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

So thanks, everyone, for attending this morning. My name is Eric Coldwell. I cover the pharma services space at Baird, and it's really a great honor to have Charles River with us today. I knew I was going to get Jim on stage. I didn't know I could convince Flavia, but she decided to join us as well as strong arm, Charles River's new CFO, for those of you who haven't met her yet. Thank you for coming up here. I'll try to leave you alone and not pester you too much, but I've been told you could already handle the event on your own. So we should be good to go. So I think everyone here knows Charles River has been one of our absolute favorite companies over a long period of time and just an honor to have Jim with us again this year. Thank you for always making the effort. Were you going to do a couple of slides or you -- just remind me, I think last I heard maybe a couple -- but it's up to you.

I can give. Always a pleasure to be here, by the way, and to see you. I guess just as a quick update, second quarter, we had 9.5% growth. We had a 100 basis point improvement in our operating margins. We have very good demand across most of our portfolio. We had 340 basis points of sequential improvement in our DSA business, which is 60% company. We have a headwind now from our CDMO acquisitions, which we did several over the last 2 years, which I'm sure, we'll get into with you. So I'll just leave it at that for a moment. So we had that headwind. We had some FX and interest rate headwind as well, which caused us to reguide in the second quarter. So our sales growth is now 10% to 12%. Our EPS is now $10.70 to $10.95. And we're quite -- and we're reaffirming those numbers today, and we're quite confident that we'll deliver the low double-digit growth rate that we said that we would deliver on our second quarter call. So things are generally in good shape.

I like to hear generally in good shape. I might focus on generally -- because you know, I'm myopic, so last quarter, and you highlighted this, Jim, you talked about a number of macroeconomic factors, things that we have seen across the industry that have been exogenous transitory onetime, not things I would capitalize in the long-term valuation of the company and R&D support broadly but -- can you talk about -- can you segregate the FX interest rate, inflation, those type of items from core fundamentals. You did make a very modest adjustment on core fundamentals, primarily around CDMO. Can you segregate the exogenous stuff there, the macro stuff from the company's specific items, if you will, and talk about the impact on your '22 outlook when you last gave it. And what I am ultimately going to get to is, it felt like CDMO was the vast majority of the operational cut, but you did also mention a slowdown in discovery, and I'm going to sort of jump into that direction next.

It was principally the CDMO business for sure. So Safety Assessment business is performing perhaps the best it ever has. Our research model business is strong and several parts of our manufacturing business were strong as well. So -- and we have orders booked a year out in the Safety Assessment business, which totally unique. We've never seen that sort of backlog elongating. And it's looking at an escalating price points. So the prices are sort of increasing every quarter. So we feel really good about the overall demand. We feel really good about the scale of our business and our competitive posture and strength. Lots of clients want to work with us and stay with us through the life cycle of our drug. We have lots of questions about biotech funding, which, as usual, I think, are incredibly overblown. But since you're sort of teasing that question a bit. I think biotech funding is fine. I mean, it wasn't -- it's not the best year, but it's not the worst year either. Most of our biotech clients have at least 3 years of cash. There's a small number that probably have less than 2 years of cash. Any biotech company with less than 2 years of cash that actually has a decent drug or promising drug for an unmet medical need will get it funded probably by big pharma. So we're actually not hearing anything from clients about funding. I want to slow things down. I'm concerned about my burn rate. I'm concerned about budgetary issues. What we are seeing in the Discovery business, which is probably that, although now in saying it, lots of proposals, winning the work and clients delaying signing for longer than we would like. And so if you assume what that is, that's definitely small companies saying, well, I got to get this thing to the clinic. So I got to save my money through preclinical work, get to the clinic, which definitely would help our safety business and maybe cause a Discovery business to be too soft -- to be soft. Discovery business only 15% of DSA, so it will have a trivial impact on the results and probably not be discernible at all, but we called it out because it's kind of underlying the situation. I don't think it has any implications on the safety business at all. And just go to the CDMO business, as we've discussed in the second quarter in depth. I think we bought very good assets. I think the demand is terrific. I think several things are at play here. One is that it's new space, it's certainly new space for us, but it's a new space for our competitors, for the regulators and even for our clients. So we're all learning the science as we go, number one. Number two, we had a pre-existing COVID vaccine manufacturing contract that rolled off. So we bought a company that had that instead of making plasmids and so we have to retool that space. And I think the last thing is in our learning about the business and understanding of the business, the sales cycle is longer than we anticipated. And so to put those things together, that's the headwind. If we didn't have the CDMO business or if it was performing as we had anticipated, we certainly wouldn't have had to reguide.

So just wrapping on Discovery and moving on. Discovery, 15% of DSA segment. DSA segment, a little over half of the company. So Discovery is less than probably just under 10% of the total firm, maybe a bit less than that. You were originally thinking Discovery would, if I recall, would be a low double-digit market grower. It feels like it's still growing this year, just not growing at the clip you expected. Is that a fair assessment? That -- it's not actually shrinking. It's just not growing at the clip you expected.

It is. It's definitely a business that has, and I think, again, will continue to grow low double digits. I think it's a little bit of an air pocket right now with clients sort of watching their spending, we'd like them to tell us that because we would tell you all that, but they're actually not which is quite interesting. So they anticipate that the market will come back. Some of those companies who went public, perhaps prematurely. I do think the venture firms are well financed. So I think they'll continue to fund these businesses.

All right, Safety, and then we can move on to the other segments, but these always seem to be the highlight or the focal point, especially in a market like this. The Street ultimately, you've talked about your strong growth rates. You've put up good growth rates, record backlog, great pricing, et cetera. I have just a couple of questions around this. First comment, it feels to me that if the industry had more animals, people, facilities, you would have had more revenue. It just -- it feels like there's been tremendous shortages across the industry, which has allowed for very good pricing, and some of that pricing also hasn't flowed through yet. So we really haven't seen peak revenue performance coming into this period of whatever is going on in the world that others are talking about. Would you agree with that assessment first? And then secondarily, when you think about safety longer term, you're sitting on over $3 billion of backlog, you've booked up a tremendous amount of next year. You're talking about higher prices. You have new facilities coming online. You've hired a lot of people. Where does that market grow in long It just -- it feels like it could be in a world where we want to think everything is going to be slower than we've modeled. This feels like a business where it's going to be hard to actually slow it down.

Yes. That's a lot. No. I mean, it's a good question. So several things at play here. One is that we've consolidated a lot of the players. So we have a larger portfolio than the competition. We have most of the pharma companies have either stopped doing toxicology or at least are doing less. So there's no internal capacity for them to take the work back in-house assuming they wanted to. And basically, all of biotech, which is the preponderance of our revenue right now has no intentions, financial ability or desire to go into the tax business. So all of biotech, including even the big players are outsourcers. So the demand has never been as robust. So that's number one. And I don't see why or how or when or if that should slow down. There's no reason for that. There's so many new modalities to treat diseases, particularly cell and gene therapy and immunotherapies and all the RNA drugs. I mean it's just -- it's sort of an incredible time in drug development, right? So limited competition marketplace that's well funded and everybody has to get their drugs through preclinical to get into the clinic. And by the way, we get paid to tell them the drug is toxic and isn't going to work, but they have to do that work with us as well. The other thing that's happened is I think the studies have gotten increasingly more complex for a long period of time. They're just very complicated. What's the impact of the drug on the immune system. What's the impact of the drug on your genes, what's the impact to the drug on your bones, they're really sophisticated stuff with the impact of the drug on an unborn fetus. And so we're finally getting paid for the complexity of the studies. And so some of that pricing is the complexity of the studies and some of the pricing is -- just give me a slot. I'll pay you whatever you want. So where pricing was always the first question that we got from clients even big pharma. It's like the fourth, fifth question now. It's kind of like, do you do this type of work? Do you have a slot for us? How fast can you get us the results? Can we self-educate on how the study is going? And oh, by the way, what's the price? So just trying to get back to original question. Could we do have greater sales if we had more space and people? Probably, and I hate to even say that. We're building -- we built space at 5 or 6 different sites contemporaneously every year. And we build space slightly ahead of when we need it. So we don't ever have excess space by the same [indiscernible] spaces very well utilized, which terrific for our margins. I'd say that staffing is a little bit more of a challenge, although we've done very well and particularly well in the Safety Assessment business. So we're well staffed and well capacity. That's not a word. And we'll always be careful on pushing capacity too much just because historical air pockets. But I do think that the demand curve is actually intensifying. And so I don't see any reason why pricing should ameliorate in any way. And not only we've looked into 2023, we've got some looking into 2024. So we have a year's worth of backlog that we -- so we've never seen that before. We've been doing this for 22 years. So I do think it's sustainable. Hopefully, it's -- we can have more of it, and we certainly are focused on taking share.

Let's hit on CDMO. I think you know my view, which is it obviously got off to a rocky start. I want to spend some time segregating what was known challenges versus unexpected challenges, of course, but I also want to just highlight that it's 3% of the company, and it's not going to be bad forever. If I know your history, you'll find your way. You've talked on rebuilding the business, integrating the business. You've talked about the efforts at Cognate and Vigene and Cobra repositioning the U.K. to -- back to plasmid work, building out the centers of excellence. I could go on and on. In my mind, this creates a really good runway at some point in '23 or '24. And I'm trying to get a sense on how long these initiatives to rebuild the sales force and do the reposition the facility upgrades, the regulatory approvals, how long does it take for all of this to come together? Is this -- we knock off a big chunk in 4Q and then we're on a pretty good path in '23? Or is it more of a multiyear process to get repositioned?

I don't think it's multiyear. So as I said before, I think they are very good assets. So we have service capability to actually make gene therapy drugs, make gene therapies. And we have product capabilities on the plasmid and viral vector side. We've got pretty good geographic capabilities as well. And we really had to recapitulate a lot of what we bought. So we have new management. We have new sales organizations. We have different and better regulatory folks. We have first audit of the EMA, which is the European version of the FDA of our manufacturing facility in Memphis, and we had terrific results there. So that's probably unique to any company in the world has that. So we have clients that are all in the clinical phase. We have several that are talking to us. Well, look, they all assume and hope that the drugs will be commercially viable, but several are potentially closed by that, I mean they buy the finished Phase III and are close to filing or finishing Phase III. And so they're talking to us about manufacturing. So that business some of our clients will become commercial. I'm not going to predict when or how big the drugs will be. But obviously, if you're making drugs on a commercial basis, you have the consistency of production, you're going to get your manufacturing methodology really fine-tuned and you're going to improve your operating margins, plus you're going to have great visibility on what your sales are going to be. So we like that business a lot. We are already a principal player in cell therapy, end of sentence, full stop. And I think we have a potential the largest player in the world in cell therapy. It's not particularly highly competitive at the moment. And if you take the cell therapy business and you sort of amalgamate that with our biologics business, which is one of the principal reasons we bought it, and Safety, we have about 10% of our revenue already in this space. So we're going to have centers of excellence. So one company doing plasmid, one doing viral vector and one doing the manufacturing. They were all in the midst of building a space when we bought them. So it's not that we decided to do this when we bought them. So we're finishing the space, which was appropriate, particularly on the manufacturing side. The clients are really interested in, okay? So when we get commercial, we have enough space for us. So we have to sort of walk carefully there and plan for the future, but not get over our SKU. So I think the demand is quite good. The sales cycle is a bit of a surprise. So it's longer than we thought. But -- so to answer your question, it will have elements of sequential growth. And without getting too much into '23, I would be very surprised if the entire business, all the cell and gene therapy assets don't perform meaningfully better in '23 over '22 that's a low bar. I get that. But the businesses will be well run. Clients don't even know we're in the field. It's a good analogy with Discovery. So it took us a while for people to even know that we did Discovery and what did we do in Discovery and how deep and why did we go. So we're working really hard on a very sophisticated marketing program and also linking this with our Biologics business, in particular, and Safety less so. And the feedback has been good. The client base is pretty interesting. It's very small biotech and very big pharma and some clients in the middle. So I do think we're getting some nice traction. It's unusual for us. We're not enjoying it. It's unusual for us to buy businesses and have them not be performing immediately. But I do think it's a function of the newness of the science and newness for us and the learning curve. And the integration is actually going quite well. I think the businesses are really well run. And the feedback from the clients, particularly on the regulatory side has been really encouraging.

So if I recall the numbers precisely, I think it was 150 to 175 basis point headwind on revenue and $0.30 to $0.40 of the earnings delta on the last update from CDMO. Is it -- I suspect it's never as simple as we want it to be, but could a recovery be recapturing what was lost this year? Could it be that and then some? Or would it be the depreciation on the new sites, the incremental headcount for staff, whether it be scientific and/or sales staff that we can't quite expect at this point that we could get recover in '23, what we lost in '22?

Yes. I mean, I think it's possible. I think we're a year off of our acquisition plan. I don't think that's the end of the world. I think that our ROIC will still deliver what we intended it to between year 4 and 5, which is usually the metric that we use. The learning curve is just essential to be going through it and to be making these changes. As you say, it's a small enough part of the whole company that we have enough diversification to offset that. And we very much want to be in cell and gene therapy because it's arguably the most powerful modality that we've ever seen in modern medicine. And our role is to support everybody across multiple modalities. So we had no interest in waiting it out. We do have a bunch of fair amount of revenue across our legacy portfolio, and now we have directly in those businesses. And yes, so we would anticipate a much stronger '23.

I want to talk about research models for a minute and really maybe more about the service part of RMS because you have reposition that business pretty dramatically over time. And you're talking about very good growth and a lot of investment in your cradle initiatives. You do have not service necessarily sort of hybrid, but you have this human cell supply business now, which is also may be set up for better growth in the future as people can get back to those sites and you've expanded those sites, but it seems like that RMS business, which historically investors thought of as the animal model business, it feels to me like that business is so much more now between gems and RADs in-sourcing/ cradle. You have the human cell supply business in there. It's kind of taken on a life of its own. So the question is what is the long term given those mix changes, what is the long-term growth and margin profile of RMS because it certainly feels quite different than what we might have been looking at 10 or 20 years ago.

Yes. So it's very gratifying, what's going on. I don't know -- this is a business, as you say, that had low single-digit growth at 1 point. It's now got at least high single-digit growth and perhaps can be better. Operating margins in the very high 20s perhaps can be better. I think directionally, that's true. So we've got very high growth in China. We have very high growth in our service businesses, particularly our genetically engineered models and this turnkey laboratory capabilities that we have now and multiple facilities around the world, providing just incubator space. Incubator is probably not the right word because some of the clients are big pharma. We're providing space for clients, large and small, who for whatever reason, don't have enough of their own space and don't or don't want to build it either to just house the animals and help them with their work or actually do the studies for them. I think we're up to about -- we're going to have 25 facilities by the end of the year, over 300,000 square feet of space. It's a high-growth, high-margin business. And it's very much a feeder for Discovery and ultimately Safety. South San Francisco, Cambridge Mass, Shanghai, Cambridge England in London. I mean real important centers of excellence. So -- and then the cell supply business, which got COVID hit, that is a word of these days, right? So to shut down some of our facilities and that's a business where people come in and get blood and you spin the blood down, you sell the cells to people doing cell therapy. So we definitely -- the business was stunted a bit by COVID, but we had a couple of sites and we have new products -- new management, new products and new sites. So that business should also be sequentially building through the back half of this year and into next year as well. So yes, RMS as a segment is moving towards a much higher growth business with what's always had very good cash flow. So that will continue. But I think the operating margin expansion is possible. The Service businesses, they're interesting. Some of them have lower operating margins than the core producing cell animals, some actually have higher. So it depends on the scale and the Service business that we're in. Again, we're providing service, in some cases that no one else has or very few people have. And we also saw more people beat a path to our door, particularly in our genetically engineered models business during COVID, where they couldn't rely on their own facilities or competition. So it actually COVID as a bit of an instigator to more volume.

Yes. I was -- I think for me, the big focus was going to be on -- with the -- what I would call a mix shift towards services. Obviously, the Street normally would think of Service being a lower margin business than this differentiated almost exclusive animal models company where clients don't want a shift. It's a catalog business. Prices go up every year. The question is just how much. It would seem like a services transition might cause some margin degradation that give you better revenue growth, and it doesn't sound like that's going to be the case.

I mean I'd say on the margin at the moment, the product business is probably slightly more profitable, but some of the profitability in some of the Services businesses is quite high and improving. And the Explorer business that we just bought the interesting solutions business, we will be able to improve the margins in that business as well. So we're always organized to do that. It might be a slight drag with those businesses will grow faster.

Okay. In our last 5 minutes, I'm going to put your feet to the fire a little bit, but obviously, the way you started the presentation or the conversation today, I already know what some of the answers are going to be or I have a hunch. But you did mention the challenges and not being comfortable with are accustomed to the challenges with the CDMO, I look at the human cell supply business and say that really was just -- feels more like bad luck. You bought a company whose primary site was in California and then the world shutdown. But to be fair, you've had a couple of acquisitions that, for whatever reason, have not panned out as your base case or your business case would have suggested. Does that change -- and maybe Flavia, maybe you can jump in here and lend some thoughts as well. Does that change your philosophy on M&A, whether it be the type of M&A, the pace Jim, to be fair, we talked about a reset you did after WuXi, what all those years ago, 11, 12 years ago and how you really went back to the core on SOPs for what you looked at in benchmarking deals. Has it had -- have you gone back to the drawing board? Are you thinking about philosophy or strategy on deals any differently given a couple of challenges here in the last 3 years?

I think a principal distinguishing feature of Charles River is everyone, maybe the distinguishing feature is the portfolio. So -- and the breadth and strength of the portfolio is largely the result of M&A. So we -- for those in the audience who don't know, we did a leverage buyer at the end of '99. We've been public for 20 -- over 20 years. We bought 60 companies in those 20 years. Since the WuXi debacle, we bought 25 companies pretty much flawlessly in terms of returns, growth rates and building out the portfolio. All of our Safety business was bought. All of our Discovery business was bought. Microbial was bought, biologics was bought. So I think we do it well. You never do it perfectly. And this is sort of a reminder of the complexities of integration. I think anytime you move into any new area, even an adjacency, we saw this with our discovery business, it's higher. And so maybe give yourselves more time internally and how you communicate that with the Street, maybe you structure it differently. Maybe you dismantle some things more immediately than we have done whatever. So we're certainly spending time completing the integration of the businesses that we bought, thinking about what the next series of acquisitions will be. We have areas that we've identified to move into. We do think that the portfolio continue to be strengthened externally. We will always do that thoughtfully. We have a full-time team of people that does the due diligence and does the integration and we have integration leads that go in and stay with the business. We use our own salespeople to do that. So I think it's just a reminder that you never have this lift in, it's always going to be hard work. It certainly doesn't change our strategy or philosophy around that.

All right. The last one, and I'll conclude with what is probably the hardest one, and I'm not sure how you answer, but it's the topic I think most people are looking for. A number of companies in this broader R&D support world, and you know I don't view you as a CRO, but in that broader industry of R&D support, a number of companies gave guidance in a period of almost euphoria record results at ridiculously good 2021 all-time high stock prices. And a number of companies came out with long-range plans that were higher than what was witnessed pre-COVID. Then we get interest rates, inflation, more supply chain component issues, obviously, continued labor issues, FX, Russia, Ukraine, China rolling lockdowns and the list goes on and on and on, the world changed. It became more complex. Philosophically or strategically, does it make sense to -- as I've written some notes, take a mulligan and start over. And I'm not asking you for guidance today, obviously, I know you can't go there. But -- does it make sense to start over? I mean people love your company when you grew 7.5% pre-COVID for 5 years, the real growth rate. Now you're guiding double-digit. Does it make sense to revisit that?

Sure. I mean, we certainly -- we're in the midst of our '23 plan right now. We're in the midst of our 5-year strategic plan. We had what you just described, we had an amazing '21, and we had a plan for '22 that we thought was really easily doable. I mean -- yes. We thought it was a plan easily do. So there's a lot of headwinds in the world right now. By the same token, I do think that our portfolio is uniquely strong and the demand is quite consistent right now, but we'll certainly be paying attention to put together numbers next year that we're highly confident that we'll make.

Well, you've -- I think you've convinced me at least that the organic and the fundamental part of the company is in a very good spot. So I think we can all live with exogenous items that happen transitorily especially given where the stock price is. But that's my personal view interjected into this. So thank you so much for the time today. I really I'm sorry to bring you on stage and not get a lot of Q&A, but I appreciate you being here and looking forward to working with you. It's -- you joined a great company. So Flavia, thank you.

My pleasure.

Jim, always a pleasure.

Thanks, Eric.

Okay. We're out of time. So if I can read this, we have Perkin Elmer, going up next in session 1, Accolade in session 2, Nurix Therapeutics, and 3 and Reneo Pharmaceuticals in 4. Everyone, please join me in thanking Charles River for the presentation today.