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

All right. Thanks, everyone, for joining us. My name is Tejas Savant and I'm the Life Science Tools and Diagnostics Analyst at Morgan Stanley. Before we begin, I'd like to remind our listeners that important disclosure information can be found at morganstanley.com/research disclosures. So it's my pleasure today to host Charles River, and speaking on behalf of the company, we have Chairman, President and CEO, Jim Foster. Thank you for joining us today, Jim.

Maybe to just set the stage, let's start with the biopharma funding environment. You've called out sort of stable to improving trends here in the second quarter. It's something we've heard from other life science companies as well over the last couple of days. But then on the other hand, you've also talked about I guess, an inevitable normalization following a pretty unique multiyear period of R&D budget strength. Help us think through those sort of 2 opposing dynamics.

Sure. So I think there's a certain level of conservatism on the part of our clients since nobody knows when things will be improved significantly, particularly thinking about IPOs and secondaries, when -- when I'm saying that, I think the VC investments have been substantial. I think pharma has been a huge source of capital, particularly for really good drugs from unmet medical needs. But we had things get incredibly frothy in '20 and '21. We had backlogs elongating out 18, 24 months, which was enjoyable. But very difficult for the clients actually to plan out that long. So what has happened with some regularity is they book a slot to start a study out 24 months and now when they get to 20 months, so like we have to let that go because we actually don't have a drug ready. So I would say, more normal healthy backlogs is 9 months with 13 now. That gives us enough visibility on where things are going, gives the clients enough time to plan. It gives us some leverage from a pricing point of view and it gives us some leverage from a managing our headcount and capacity as well. So pricing has been reasonably significant. I don't know, 5, 6, 7 years now it's been a while with some significant volume increases. So there is a duality you have some of the big drug companies who obviously can afford to prosecute whatever drugs they want to develop, but they still have to make budgets and they're public companies or whatever. So they only spend to a certain point. I think some of the smaller biotech companies who are reasonably well funded just because of the uncertainty when the capital markets will open up again, just being more cautious, that's had the most direct impact on our Discovery business, I'd say, end of sadness and to some extent, in the Biologics Business, and the Discovery business obviously comes before safety. You can't have that be for too prolonged period of time now because then you're going to have no drugs later on. So we often see this spending. Well, for the last few years, we've seen healthy spending both in Discovery and Safety. Now I think it's more nuanced the Safety in the Clinic. So and then, of course, there's a patent cliff coming large it's the last one, but there's patent cliff coming. So clients are quite cognizant of that. So I'm sure everybody has their own sense of when they think the IPO market will open. None of us have any idea, but we have a sense of that. And so the clients are trying to vet that and they're doing that by prioritizing their portfolios very carefully and only prosecuting the drugs that they think raise commercial opportunity.

Got it. Do you know the -- your customers are bringing up IRA and then the implications of the IRA at all, now that the initial list of drugs up for price negotiations out there from CMS. I mean it's early days, a lot could change, but is that part of your customers' longer-term calculus?

I think it's impossible for me to answer that. We're not hearing about it much on the clinic. And obviously, there's some sort of initiated. So they're pretty unhappy with that. And I don't know what the punch line will be about whether they'll be successful or not. I think a lot of people think that the government is going to start with 10 drugs, and it's going to increase from the -- raises the whole issue of patent life, and you really protected reading this morning that some companies -- insurance companies were raising the price of generic drugs. So the sort of pricing dynamic is all over the place. And it's -- and even if it sticks and it's detrimental to the clients, which I suspect it would be, way too early to talk about what the impact would be to us. I could argue that it would necessitate more outsourcing. I actually could say that without being positive, particularly by the big drug companies to do less inside since we can do things as quickly for the same or better quality of science that are much lower price points. So if they have to cut things back because patent life is somehow threatened that could be beneficial.

Got it. Just looking closer at your safety assessment backlog growth, I mean, are you seeing any sort of uptick in either sort of conversion or cancellation rates or proposal volumes? Have those metrics now bottomed in light of your comments around sort of signs of stabilization?

So this is not an inter-quarter update. But I would say that's hard to say. Slippage and cancellations is sort of a cost of developing drugs. So when none of the CROs existed, that happened all the time with the drug companies, right. Drugs weren't ready on time. They couldn't -- toxicity was too high. They couldn't formulate it in a way that would be tolerated by the patients. So we've always had slippage and we've always had cancellations for which we usually can exact the penalty sometimes now with a larger client. So I would say that's a proportion of cancellations and slippage has increased, a, because the dollar volume has increased, and b, because the backlog has elongated to the point where they actually don't -- as they said earlier, they don't know what they're going to be doing. So I think that -- and I don't know -- I don't know whether that's bottomed out yet. It sort of feels like there is moving towards the normalization of the time frame to wait, which, as I said earlier, I think, is great for all of us, right?

Right. Fair enough. What about sort of industry-wide capacity utilization? You've had the exogenous sort of NHP shop of the system, you also have some normalizing demand trends. Where does that stand? And how do you feel about your ability to continue taking price here? And obviously, that's not the only variable. There's lots of other things at play that sort of drive pricing. But just give us a flavor for that.

I would say our capacity is extremely well utilized. It has been for at least a decade. We've built very small subtle amount of incremental capacity every year. In, I don't know, 5, 6, 7 different sites because clients like proximity. We've tended to utilize it really well. There was enough play in it so if business is better, than we anticipate as it was in 2021 and '22, we can still accommodate that. But if it slows in a meaningful way, we won't have too much capacity. So -- and it feels like with a couple of exceptions, it feels like price is readily available across the entire portfolio. It certainly has been in safety now. It feels like almost a decade and it's been accelerating for the last 3 or 4 or 5 years. So both volume and mix and price are at play here. I think as long as capacity is well utilized just given the nature of the competitive dynamics that we'll be able to continue to get price.

Got it. Switching to NHPs. You've been able to do a really good job mitigating those supply chain issues by looking -- moving work overseas. What's your confidence in being able to do this on a permanent basis, should the need arise in light of sort of your capacity abroad? And are you starting to see any evidence of share shifts in terms of your ability to do this relative to the competition?

So we're quite confident that we can continue to do this add into an item, that it's probably a permanent change on non-U.S. facilities, particularly the ones we're talking about now are quite substantial, lots of experience doing this complex amount to work well staffed, friendly governments, help in building new space in terms of financing, readily available staff and as it turned out some incremental capacity, which was available when we needed it. So we're quite confident we'll be able to continue to do that. We still do a lot of NHP work in the U.S., but less than we did last year. And we have multiple sources of supply now, and that's -- and I think it holds us in good stead. So the NHP supply is plentiful, I would say, right now. That's obviously a good thing. We have not disrupted any of our clients just in terms of study start dates throughout this whole craziness, not at all. So we started studies. And so I think clients are quite pleased with that. I think we've demonstrated the power of this large international infrastructure that we have with a lot of safety sites. As I said earlier, a lot of clients like proximity. Our Europeans will want to work in France or the Netherlands, they'll work in the states, if they have to or the expertise is better. We've also moved more towards being able to direct the clients to the site that we want them to work out, which is something we've always aspired to do, but we really haven't been able to do as robustly as we have for the last few years. So we want to be able to say, okay, thanks for the study. We can start it in 6 months, and we're going to do it in Edinburgh, Scotland. I hope you're okay with that and you want the client to validate Edinburgh and feel good about that. So right now, that feels to be increasingly the case.

Got it. One of the questions we get on the NHP situation, Jim, is, could the U.S. investigation broaden to include other countries beyond Cambodia. When do we expect to get some sort of clarity around that? And then the other part of the equation is, occasionally, we'll get the ask around could China start importation of NHPs from Cambodia to perhaps like tamp down local pricing in that market? And how do sort of these dynamics impact sort of the global supply situation?

It's impossible to predict what will transpire and impact other geographies. We don't think anything will transpire, but we don't know that for sure. I don't want to talk too much about this DOJ thing, except to say that, as we've said multiple times, we believe with regard to us, it's without merit, we've had very few conversations with the government about that. So it's been very slowly evolving. And so we have no new information. So this is going on for months, right? I thought this would be resolved in a couple of weeks. Going on for months. So what's the basis of this? Is there a basis of this? Does it really have anything to do with us? How will it swap over into the geographies, we don't know. So and all we do right now is run our business as well as possible with great integrity and speed and sign other sources of supply for our clients, which we have done. The China thing, I have no idea, I hear from the folks who work with and for me every quarter that China is about to open up both the import and export. I don't see any evidence of that happening, so it's just noise. They have a large supply -- in-country supply. So it seems to us that they can take care of local demand from local pharma companies and CROs could they bring animals in from Cambodia, I guess. I don't know why that would be preferable, we can barely answer that. I think it depends on the price point. So we're not spending any time worrying about what China is doing. It's having no impact on us. We have some sources of supply in China. As I think you know, we're actually selling those animals in China, the CROs pretty good margins that really wasn't our preference. Our preference was to get those animals out of China and use that for safety assessment. And of course, we pivoted the Cambodia only because China closed its borders, and we knew that would happen. We knew eventually the China is going to wake up and say this is a valuable natural resource that we have. We're going to keep it in country for ourselves and we're not going to allow these animals to be transported to the rest of the world. So not a surprise.

Got it. In terms of the more budget-conscious mid-cap sort of biotech client base, is that greater sort of openness among that sort of customer constituency to look at some of these Asian CRO partners in the context of them not having to grapple with some of these challenges?

I think some of the very small companies that are poorly capitalized or have consultants that tell them it's the only way that they'll be able to sustain their growth and stay in business is to do things at lower price points. The capacity that's available in China is quite small. And most of it is used for local Chinese companies, but we really see this from a competitive bid point of view, we're not really bidding against these Chinese companies, but we hear that some clients are going there. I think that's -- I mean I think that's fine. There are some issues associated with doing that, right? And we're going to get lower price points, probably worst service, probably worst science and some risk associated with IT and all of that. So it's definitely not the preference for most of the clients in the space and the amount of capacity in the -- in our infrastructure, for instance, is so dramatically larger that it's really not a concern of ours.

Got it. Switching to the Manufacturing Support business, Jim. You saw really strong growth in CDMO last quarter and you called out the central excellence model that you've set up there and your investments in commercial readiness and rebuilding that funnel. Are you seeing any impact from the funding headwinds, particularly for the cell and gene therapies or modalities? Is there perhaps a degree of industry-wide overcapacity at the moment?

Doesn't feel like it, we're hearing that a lot. I can tell you that we have -- we definitely don't have excess capacity in our CDMO business. We just built some new capacity. We have a larger number of clients than we had 6 months ago or a year ago. We also have 1 client that's moved from clinical phase to the commercial phase, which is great. We've had a bunch of government audits of our site, and we have several clients that we're dealing with, all of whom I have some interaction with personally, that believe that the drug is on the precipice of being growing commercial. They are all gene-modified cell therapy drugs for horrendous diseases for which there is no alternative therapies. So these are unmet medical needs. Yes. There's a fair amount of caution on the part of the regulatory agencies in terms of improving needs. I think there's 13 or 14 cell or gene therapy drugs that have improved in the world and over 3,000 that are being worked on. So that's a very small number. There's some concern about the safety profile when you are dealing with people's genome. Having said that, there's a great promise in these drugs. So where the sales cycle is long, but I think we're doing a good job building a base of clients. And look, we have no control over when these drugs go from the clinic to commercial. I don't want to have an opinion because the client's opinion is always too optimistic. And I think the amount of drugs that they think that they're going to manufacture with us the first year usually optimistic. But having said that, it's likely they'll get approved. And we are having discussions with pretty much all of those clients with some take-or-pay arrangement. By that, I mean, okay, so we don't know when we're getting approved. And we actually don't know how much will need of the product. But you better have the space for us because we don't have our own way. So that's a good proposition for us. And basically, they're going to pay us what they would pay us if the one was full and generating revenue. So we're having those conversations right now as well. So I'd say that business is logarithmically better than it was a year ago in pretty much every way clients, quality facility, quality staff, quality of sales organization, sophistication and sales organization and sophistication of ability to manufacture. And also, the connectivity between our CDMO business and our Biologics Business where we're testing just large molecules, a little bit our microbial business where we're doing some testing as well, usually before they go into the clinic or after the drug is approved in our Safety Assessment business. So the strength of our portfolio has always distinguished us from the competition. And so it's overcapacity, thing that's about the third time I have heard that today. I think some of the larger CDMOs may have some capacity issues. I don't know whether it's specifically in gene-modified cell therapy. We only have a couple of these companies that we compete with. And while they're good at what they do, I certainly wouldn't disparage them. They don't have the breadth of portfolio that we have. So I think we have a better opportunity to sort of pull the work in than they do. So it's still early days, still definitely not happy with the margin profile of that business, increasingly happy with the growth rate, though.

Got it. That's great to hear. And I will get the margins in a second in manufacturing support, but microbial solutions versus biologics, safety testing, opposing dynamics there at the moment. I think you called out bio-care and cell banking as pockets of weakness for biologics testing. And then Microbial Solutions actually seems to be pretty resilient. So walk us through what you're seeing in those 2 sort of segments?

In the biologics business tends to start off slow in Q1. So -- and tough to read. What, if anything, that says about the rest of the year. So it started off slow. I do think that the biologics has been impacted by some of the slowdown in demand by a smaller large molecule companies, biotech companies that are concerned and the viral clearance stuff and cell banking are some things that they can delay until later in the process. Cell banking is something that if they want to, not small companies, but some of the larger companies can do themselves. So both of those activities are highly profitable and pretty high growth rates. So they're waiting a little bit until later on in the drug development process there. It's tough to predict that work comes in very quickly and goes out very quickly the nature of the work is relatively short, the margins are quite good. So I don't want to get into specifics for the back half of the year, but we'll -- typically, we see that ramp. Microbial business has tended to just be steady. It's a bit different. It's a quality control clearance. I mean you're testing drugs that have been manufactured to make sure they didn't become contaminated while they're in the manufacturing process. And that's required by law. So it's a different dynamic than the biologics testing not optional. So if you have a drug and it's going to the clinic, or you have a drug and it's commercially viable, you need to do this work. So it's a business that's had really good staying power for us, both in terms of its growth metrics and margin profile.

Got it. On margins for manufacturing support, I mean, I think it's probably one of the more underappreciated sort of levers you have in the model today. I mean, the margins there once upon a time were almost 30% plus. Do you see a path to recovery there just from positive operating leverage. I mean, as you see that rehab in the CDMO piece. Of course, there's some offsets from biologics testing, et cetera, and perhaps a tighter funding environment. But walk us through your expectations for leverage in that business?

The margins there are in the mid-30s for the year, we had a couple of years where it was 36% or 37%. So the way we look at the CDMO business that's accretive to revenue for sure. That is, as I said, that will be increasingly less dilutive to margin over time. As the business gets larger as we have more commercial clients, as you are manufacturing the same drugs over and over again, we should see some efficiencies. We obviously will price commercial product a lot higher than when pricing product is in the clinic. And of course, the client can afford to pay for it because now they're getting paid for their drugs. So I think directionally, Microbial business is extremely profitable and Biologics had a slow couple of quarters had a very strong year last year. So directionally, that could be accretive as well. So when we bought the CDMO businesses, what we said was there would be a headwind to margins for a while. I don't know what a while means, but less dilutive each year. Still -- we still stand by that. And as I said, as it gets big enough, it has the propensity to be accretive to margins, but we don't own that for a fact. But I do think that whole segment has the ability to grow faster on the top and the bottom line.

Got it. Fair enough. Switching gears to RMS. I think you talked about over 50% of RMS revenue coming from academic and government customers. One of the questions we've gotten is if NIH budgets do see a low to mid-single-digit decline next year, could that be an overhang for RMS?

I mean, I guess, I don't know why you'd see a reduction in NIH budgets. But it takes a long while for that to flow down to us. So maybe not, we have a fair amount of government contracts. We have long-term relationships with these academic institutions and some of the government folks. So yes, potentially in time, that's possible, but I don't think we would see it anytime soon.

Got it. And then China, I think it's sort of a low double-digit percent of RMS sales mainly on the model side of the business. We've heard some pretty alarming commentary from life science companies in terms of what's going on in China there and biopharma customer disruption, some of them called out and anti-corruption sort of crackdown, I'm not sure that really impacts you. But just curious as to what you're seeing in RMS in China at the moment.

So I think some of the tools companies are having a rough time there, which is probably what you're referring to. And so some of those products are unlikely to be bought, if they're really watching the dollars. I think our portfolio is much more basic from an R&D point of view. And so you sort of have mice to do your Discovery work, you're probably not doing Discovery work at all. Our competition is primarily Chinese companies. And while they're working hard to have good quality. I think a lot of them have been struggling. They have no history. They have some money probably from the government. And we've seen none of our international competitors going to China, which is really surprising. So we're kind of on our own from a historical quality and reputational point of view. I think if you want to get a drug, a Chinese drug sold in other parts of the world, analysts that you use to discover that would be pristine. And when you write that up, I think you're going to have some regulatory focus on that. So China is a complicated market for sure. The COVID issues have been complicated. But the government has pretty much left this alone. We built a bunch of facilities because of the size and scale of that country to be close to some of these smaller cities still at 10 million people in them and that business has grown pretty much -- we're probably slightly more than 10 years in China, and it's growing really nicely.

Got it. Last couple of minutes here, Jim, I want to talk about M&A, right? So in terms of just key learnings from Cognate and Vigene, is there anything you'd look to do differently in terms of your approach going forward? I know it's sort of not a near-term priority for you. And second, just given the regulatory backdrop and the antitrust scrutiny, how does that sort of impact your preference for size or financial profile and how you weigh those factors versus strategic fit?

So we have a fair number of conversations going on right now with potential targets. Most of the sellers are private equity companies. I don't know yet where the multiples are going to come down or not. We'll see as we get into some price conversations. Some of the things we're talking about, I don't think we'll have -- I don't think we have FTC problems in them at all. And I think we want to stay close to our knitting. So obviously, one of the obvious complexities in the CDMO business is it's a new business for us and that's new science. So I think it's been more complex than we had anticipated. But some of the things that we're looking at. And most of the things are except for one company, most of them are of moderate size.

Got it. I want to talk about -- you have an Investor Day coming up shortly, and I don't want to steal your thunder next week. But a couple of years ago, you sort of pegged your long-term targets at low double-digit top line growth, 50 bps annual margin expansion. And to your point, I mean, it came on the heels of an unusually strong funding cycle and your CDMO acquisitions back then. How do you think about sort of the puts and takes as the sort of frame your presumably revised long-term growth outlook next week.

I'm not going to give you the specifics, but we're going to give an outlook for a few years. I think that we feel comfortable that we'll be able to call that accurately both with regard to top line growth and margin accretion and also free cash and other things like that. I think we have a really good sense of the competitive dynamic and how that's unlikely to change in a material way during that period of time. And we tried to make some reasonably conservative estimates as to demand curve and what's going to happen with the IPO market. But we feel good about sort of directional, what the demand will be on a directional point of view, and particularly good about the breadth of the portfolio.

Got it. Fair enough. Looking forward to hearing more next week. Thank you so much, Jim. I appreciate the time.