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

Hey, everyone. Good morning. Thanks for joining us today. My name is Tejas Savant, and I'm the life science tools and diagnostics analyst at Morgan Stanley. It's my pleasure to host Charles River this morning. And with us, we have Jim Foster, CEO of Charles River. Jim, before we kick it off, I just want to quickly rattle off the disclosures here. Please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. And if you have any questions, do reach out to your sales rep.

Jim, so thanks again for joining me.

Pleasure.

It's been sort of an unusual year for Charles River, puts and takes -- just to set the stage for us. Can you just talk about what you view are your key accomplishments year-to-date areas for improvement? And what are you most excited about heading into '23?

Yes. We're really pleased with our movement into the cell and gene therapy space. I think that's a -- that's an important addition to the portfolio. We want to service as many clients across as many modalities as possible. We feel really good about that. Feel really good about the growth rate and sustainability and elongation of the backlog in our Safety Assessment business, which we're booking well into '23. And coming into '24, escalating prices. I think that's a manifestation of the financial strength of the client base, the scale at which we're playing, and just to share number of drugs that are in development on. So we feel really good about that. We feel really good about the have been calling the renaissance of the research model business, but the growth rate of that business, we have -- it's moving to a point that we haven't seen probably in a couple of decades. And demand across the historical Manufacturing segment is strong as well. We've done a really good job also in staffing our businesses at a time where staffing is complicated, for sure. It's a challenge. We've had to pay more, but that's appropriate. It's particularly important in our Safety Assessment business, which while physical capacity is important labor capacity is more important because these people are performing the study. So we continue to be pleased with the portfolio. We continue to be very pleased with our competitive posture, and we continue to be pleased with the relationships that we have with our clients. And I guess the last thing I would say because I'm not sure you will get into this is that we're doing a fair number of these technology deals we provide either debt or equity financing small amounts, but cutting-edge technologies that will distinguish us. It's kind of an R&D investment on our part. We have about 20 of those right now. We bought one of those companies. We probably, over time, will end up by maybe 1/3 of them, most of those will be in discovery. So that's a way to do -- and we do the sales and marketing for them for a year. It's kind of a living due diligence. So it's a great way to access technology, a great way to understand the company. It's a great way to exclude things that you try that the technology doesn't work well. So the demand curve feels particularly good at the current time.

Got it. That's a great overview. So maybe we'll start with the CDMO business. Obviously, more recently, it's run into some challenges around integration and the transition away from COVID work, et cetera. What are the key lessons you've learned over the last 6 months that perhaps helps inform your -- how you think about future cell and gene therapy expansion? Is there anything you would have done differently?

Such a good question. So as I said a moment ago, we decidedly moved in the cell and gene therapy space because it's an important modality. It's like 3,000 drugs in development right now, probably 2/3 of those are in the preclinical. What we found was that in our legacy business, we had a lot of sales that were directly selling gene therapy base. So we're already participating substantially. And then we bought a couple of cell -- product companies to cell therapy manufacturing and plasma and viral vector business to be literally in the business. We bought them relatively quickly. If we could have changed the cadence a little bit, we would have, but deals have a hard beat and they come when they come, and they were really important. So I think we bought very good assets -- buy the same assets today. I think we're talking about brand-new science. We're all learning as we go. Cell therapies is nascent. There's only 10 cell or gene therapy drugs that have been approved. So we're learning. Our clients are learning, the regulators the learning, and we're learning through the integration process. We've recapitulated a lot of the management, the sales organizations, the regulatory organizations. We found that the sales cycle was a bit longer than we had anticipated. I don't know. I wish we had found that earlier, but we -- you have to live in the business for a while. It is an adjacency, and it's a new business. So I don't know if the lessons -- the lessons are that it reminds us a little bit of our -- when we moved into chemistry years ago. And of course, that was a new business for us, but that wasn't new science. -- maybe should be more conservative with your estimates for the first couple of years rather than 1 year. I think we're a year off of our acquisition plans. I think that's not the end of the world. I think we will have a very strong year. We will have a stronger year next year in the cell and gene therapy space. We obviously have good comps. But we understand the business well. We have a new sales organization. As I said, we're beginning to bring in new clients. I think some of our clients -- all of our clients in the cell therapy Manufacturing business are clinical. Several of those clients are talking to us about preparing to go commercial. We have no prognosis on when -- or whether they'll be successful, but we presume some will, by the way. I think you all know that we had a successful EMA audit which means that at least the European Union thinks that we're ready, right to produce those drugs. So that's really important. I think the EMA audit, by the way, is probably just as important as the strength of our sales force in terms of having client confidence that we know what we're doing. So we feel good about the assets that we bought, good about the forward-looking trajectory, very good about the management teams. We're beginning to have pretty good -- besides integrating those new businesses, we're integrating them with our legacy businesses, particularly biologics. So we're testing the drug before it goes into the clinic, and after it comes out. We're also doing safety the safety work as well. So like everything that we've been doing, it's all about the sort of power and diversity and depth of the portfolio.

Got it. I remember talking about the WIL CDMO divestiture back in the day that you did, Jim. And at that point, you were sort of the view that this was too far afield for Charles River. Clearly, since then, there's been an evolution in your thinking, there's been an evolution in the market as well. So walk us through how you approach the cell and gene therapy vertical and sort of deciding to get into the Manufacturing business.

So as you said, we acquired a small molecule CDMO business with a big toxicology deal that we did we didn't go looking for that deal. And I suppose we could have simultaneously spun that off, but we decided to participate and see what the CDMO business looks like. It was not a bad business actually. It's pretty good growth and had nice margins, but we like to either be the principal player in everything that we do [ or ] maybe the #2 player. And so it became evident to us immediately that the CDMO space was -- there were a lot of really big companies, AbbVie and Abbott and Samsung, very, very big companies doing it. So we studied the market and exited, and I made one of my usual black-or-white comments, which was that it was too bigger market to participate in the big player so we were out. I'm trying to learn not to do that. I think that M&A has to be client-driven. So what happened here was that we have a large growing biologic business. Some percentage of the work is cell and gene therapy related as a safety business and some RMS and microbial as well. We had clients saying to us, you're testing our drug -- you're doing all this work on our drug, including safety work and testing, and then we have to find somebody to manufacture it. And what that does is it slows us down. We don't know them, maybe we don't trust them, maybe we are not comfortable with them. So we don't like that -- we don't have a complete solution with you. So would you move into that space. So we had a fair number of clients request to get, number one. Number two, as we surveyed the landscape of cell therapy, in particular, it's very nascent. We have a couple of competitors. I would say that we have entered the field now as a principal player in cell therapy. By the way, cell and gene therapy is about 15% of our revenue. It's not trivial. So we're entering the field as a principal player, I think, with the potential to be the principal player. So as contrasted with being a small molecule player, even making some other large molecules. We think we can play in a significant way here, and we had a lot of client requests. And this was a good asset that was available. So we're -- we think the strategy is really solid.

Got it. I want to talk a little bit about the retooling initiatives you have underway to get growth going on the CDMO side again. You've talked about the centers of excellence and also just rebuilding the sales force here. Any color you can share on how those initiatives are progressing so far?

Just that they are progressing, we were doing multiple things at 2 of our sites. So one of the sites we're just making viral vectors when we did some other things there, the other site, we're just doing plasma. That's a site where we had a COVID vaccine manufacturing contract that preexisted our acquisition that rolled off. So we have to move back in. So I think the clients knowing what we do and where we do it is really important I think focusing on it is critical. We can support multiple geographies from single geographies in that space, which I think is working well. So -- it's ongoing, integration is ongoing and that -- those centers of excellence have been established, have been staffed appropriately, and we're marketing and selling them hard.

Got it. As we think about potentially expanding the cell and gene therapy offering that you have, Jim, not on the table now. Clearly, you work to do in the cognate by gene front in the near term, and you've sort of deprioritized M&A a little bit here. But in the past, you've talked about the importance of co-location. And perhaps over the long term also, there's things you can probably add around storage and supply and the shipping aspects of it. Would that be sort of a natural direction for you to take this portfolio in over the medium term?

Yes. As I said, we have acquired good assets, and we have a large portfolio, both new and legacy in the cell and gene therapy space, which I think will grow substantially. We certainly want to integrate those businesses and get them humming. We want to invest in them appropriately, I was going to say aggressively or appropriately organically. And I think when we're comfortable that, that's going well, I mean, inevitably, we will find some other [indiscernible] or some geographic gaps or scale gaps. The only problem with some organic investment is sometimes it takes longer than the market will tolerate. The science is changing very, very rapidly, and so we want to keep up with it. We have mapped out a whole M&A strategy, not just in cell and gene therapy, but in discovery and RMS and other things that we do. There are other assets that we're interested in, and we have conversations going on prospective sellers almost all of whom are private equity. So the businesses are always the sale at the right price. So we'll add to them as necessary and appropriate. I think, as you know, while I think our M&A activity and strategy has distinguished the company and helped us build a very interesting portfolio. We're not going to do deals just to be larger. So we'll do that very strategically and thoughtfully.

Got it. Fair enough. You talked about sort of cell and gene therapy being about 15% of the top line today. And in steady state, I believe we've talked about sort of the mid-20s growth rate for the segment. I mean if you were sitting here, in 3 years or 5 years from today, how big do you think this business will be as a part of Charles River?

I mean it's tough to say. And we want to revalidate those growth rates given the world at large, and the fact that we're in this business on a significant basis. But let's just assume that those are good numbers. It will grow disproportionately fast in the company as a whole. It will drive the Manufacturing segment disproportionately fast. I do think that the margins will improve, obviously as the scale increases, but particularly as the clients become commercial. So if we're making larger quantities of a drug consistently over a sustained period of time. Obviously, we'll drive -- we'll be more efficient. We probably can get higher prices because the clients are now being paid for the drug as opposed to just spending on it. So it's going to be an important field as immunotherapy is as monoclonals are as a lot of our small molecule work is, I do think it will continue to drive growth rate across all of our other businesses. I mean it's a very complex field. There's a lot of work being done. I think our venture firms, some of whom were LPs with some we just work with are saying that at least 30% of all the companies that they're creating are cell or gene therapy based -- and I think the prognosis is that by 2025, 20% to 25% of the drug will be approved as cell and gene therapy based. So assuming that all plays out, I think we have a very strong business. Even if it doesn't play out, the backlog work that just has to get through the preclinical segment and into the clinic is quite significant. So we think we're going to be very busy for a significant period of time.

Got it. Quickly on biologics testing. You've talked about some of the cross-selling opportunities there with cell and gene therapy manufacturing. What percent of your biologics revenue today is related to cell and gene therapy programs? And then do you foresee this COVID impact that you had here in biologics testing in the near term, essentially being in the rearview mirror now? Or is there a little bit still remaining?

Yes. So I mean, there'll be probably a trivial amount of COVID vaccine testing that we do in the biologics business. We had about $60 million of straight up COVID work that has kind of ameliorated over time. The [Audio Gap] both can give your questions, sorry.

The first part was just the cross-selling, obviously. So yes.

Yes. So I'd say a meaningful proportion of biologics is driven is cell and gene therapy. I think it's more about the growth rate of biologics than the actual dollar percentage. It's an important part of the portfolio. We -- we do have a very tight literal connection between the people that run the biologic sales force in the cell and gene therapy group. So they're literally connected reporting into one another. So -- and we probably -- not probably, before we got into the cell and gene therapy business straight up, we were doing a lot of the testing. So we're cross-selling both ways now. I do think that those organizations are working closely together. A lot of the sales organization is new, as I said, on cell and gene therapy. But that's the closest connectivity. I think it will continue to be an important driver of the biologics business.

Got it. Switching to Discovery. I mean you've talked about some elongation and customer decision time lines. Have those trends essentially held steady through August and September? Or has there been some marginal sort of deterioration?

So we don't want to give mid-quarter updates. So I want to stay with what we said in our second quarter call. And of course, we're reaffirming guidance. So I think what we would say is we feel really good about our DSA business as a whole. Discovery is 15% of that. There's definitely some pausing by clients. So the proposal volumes are quite significant. We're verbally winning a lot of that work, clients -- some clients, very small clients are positive before they're signing it. They're not telling us that they're pausing because they have any concerns about funding. We suspect that, that could be the case, though. So we're watching that closely. We're asking them. We're trying to get more definitive answers for them. But if you look at DSA as a whole, that business is -- we're booking well into '23 and '24. As I said earlier, the back half of this year will be quite strong, as we said in our guidance. We have escalating volume and pricing in the back half of this year, principally for Safety, which will offset any of the discovery issues. So it's a little bit of a tale of 2 cities. And some of the folks that are pausing, may be pausing to be able to bankroll, other drugs that they own that are at the preclinical phase or about to go into the clinic.

Got it. And on that point, the $3 billion in backlog on the Safety Assessment side, as you think about your customer base there, what percent across both your sort of public and private customers do you think need to raise capital in the next 12 to 18 months? And I mean, even qualitatively, I think you had talked about, I think, customers with less than 10% of cash on the public side being about 10%. So is that total number greater than 10%? Or is it less than 10%?

I think it's probably less than 10%. So look, we have a big pharmaceutical contingent, which is obviously well financed. Most of our -- we have more biotech revenue than pharma revenue. Most of those companies have at least 3 years of cash. There's a very small number, 10%, as you said, it probably has less than 2 years of cash. I think the story with them is not necessarily new, a little bit, but not necessarily new. So if you have a really potentially hot drug for unmet medical needs, and you're running low on cash, big pharma will come in and bank roll those companies, I'm sure of that. So as I think -- as I know you know, 50% to 70% of all the drugs that the big pharma companies have are externally [indiscernible] licensed in. And biotech to a large extent, it's a Discovery engine for big pharma. So I think if you've got a very promising drug, pharma is going to buy your company, buy the drug, license the drug, get the U.S. rights to the European rights or you might merge with somebody else. I just think that some companies that don't have a potentially promising drug that are running short of cash, will either get merged or go belly up. I don't think that's new. I think we've always had churn in our biotech base. will be more pronounced now if the capital markets stay closed, maybe. But I still think it's a relatively trivial percentage of our total revenue. And the offset to that is the fact that the venture funds have never been richer. So venture firms are raising new funds every 2 or 3 years instead of every 6 or 7. They're raising bigger funds. They're starting new companies every year. So there's probably 100 or 200 new companies every year to replace a couple of hundred that go belly up for a variety of reasons. So -- and most of the new companies are virtual. And all of them have no internal capacity to do anything that we do. So I don't know. Look, we're watching it carefully. We know that there are some companies that probably shouldn't have gone public. You know what I mean by that. So they went public perhaps prematurely. We're kind of in [indiscernible] secondaries that may or may not happen. So they either get saved by pharma writing in our white horse, so they don't. So I think it's a very small cadre of our client base though.

Got it. In terms of just that 20% growth or in excess of 20% growth you expect in Safety Assessment in the second half, Jim. How much of that is just the amount of pricing that you've been able to capture this year? And given some of the macro backdrop here, are you seeing any kind of customer sensitivity to pricing increases just yet? Or is that just such a dearth of capacity and good partners that you feel pretty confident about them.

The pricing paradigm is just very interesting and very satisfied. I have to say. I think we have one of the most perfect supply/demand balances we've ever had. We've been providing exquisite work for clients for a long time. The studies are getting way more complicated. And I don't think we're being paid well for them 5 years ago. We're getting paid okay for them. But given the fact that they couldn't do it themselves and given the fact that our competitors couldn't do it, we should have been paid better. And our conversations with clients was always price first and everything else second. Now it's do you do this kind of work? Do you have a slot open for us? How fast can you complete the work once you started? Can you get me the data a more consistent basis. Oh, by the way, we're surprised. So it's very, very different pricing conversation. So we're getting escalating prices all the time. So as we work through the back half of this year, including the third quarter that we're in now, and the fourth, the prices just continue to escalate. We also have a nice mix enrichment, which is so we have general toxicology and specialty toxicology, which tends to be less price-competitive. And we definitely taking share. So we have all of that going on. I think the price is a function of the clients being well financed, having very robust portfolios, having limited places to go. And even for the big pharma companies that used to do all the toxicology internally, many of them or most of them are externalizing some or all of their talk. So if they don't want to wait a year or 9 months for us, they can't go back in house. Some can, but most can't. So it's a very interesting balance. We're building space appropriately ahead of when we needed. So last year, we'd be at our operating plan, we had incremental space. We have enough people. We're building space now for next year and the year after. So -- and the last thing I should say, which is worth watching is we're finally having clients, and I'm surprised this didn't happen 10 years ago, certainly 5 years ago. We have a few clients that are taking dedicated space deals with us. So they're actually reserving space that could be empty if they want to start a study next month as opposed to next year. That makes so much sense to me. Preclinical tox is only 20% to 25% of the cost of doing and making a drug at all in the clinic. Certainly, they can afford. It's certainly a big pharma [indiscernible] biotech can afford. They don't have their own space. Why in earth they all doing this. So I do think we're going to see more of that. I think that's good for us. It's good for them. It allows them to start earlier. We try to keep some amount of space available for clients to absolutely have to start tomorrow because they have what they think is a blockbuster drug. But -- so it's been very interesting to watch this dedicated space activity. We had that 20 years ago, interestingly with a few clients. So there probably will be more of that. I think that's appropriate. And I think that's the best way they can hedge against, I don't know, less having institution capacity, our competitors having [indiscernible] capacity, or they're not being able to count on themselves.

Got it. Two news items out of DC. I want to get your thoughts on. On the biologics side, obviously, the biomanufacturing, Executive Order that came out of the White House. What do you think are the long-term implications too early to tell given the details.

I don't really not sure to make about that. I mean that's a lot of politics. Could be beneficial, but we'll see.

Got it. And again, more politics. But Inflation Reduction Act, what does that do to small molecule pipelines, in your view?

Yes. So that could be detrimental to some of those companies getting bought -- or getting bought for higher valuations. I mean it looks like that's based -- that's focused on the top 10 or 20 drugs, not every drug. Probably was predictable. Probably is not going to dramatically impact R&D, or really breakthrough drugs. We have a pretty healthy investment in large molecules. It's about 50-50 now in terms of the approvals. We have capabilities in large molecule and increasingly so -- sorry, small molecule, and increasingly so and large. So I suspect that will have very little impact, if any, on us. It could have an impact on the salability and maybe the share price of some of our clients.

Got it. Switching to RMS, Jim, I mean, to your earlier comment of this renaissance of sorts that's happening there. What's driving that in your view?

Yes. I mean it's really nice to see finally. It's continued pricing. We always get price, high growth in China, very high growth in our service businesses, including an acquisition we just did. In generic engineered models, and then having this incubator space for both large and small clients. The cell supply business, which was the only [indiscernible] company that actually was sort of slowed down by COVID. We actually had to close our donor rooms, was beginning to pick up again. So if you aggregate all of those activities, we should have at least high single-digit growth in that business. And I think an opportunity to over time grow our operating margins.

Got it. On China, obviously, expanded lockdowns there in Chengdu, Shenzhen, et cetera, you still feel pretty comfortable with your back half guide and what you're expecting out of the region? I think there's about a 200 bps headwind in the second quarter or...

I think that was principally second part, I think we're past that and the Chinese government would have meant that they sort of overreacted to that. I think if there's other COVID issues in China are going to be much more thoughtful about the way they restrict people's ability to move around.

Longer term for GEMS, I mean, as you think about sort of some of the ethical and safety concerns that keep coming around the FDA is starting to explore alternative technologies to animal models for preclinical. What's your take on that? And how are you sort of planning to position for that shift if it were to happen?

I mean I don't think there's going to be a shift. But we have -- going back to these technology deals, we have investments in 3D modeling, bioinformatics and AI. I think that theoretically and strategically and potentially some of that may be real. I think it could impact positively, the Discovery process that you may use AI, for instance, in Discovery. Regulators certainly are interested in driving that sort of change. And validating those technologies is really complicated. So we probably look at a dozen technologies a year for companies who want to sell themselves to us that are alternative technologies. So I think that it's unlikely to see any of that in the Safety Assessment. It's likely to see some of that in the early phases of Discovery. I hope that some of these investments we make, pan out and those become acquisitions for us.

Got it. Last one here for me. I want to talk about margins a little bit. I mean I think your guide sort of points to about 21% this year, and you have a 22.5% sort of 2024 target few moving pieces in the near term, outsized pricing and then you've got sort of FX and some of the macro pressures, et cetera. And then, of course, I mean, the CDMO headwinds and the expansion plans in DSA. So you put all of that into a blender, do you still feel pretty good about 50 bps of margin expansion for your -- through '24?

I hope so. I think we're in the midst of finalizing a 5-year strategic plan, which we refresh every year. Obviously, we'll deepen our operating plan for '23. Obviously, the world is a little bit more complicated and a little bit more different. We've made a bunch of acquisitions. So I think we have to relook at our long-term guidance, and we'll be talking about that at the appropriate time.

Got it. But is it fair to say that perhaps a linear rate of expansion is not the right way to think about it, and there might be...

Yes. I don't think it ever was linear. I mean I think we have a digitization initiative. We have our DSA business, for sure, we should see some margin improvement. We have a couple of places. We have some headwinds. I think we have a stronger competitive posture. So I think directionally, we'll improve our margins, what the time frame is have more to come.

Got it. Well, that's a great place to leave it at. I covered a lot of ground. Thanks so much, Jim. I appreciate the time.

Thank you.