doing a good job while improving the operating margins across the board, but particularly in that sector. We have said that while CapEx as a percentage of revenue will be about 6% this year in 2021. It will be around 7% next year. And that accommodates for continued expansion across the board, particularly in safety and, obviously, our new business, CDMO space. Well, I don't think it's more capital intensive. It's just a new business, which will require capital, particularly as clients move from the clinic into the commercial sector. So I'm confident we can continue to get it right by tweaking and adding space in multiple sites. We won't greenfield it. We don't need it. We have 12 -- we have a dozen sites in safety. And we have room to grow in many of the sites. We have sufficient land and infrastructure and backup. So another site really doesn't do anything for our clients nor for us.

Thank you for that. Well, I appreciate the comments on clients not building. I mean we do agree. And I'm also thinking a bit about the competition in safety. And for me, the big nuance or the differences you and your largest competitor have consolidated #4, #4, #4 and #3 over the last 7 years. So the new #3 is obviously on the smaller side of things and it really drops off of a cliff after that. They're just not going to have the capital to invest the way that would have happened 15 years ago. But there is the lingering question of what happens in -- with competitors from Asia Pac, which obviously get incredible capital access and valuations. And whether we might see some start-ups or some of the incumbents in China, for example, building more space and if that could be disruptive. But that's really where I wanted to wrap it.

I think the focus of the Chinese CROs, albeit well financed, will be to provide those services in China for Chinese clients. And there may be some small stuff around the edges, but the capacity is trivial. And even if they crank it up, it will be relatively trivial. The scientific rigor and capabilities are not nearly at the same place. And I just can't imagine a scenario by which most of our client base would be interested in getting services from China.

So with the -- with the increase in COVID here over the last couple of months, the hospitalizations, the positive test rates going up again here in the U.S. and, of course, still very challenging in other parts of the world. I am curious if you've seen any impacts at all in areas where similar to 2Q 2020, whether it was HemaCare, your microbials business, academic demand, has that changed? Have you seen any inflection points in those categories or any new categories based on what's going on with the case counts, hospitalizations and the way COVID continues to unfold?

I'd say the variants and the lack of vaccinations, which is obviously causing a rise in this country, are not really -- are really not posing any new issues for us. We've got access to our clients in the microbial business. We very much doubt that we'll ever see a wholesale shutdown again on academic clients anywhere in the world as we saw in the second quarter of last year because people were really disappointed that they did that in retrospect. We've got some small benefits from COVID, probably in the biologics business, principally testing all the vaccines and potential new generations of vaccines. So the only business that is hampered by COVID, albeit a very small one, is our cell supply business, where our donor runs and numbers of available donors are somewhat restricted by social distancing, concerned about being lying on a bed next to somebody and donating blood when you don't really have to do that or inability to move around in the particular state that you live in. So we're not at full tilt in that business. That's the sort of negative. The positive is that Solero had -- HemaCare's principally California based, Solero has sites in the Massachusetts and Washington state. Those donor rooms are open and expanding. So that gives us more donor capacity. Because some of the products are similar, although some are complementary. More donor capacity and more donors. We would imagine that we will continue to dig out of it through the back half of this year. It's way premature to comment on next year. We believe in those businesses. Our valuation models of those businesses is growing at, at least a 30% clip. And I do think it'll get back to that. The question is when. What does COVID look like? What is -- what do donor room restrictions look like, I don't know, in November or next February? My crystal ball isn't that good. I do think it will continue to improve though. And that's the only modest place that we've got any headwind from COVID.

That's great. Wrapping up on this line of questions. Can you just remind everyone what your net headwind, tailwind conversation is related to COVID specifically? And the reason I asked the question is there are so many -- so many companies in the life science tools and services and outsourcing world that either have difficult comps going into '22 because they had outsized benefit or perhaps, in some cases, easier comps going into '22 because COVID was more of an immediate hit. Can you remind us where you stand up, especially for the newer investors on this call, where you stand in terms of the net headwinds and tailwinds as we go from '21 to '22?

We had a relatively trivial -- I mean the negative impact, I remember -- the number is $60 million, which was mostly in Q2, a little bit in Q3 and not there at the back half in the fourth quarter. We had a strong fourth quarter. The positive benefit was about $70 million. So $70 million out of $3 billion is a -- happy to have it, proud to do the work, relatively modest benefit. So we saw some in biologics, which will continue. But we did parse that in our Q2 conference call by saying that if you take COVID out of the Q2 numbers, biologics still grew over 20%. So happy to have it there. But if there was no COVID, we'll have some small benefit from that going forward, but really, really quite small. Probably the biggest benefit that we had, which is probably impossible to calculate, is we had an accelerant -- sort of accelerating impact from COVID from the inability of clients to do work in a whole host of businesses from discovery to GEMS in Q2 because they have had to close down their own sites or our competitors couldn't support them and they pivoted more quickly to Charles River than perhaps they would have otherwise and/or tried us when they wanted to do the work internally, and we're really quite happy. So some proportion of the 13% to 15% pure growth this year will be the benefit of share gain from COVID accelerating, outsourcing, which is sticky. So I'm not sure it's useful or possible to parse it. But like a lot of companies, which is definitely embedded in your question, we didn't have a huge pop from COVID that's at risk. And we didn't have a huge negative drag from COVID that we're going to have a huge pop that's going to be very sudden and not continue. It's a very modest impact on the company by either positively or negatively. And given our size of the company in '21 and in '22, even if there's no M&A, you can -- you've done the math better than anyone, it's a very, very small amount of financial benefit.

You led me into the next question, which is around research model services. Obviously, as you mentioned, GEMS has been very strong recently, but you've also been making traction in insourcing and specifically the new CRADL offerings. I'd like it if you could possibly frame how much services, and I know it's kind of tricky territory here sometimes in numbers, but how much services within research models and services is actually driving the growth in that segment? And then more specifically on CRADL, you're opening new facilities, you've got an expansion in South San Francisco. You've got the new London facility coming online. Could you talk a little bit about those initiatives?

I'm going to guess that Todd can jump in if he doesn't like me. But I'm going to guess that services is at least 1/3 of RMS and growing disproportionately fast. So it's a big piece. Margins are kind of all over the place, but some of the margins are very high. Some of the IS margins on classic Insourcing Solutions, let's say, for the government are quite -- are lower. But there's no capital drop, usually no capital drop, so the return on invested capital is quite good. The margins in CRADL are very high. So CRADL is a very interesting business. So you've got these turnkey, whatever you want to call them, sort of incubator sites in Cambridge, Mass and South San Francisco, in Shanghai and now London. Maybe some other sites coming down the pipe. We talk about it constantly. It's a relatively modest amount of revenue but growing very, very quickly where you get -- we thought would be only small clients. Surprisingly, there are a whole range of clients, from big pharma to first-year biotech. So that's interesting, using our space and people sometimes. Sometimes, just using the space with their own people, and almost always leading to working with Charles River in other parts of the business. So on a see-through basis, the revenue is much more dramatic. So if you're doing really early small animal studies with us at Cambridge, Mass and your drug progresses, you're going to probably do more substantial discovery work with us in one of our many discovery sites. And then as it progresses, you're going to do safety work with us and biologics and on and on. So it's a very, very important pull-through strategy for us. And we're in a -- just to be parochial from a biotech, it's still a U.S. phenomenon. And it's not even that, it's a Cambridge, Mass and South San Francisco phenomenon. So -- and they're very -- everything needs to be close. You need to be able to walk the samples over, which they often do. So we continue to experience -- we have multiple sites now in Cambridge. And we'll have multiple sites in San Francisco. And we'll see how London and Cambridge -- we have a couple of sites now in Shanghai. And so clients love it. And it's a really wonderful way to be their partners really early. So we like -- the service business is IS generally. CRADL, specifically. The GEMS business is incredibly strong, very profitable, very high growth, worldwide service and absolutely accelerated even more by COVID.

You spent so much time talking about CDMO on the last quarterly call and the last conference you participated in. I'm going to take a lot of that off the plate today. Hopefully, I don't get too many tomatoes thrown at me. But I do have 1 or 2 quick questions on CDMO. First off, I've heard all of your comments. It sounds like you're going to expand geographically, you will not do greenfield, you will make acquisitions. I think that's safe to say at this point. You also have talked about the CapEx in that business being higher than perhaps other areas of your business naturally but lower than other CDMOs because of the nature of the cell and gene therapy work that you're doing. And you've not talked a lot about large-scale commercial production. But as I was sleuthing around on your web pages the other week, I noticed that you are expanding commercial production, larger-scale production in Sweden. And I'm just -- I'm curious, to what extent is large-scale commercial production really on the table? And maybe there's a nuance to that, that I'm missing here.

Yes. So we're preparing, not really in Sweden. We're preparing in Memphis where we do the cell therapy manufacturing, entirely for clinical trials. Now multiple clients in the clinic, some clients at the end of the clinical trial. So since the drugs are progressing well and we are their production source, we're working closely with our clients, some of our clients, preparing for them to file their drugs and hopefully get approval. That will be a step change for our company, for the industry. There's only 8 cell and gene therapy drugs that have been approved. And I think of the 8, 5 or 6 are cell therapy. That's very, very small. There's only a handful of companies that do this. And as we move from clinic to commercial and hopefully, the drugs get approved and we produce them, that's the best sales effort we can make with other clients and say, "Wow, Charles River has already done that. And they're working with the FDA, and they know how to do this because it's complicated new stuff for everybody." Additionally, obviously, we're producing commercial quantities, revenue contributions will be higher. Margins should be better because you're consistently producing the same thing over and over again, so you've got the scale and the efficiency associated with that. And also the knowledge and predictability of what your revenue will be going forward. So we really see the ramping up of that. And your Sweden reference is more towards our increasing efforts to increase our production of both plasma DNA and viral vectors in the U.S. and Europe. And some of those will obviously be used for commercial purposes.

That's great. Jim, we have less than 30 seconds, so I'm going to wrap it with this. I will, if you'll allow me, introduce our next set of presenters today, which will be Zimmer, Signify Health, Aurum Therapeutics and PerkinElmer. And with that, Jim -- and also, Todd, who we didn't see today, but thank you, Todd, for all your help. Thank you, Charles River, for being with us. We hope you have a great day.

Thanks, Eric. Always a pleasure. You have a good day, too.

Thanks, guys. Bye-bye.