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

Hi, everybody. Welcome to Jefferies London Healthcare Conference here in November. We are, this year, kind of moving one step toward being open. We split the conference into an in-person portion of the conference, which was Tuesday. Hope I have the day's right, Tuesday, the 16th and Wednesday, the 17th. And so the 18th and 19th, Thursday and Friday, are virtual. This is part of the virtual session. We appreciate your interest in clicking on to this on-demand video by the time it is posted. And our discussion with Charles River Laboratories. I'm Dave Windley. I'm in Jefferies Healthcare Equity Research based in the states and cover the pharmaceutical services and CRO space, of which Charles River is a leading player, in which they are a leading player. Here to talk with me about Charles River's business is David Smith, the company's Chief Financial Officer. So welcome, David, and thank you for your attendance. Sorry, we couldn't have dinner in London this year, but we'll have to hope for that next year.

I wanted to start off with a kind of setting the table on your guidance that you provided, kind of elevated guidance that you provided at the Analyst Day this year. You highlighted longer-term goals out to 2024. That included low double-digit revenue growth, kind of aiming toward higher operating margin at about 22.5%. Maybe you could talk about the factors that support and drive you to those goals. And then we're not too far past that, but how the last couple of quarters shaped up in support of those longer-term goals.

Okay. Thanks, David. And thanks for hosting us today. We appreciate that. So yes, I guess to understand the longer-term guidance, I guess it's fair to just having a quick recap of '21. So we set out the year in February given guidance. And since then, we've increased our organic revenue growth by 400 basis points at the midpoint. Our margin expansion started off with sort of modest improvement. And here we are talking about ZIP Code of a 100 basis points, similar to last year. And our earnings per share and our free cash flow metrics, the growth rates, we've doubled during the course of the year. So '21 is panning out to be a really good year for us. And that's driven by the strong client demand that we're seeing. We've got bookings that are leading into the second half of next year. The conversations with clients continue to be, can you do the work? When can you start the work? It's less about price. The portfolio is helping as well, and not just the portfolio that we've built in the recent years, but the portfolio this year with the acquisitions of cell and gene therapy players with really high growth rates. We're talking of north of 25% in the coming years. All that is contributing to us believing that we can deliver on our longer-term low double-digit organic growth rate. So a couple of weeks ago, we had our earnings call and we made an unusual step. We actually started to talk about 2022. We don't normally do that till February. But that's because of what we're seeing both in the bookings, et cetera. And so we've affirmed that we're going to get -- or believe we're going to get low double-digit organic revenue growth next year. We've also said that we expect OI expansion. We've confirmed or reconfirmed our commitment to the 22.5% by 2024, not linear due to investments that we see in the near term. But overall, I think we're talking about a really strong set of numbers.

Absolutely. You mentioned the booking out into the second half of '22, which segues nicely into my next question. You have been -- the management has been talking about studies booking further in advance. First of all, maybe you could -- I've said studies, that presupposes kind of the question I'm starting to ask, what parts of the business are really booking out that far? Is it really across the business? Or when you say that, are you predominantly thinking Safety Assessment in your thinking? I'll pause there.

Yes. I mean when we talk about bookings, we are talking about Safety Assessment, which is the largest piece of Charles River. But you're right, we've got a lot of our business which is short term. They place the order. We deliver it. Models, for instance. Microbial, for instance. Even the biologics tends to be shorter-term horizons. But when we're talking about bookings, we are talking about Safety Assessment. And we're now seeing bookings into quarter 3 next year, second half of next year. Here we are in November. Historically, we've kind of had 3 to 6 months' worth of bookings. So that shift, that demonstrates the visibility that we now have. And it's one of the fundamental reasons why we felt that we could give guidance, if you like, or preliminary guidance to our revenue for next year. Clients are keen to secure the space, and we're seeing supply our capacity begin to get well utilized. Hence, why some clients have to wait a little longer if they want to use a particular site. If they're prepared to move to a different site, we can maybe start them earlier if we've got the capacity on that site. There are -- even in Safety, there are some studies which are sort of tuck-ins, if you like. But broadly, the bigger picture conversation is these bookings that are now bleeding out 9 months or so. That's given us a different visibility than we've historically had.

And you a kind of alluded to this, but is the fact that you're booking a study in 3Q of '22 at this point, does that necessarily mean that 2Q and 1Q are full. Or is it as much an indicator that the client is trying to play in further in advance, and so they're reaching out that far?

Right. So this is an element of both, but it is actually about them securing the space further out. I wouldn't want you to believe that we have a 100% booked in Safety for Q1 and Q2. That's not what we're suggesting. What we are saying is that the lead time of discussions is further out. And that confidence in customers wanting to use us, wanting to secure that space, along with the other conversations about how they think next year is going to pan out, particularly for the larger customers. We often have conversations with them. They explain what they think their demand profile will be for the following year, so that we can plan and make sure we have the space. But that's complemented with them actually securing the space. So yes, it's a good environment to be in.

And when you talk about the larger clients and thinking about they are opening the Kimono for you a little bit and showing you what their volume expectations are for the next year, are those growing fairly meaningfully? Like what kind of growth rates are some of these clients indicating to you? I mean, because the larger guys, I would expect that you would be seeing faster growth from small players that maybe aren't sophisticated enough to think out that far?

Yes. I mean that's why the devil is in the detail. But if we take a step back, look, we've got good demand, good bookings, good conversations, both large and small, it's all looking great. So without trying to tease through month by month what they look like, it's looking good. And by the way, it's actually -- I wouldn't say it's a particular therapy area either. I mean, it's -- there are modalities that are of interest. For instance, we're seeing more demand in, say, large molecules than monoclonal antibody type studies. So that's picked up a little bit. We've had some benefits last year with COVID. There were small benefits, but most of that's rolled off as the vaccines have been approved. But we're seeing that sort of vaccine work move into biologics, where it's now in the manufacturing, they need the QC-ing event. So we've got puts and takes, but broadly, more puts than takes.

Maybe another way to come at that in a more general sense is to just compare, contrast. Again, you've noted, as I expected, was the answer. It's not a matter of having 100% coverage of 1Q, 2Q, and you're spilling into 3Q. But what is the difference? And can you give us delta in the percent coverage versus what you would normally have? And as you alluded, normal is usually pretty low because your -- the cycle of your business is relatively fast. But is -- do you have 10% or 20% more revenue covered for next year than you normally would? Is there a way to put a number on that?

It's not a number that we would call out. As I've said, a lot of our business is short term anyway. We are talking about the Safety Assessment side of the business, which can book things out further afield. But when we look at the broader business, the broader environment, the conversations with the customers, the way that they're talking, the way the funding flows are going, plus the order book -- all of that has given us the confidence that we can go out a few minute with the guidance.

Okay. Okay. Kind of relatedly, but thinking about more of the supply side, demand is a great thing. Growth, higher growth is a great thing. You've been -- the company has been very thoughtful about how you've added capacity for a decade, probably. I mean, a kind of everybody got singed in the great financial crisis, and so everybody has been a lot more careful as a result. And so you're not trying to get well ahead of your customers in putting capacity in place. Now growth is accelerating a little bit and you've got to put more capacity in place. Maybe you could talk about the areas where you recently raised the CapEx intensity, the areas where that incremental CapEx is going.

Yes. So you're right. I mean we did call out a couple of weeks ago that CapEx needs in 2022 would be up. We had historically said 7% of revenue. We're now talking about 9% of revenue. And that's driven by the demand environment that we've been talking about, particularly Safety Assessment. If you recall, when we started 2021, we initially were guiding DSA to be approaching 10% in organic revenue growth. Now we're low double digit. And then over the summer, as we were looking at our strategic plans, which go out 5 years, and then starting putting together the 2022 plan, we were seeing the need to accelerate some of the buildings. So what you're seeing in terms of this uplift in capital is a need for building out some more space, extra buildings. We're not talking greenfield. We're not talking back to your point in the question where we were at the time of our last credit tranche. This is about -- it's not a new campus or anything like that. We're talking about building adjacent to where we've already got buildings. But nevertheless, in order for us to feel comfortable that we can support that revenue growth in out years, we need to get on with the buildings. They can take 18 to 24 months to put in place. So we want to make sure that we're not in this situation, where we haven't got the capacity to fulfill clients' need. So it's less about shortening the lead times per se but actually preventing the extension of the time where customers will get to the point where they go, well, we can't wait this long, we'll go elsewhere. Now we believe the capacity is reasonably fall across our sector. So we may see others building as well. But certainly, we see the need to do that, which is why we felt it was right to appropriately signal that for '22, we would see some capital up.

So not a function of clients saying, look, July of next year is too far out. I need you to tell me that you've got more space and you can get me in, in March instead.

Yes, this is -- while the capital spend will occur in '22, it's less about '22. It's more about when we were having the strategic outlook over a sort of a 5-year horizon. And given the fact that we've seen an acceleration in the uplift in DSA, that these pieces came together that we felt, okay, we need to put those buildings in place to be in good time for the future.

And to your point on not greenfield, again, going back to about a decade ago, the company would have found itself with some buildings with quite a lot of space in them. But the approach has been modularity and incrementalism, and internal build-out of shelf space, and things like that. Am I to interpret now that like a building like Shrewsbury, which was the one that got built a little too late in the last cycle, and had lots of growth room that you've a kind of now fully filled that up, and you've got to plan a building next door to some of your big buildings on your main campuses. Is that the right way to think about it?

Yes. Yes, except I wouldn't say Shrewsbury is necessarily full, but it would be lovely if we could just build 1 big super site and service all of our customers from 1 site. That's not the way it works because partly because clients like the locality because they often want to come in and visually see how the study is progressing. But actually just hiring the staff from one area would just be impossible. We're just so big. So we have to spread the assets around the globe, which is useful, both from the point of view of client access, but it's also good from the point of view of treatment. So we do have still space available in some of our sites. Hence, why we don't need these new buildings to come online tomorrow. We're talking about 18, 24 months from now.

Yes. Okay. That's a really nice segue. Then to the cost side of the equation. You've talked about labor markets. I think on the last earnings call, you did touch a little bit, and of course, you couldn't avoid it because there's probably 5 of us asked you about it, but mentioned wage and cost inflation on margins in '22. Perhaps you could elaborate on that and a kind of be specific about the takeaways that you want us to have on those comments?

Yes. So we're not immune to the wage cost inflation, et cetera. Everybody's seeing some of those pressures. First, I would say, we can cover some of it through pricing. We're making, as you would expect, more regular price increases in these current times. You know we don't call out the price. But even when we were a high single-digit organization, we were getting priced. Now we're a low double-digit organization. We're still getting priced. So that strong demand is leading into good volumes, good pricing. And that fall-through helps cover some of that -- a lot of that inflationary pressure. And while it can take some time to permeate through some of the backlog, we've been aware, the world has been aware of inflationary pressures for a few months now. And we were pretty quick out the blocks. Clients are expecting that there's some pricing discussions to be had, and we are reflecting that in our discussions with them. And then even over the longer term, we still feel good about our '24 OI target of 22.5%. We -- when you're looking out that far afield, 3, 3.5 years from when we first put those targets out, there's always puts and takes in the discussion. And we've got a good feel about some of the benefits that we're expecting to see from the investments that we've been making. So when we pull all of that together, despite the headwinds that we expect to see, we're still posting margin appreciation for next year.

Are there elements, I think -- so sticking with a kind of whether it be human capacity or physical capacity in your businesses, are there areas of the business that are rapidly growing where you're better positioned with space today? So be it in the CDMO business, do you have room to grow there? That's obviously, as you mentioned earlier, 25% or better growth rates. Biologics testing is an area where you made a large investment a couple of years ago to pretty meaningfully expand capacity. Are those areas where you maybe you're okay for the time being, and the investment now is SA. And then once SA is done, you can a kind of rotate over and deal with other areas?

Yes. So let me be clear. For 2022, we have capacity. The conversation about the uplift we're talking about is more longer term, right? So we have capacity and we're able to recruit staff, right? I'm not saying that it's as easy to recruit staff as it used to be, but we are recruiting. And we actually, in the earnings call, gave out some numbers so that you could see the size of headcount improvement that we have made. So you've heard us talk in the past about some of the investments we've made, recruitment, and gymnasiums, and great place to work, et cetera. We did the living wage in 2018. There's lots of things that we've historically done, and are benefiting today, given the world that we're living in, from some of those investments that we're making. And we're continuing to make investments to make sure that we can keep our head above water in terms of being a great place to work, a great mission. So I would leave you with the impression that, yes, like anybody, we've got our challenges, but we have been coping with those and still feel good about 2022. Otherwise, we wouldn't have posted the double-digit organic revenue. And we wouldn't have mentioned that we'll be getting margin accretion if we didn't feel that we couldn't get on top of these things or remain on top of these things, I would say.

Got it. Got it. In RMS, moving to that segment of the business, has for quite a period been, the slower growing segment with attractive margins and good cash flow and a kind of the cash flow to underwrite growth in some of the other areas. But acquisitions like HemaCare and Cellero divestiture of the RMS business in Japan have actually a kind of changed the composition of -- and the growth mix of that business in a really nice way. Can you talk about the bigger, faster-growing areas in that business, and the margin profile of those kind of -- is it [indiscernible] mixing up or mixing down based on the faster top line growers?

Right. So okay, a few pieces here. You mentioned HemaCare, Cellero, that's our self-supply business. That was meant to be a very fast-growing unit, north of 30%. We have called out that we have had some headwinds. Basically, this is about blood donors coming in. We take -- donors coming in. We take their blood, we spin that down. We create some products, we sell to research. And with COVID, some of those donors have been reticent to come in, which I fully understand. October actually wasn't too bad, but that's only one month. But we do believe when we get into next year, COVID should be behind us, cell supply should be a tailwind and to continue to give us that growth rate that we were expecting when we first acquired it. So that's one part of the piece. Another part of the piece is China. They got through COVID remarkably quickly. And throughout the year, we've been talking about how China has been doing very well. Talking about COVID, last year, RMS in particular, obviously had some serious headwinds with COVID. So did our competitors. We got advocates quite quickly. You've heard us mention before that we had a number of principal investigators approach us, and therefore, we were able to pick some share up, and many of those have stayed with us as we had hoped, and as we've signaled that they would. So that's kind of giving us, if you like, a tailwind out of something that was obviously a very difficult period of research models time during particularly Q2 last year. And then there's the cradle initiatives. Any -- this is basically a building that we have a lab that we have where people can come in and make use of the lab. So we provide the infrastructure and they can bring their scientists in and do some work there. And we've got those scattered around North America. And while any one of those is small in the great scheme of Charles River, you put that cluster together, it actually helps the growth rate for research models. So that gives you some of the top line aspects of why research model says to your -- I think you were using words sort of face lift. But in terms of margins, we don't actually break out the margins publicly by those themes. That said, our '24 target is to be in the high 20s, and Q3 was 26%. So there's still a little headroom that we can have in the margins as we go out to 2024. Cell supply, for instance, becoming a tailwind would be one of those.

Okay. So jumping off of the cell supply, as the early-stage part of the continuum of cell and gene therapy activities that Charles River has launched itself into, you've made these transformative CDMO deals as well to become more comprehensive there. Perhaps you could maybe help investors understand the continuum of what Charles River can now provide? And we're going to do a spotlight on this at our [ Investor ] in about a month or so, but maybe you could talk about how the pieces fit together.

Yes. Okay. Actually, if I take a step back and just talk a little bit about Discovery, you could go back and talk about safety, but we started safety 20 years ago. Discovery, we've kind of got more serious with that about 5, 6 years ago. And 5, 6 years ago, people didn't really know we did Discovery. We've built out the pieces with acquisitions. We've got some strategic relationships, and people now know us for Discovery. It's a lot easier to sell because they approach us than trying to sell to somebody who didn't know you do it. And when we bring them in and they start doing some work in Discovery, particularly those that have never worked in Safety before, we have the opportunity to educate them. There's a touch point in that they've got a contact person and we can help cross-sell. Same with cell supply, right? In that, we've built out some pieces, HemaCare, Cellero, cell supply products helped in research, which is why it's in the research models part of our business. We do cell and gene therapy in Discovery and Safety, but we've now bought these CDMO capacity with the Cognate so that we're covering pretty much the spectrum of the work. And so customers can go, okay, Charles River is doing cell and gene therapy. We have a problem here. Maybe they can help solve that problem. And again, we have the opportunity to educate them, particularly if they've not entered into the later stages of the program. And we get a touch point, which means that we have the ability to cross-sell. So ultimately, the -- if you take a step back, the thesis that we have is similar to what we did in Safety, and we've proven that out because we're now the largest provider of Safety. We're in the process of that with Discovery, and have got to a reasonably good critical scale with customers. And I think sell cell supply and cell therapy, emerging modality. It's still young, but we're getting in on the ground on that one and help to build out a [indiscernible]

Yes. Charles River, at least Jim has talked about when I've asked this question within cell and gene therapy, he's kind of talked about the choice to focus on cell between cell and gene, and then gene-modified cell therapy, so maybe that's a little bit of a hybrid. Is the intent still to be a little bit more targeted in the cell and gene therapy manufacturing competitive space? Or would you anticipate that with comfort with CDMO businesses, and growth in that space, that Charles River would eventually find itself in a kind of the whole waterfront the cell and gene therapy manufacturing?

Well, so certainly, it is true. Cognate strength is cell therapy, right? It's 1 of 3 players. All 3 players have the opportunity to grow organically. We've posted north of 25%. We've also now do the viral vectors in the plasma DNA. We also did biologics testing as well, which we've been doing on cell and gene therapy for a while. So again, the idea of being they may come in to do the cell therapy, but they don't need to go elsewhere to get the viral vectors or the plasma DNA or the QA testing, which is all part of the components into even cell therapy. It's kind of a one-stop shop. So we've actually had clients that have actually said they were pleased to see an organization like ours start pulling these pieces together, makes it easier for them. We've also said -- we've also had clients talk about how important it is around the quality of the science in this space. And I believe we've got a good reputation with clients about our science. And so I think, again, these are -- it gives us the ability to build something in the cell therapy space that could be quite unique. How we build out on the viral vectors and in the plasma, time will tell. Clearly, we have the ability to sell those directly. But I think it's too early to call how that might play out.

Got it. Okay. And then within cell therapy, and you've talked me through this, but I could stand here again and maybe others as well. As a backdrop, Charles River, I've heard -- covered Jim for 20 years and have heard him say over and over that Charles River's aspiration in this space is to be have a 1 or 2 competitor in the space. You want to be at the top of the league table. The -- my perspective is watching a number of these other players in cell and gene therapy, as it is growing very rapidly, devote a tremendous amount of capital to the build-out of the capacity that they believe they need for that space. You all have emphasized that the cell therapy side of that niche is a little less capital intensive. And so you think you've maybe insulated yourselves from some of the very highest CapEx spending numbers that we're seeing. Perhaps you could explain that a little bit and put a point on that.

Yes. I mean you're right. When you -- I mentioned earlier, we're 1 of 3 in gene-based cell therapy, right? The others do traditional small or large molecule manufacturing, right? And that does require a lot of stainless steel in building that out. So in terms of becoming #1, if you are saying, will we become the #1 CDMO player? I would say, no. But if you say, okay, let's take away the small and the large molecules and just talk about cell and gene therapy, it's still a small base, it's a rapidly growing emerging unit. Time will tell. Maybe we become #1 in the cell therapy. Maybe it's a bit broader than that. As I mentioned earlier, we've been on a 20-year journey with Safety Assessment, right? We really started to getting heavy in Discovery about 5, 6 years ago. And we've only just started on the cell and gene therapy franchise, in terms of building that out with a wider spectrum. So we will have to see. But I think it's going to come down to quality of the science, quality of execution. To your point about capital, at the moment, we're not in manufacturing. We're still in the clinic with our clients. Difficult to call when they move across to scaling up for manufacturing and wider distribution. A lot of the cell therapy is actually done in -- can be done in smaller containers. It can be very bespoke to personalized medicine. How that ultimately scales up, that's not fully understood. A bit like when biologics came about. How could we price a biologics but we found a way or the world found a way to price for the manufacturing of biologics. I think we'll find a way of how we scale up personalized medicine, but it's still early days in that journey.

And so just to pause on that point that you've made about smaller containers. Are we talking -- I mean, are we talking about single-use bags essentially that cell therapy uses in generally 5,000 liters or even significantly less than that, I guess.

Correct. It is that scale as opposed to the huge [ bags ] that are done in small or large molecules, which is less personalized, of course, so they can produce that on scale in book. Whereas where it's more personalized, it's done in a smaller unit.

Yes. Okay. Maybe skipping forward to sticking within manufacturing, but thinking about your microbial solutions, which has just been a steady eddy business since before I was a sell-side analyst, which is a long time ago. But did have some impact from COVID, I think from just difficulty in a kind of grows razor-razorblade business and putting those instruments in place, then creates more demand for the reagent. If I remember correctly, the instrument installations were a kind of impacted by the inability to get into locations. Perhaps you could talk to us about where that stands. And how that has caught up with the reopening of the world.

Yes. I mean you're right. Microbial, for 20 years, we've been able to say it's a double-digit grower organically. We can't say that now. We'd have to say it's been a double-digit grower, except for the COVID period. And it did grow. It did grow during that period, the last year or so, but not quite at the north of 10%. Because to your point, we had difficulty getting access to sites to install the new machines. Now we're back to double digit again. I wouldn't say that we've had a meaningful catch-up. It's not as if all the doors opened up one day and we were allowed to go and install. But it feels very much back to business as usual. It's as if the COVID delay is behind us, and we're now back to the way we were running before, seeing some nice growth rates for that unit. And we expect that to maintain for a while.

I think we just have a couple of minutes left, but maybe to finish, we've had back and forth discussions about biotech funding. Jim talks about how robust that environment is, and you all have relationships with a number of VC funds. Maybe you could talk about the rigor of your tracking of the amount of funding going into the small biotech clients and the capitalization that they do have. And the cash on their balance sheet spend on your services because, of course, as we've already covered, Charles River's business is relatively short cycle. And you don't have 3 years of backlog that you can point to as the indicator of your confidence in your double-digit growth rate. So I would think that you have these other ways of assuring yourselves that, that demand is resilient and persistent.

Yes. We -- as you know, we work with VC units. We -- not just because we get the gain on the investments in the VCs, but also because they put work to us. And we've called out in the past the sort of revenue and the margins -- sorry, the profits that we make out of that. So it's a very nice franchise. But really, the other thing that we get from the discussion and dialogue. So they're often talking to us about emerging technologies and so on. But to your question, they also give us a feel for how the cash flows are going, et cetera. We've seen other data points externally as well. We've done our own work, but we've seen other external data points that suggest that these smaller companies that haven't yet got to the market, and therefore, don't have a cash flow coming in from a launched product have something of the ZIP code of 2 years' worth of cash on hand. The market still seems to be very strong. So anyway, the different channels that we get all seem to be pointing in the same direction that we've seen for some years now. That confidence is there. Cash is there. We haven't had that canary where that canary is the signal when the first conversation is pricing. At the moment, it's about when can you start, can you do the work? And I guess it's a start shifting to the first conversation being what's your price point. That might be the canary that suggests that things are shifting, but we're not seeing that.

Yes. That's very helpful. It's a good point of emphasis. So that's the telltale sign when the client gets more price sensitive that maybe the covered is growing a little bear and they're getting a little more nervous about how fast the cash is disappearing.

And we deal with so many, thousands of different companies of different sizes that we have lots of data points on that. So that, again, would be one of the key signals that we would have because it was about to be a shift.

Yes, that's a useful road side for us to keep in mind. I think we're coming up to the end of our time. So David, I want to thank you for your time, Todd, as well for helping us to coordinate. We'll look forward to talking to you in the not-too-distant future. And I wish you all investment with the rest of the quarter. Thanks to our investor audience for your attention and participation in the conference. I wish you a good day. Thank you very much.

Thank you very much as well.