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

So they say we're ready to go. So Dave Windley with Jefferies Healthcare Equity Research coming up on my 24th year, believe it or not. So welcome to Jefferies Healthcare Conference 2024 June here in New York. Very appreciative of your attendance and interest in our next presentation, which is Charles River. Flavia Pease is the company's Executive -- Corporate Executive Vice President, got that right, Corporate Executive Vice President and CFO, more importantly CFO. And we're just talking outside that she's just past her 2-year anniversary with Charles River and our fireside chat in November of '22 in London was one of her first. So we're revisiting our discussion here. So thanks again for being here. Good to see you.

I wanted to just start right off the top on kind of the outlook for the year and, call it, captured in guidance. 1Q had some factors, some transient. I think you guys have described factors that influenced growth in the first quarter. So 1Q starts a little bit below your expectations for the full year. And then you're expecting, I think, growth to ramp a little bit and margins to expand a little bit. And so maybe you could talk through the kind of the key drivers of each of those to get to your guidance for 2024.

Sure. Good morning, everyone. And Dave, thanks for having us. It's great to be here. To your point, our outlook for the year after the first quarter remained consistent with the guidance that we provided in February. The way the first quarter happened was consistent with what we expected. There was just a bit of a shift in gating between Q1 and Q2 driven by timing of NHP shipments. Manufacturing performed a little bit better. But overall, the guidance and the outlook for the year remain intact. So that gets us to your question around how did we guide and what are we seeing the year developed, especially with a slower start and then a bit of a ramp in the second half. So let me first start by saying, if you actually look historically and you exclude last year, which was a little bit of abnormal year in terms of the quarterly trends, we tend to have about 52% of our revenue in the second half. That's just our normal trend. And then this year, at the top end of the range, it's the same level, 52%, consistent with history. Obviously, that assumes a modest improvement in the demand environment in the second half. The good news is the factors that will lead to that, we saw some of those signs in the first quarter. Funding was very robust. I think you just published your May report, I think, today or yesterday, and it was, again, another good month, a little bit lower than the Q1 average, but still flat to April. And funding was robust among all sources, PIPEs, VC, IPOs and especially IPOs was nice to see that picking up in the first quarter of the year. So with funding improving, we also saw an improvement in proposals, which is a leading indicator to eventually bookings and then revenue. I think you also talked about that in one of your reports that it does take a little bit of time for that cycle to go through. But if you look historically that's what we see in our industry. So we're seeing those leading indicators that lead us to believe that there is this possibility assumption that the second half is going to start picking up a bit of steam versus what we're seeing in the first half. There's also the comps. Our first half last year was stronger than the second half. And so just on a comps basis, you're going to have declines in the first half as we saw in the first quarter and guided to the second quarter and then a nice growth rate in the second half. If you go then to margin and earnings, there's an intrinsic leverage that happens in our business. And if I go back to the same last 5 years on that 52% of revenue in the second half, we normally get 54% of margin. So there's a normal leveragability in our business to deliver additional margin once your sales expands. This year, in the top end of the guidance range is a little bit more than that [ 46%, 54% ], and there's reasons for that. First of all, in this lighter demand environment, we have done some restructurings and some reorganizations to rightsize our workforce to the lighter demand environment. I think we talked about that in the first earnings call, we can get it deeper into it. But we didn't, let's say, cut as deeply as, perhaps, we could because there's an expectation that the demand -- that this phenomenon is transient and the demand is going to come back. And so we have an ability to accommodate work in the second half without having to add as much staffing. So that helps with the margin expansion. In addition to that, those actions that we took, we also talked about, it's about $70 million that we guided for the year. And while we started some of those as early as last year, I think last year, we said they were annualizing to $40 million and then we continue to look at given where demand was and now they're annualizing to $70 million, but some of them were still being implemented and executed in the first quarter. And so they pick up steam, and they will be fully implemented by the third quarter. So you have a benefit in the second half of additional savings associating with some of these actions versus the first half of the year. And finally, I think we talked about also when we acquired Noveprim that business has a bit of seasonality. It's strongest in the fourth quarter given the shipping patterns and trends. I don't like to go through laundry list of things, but there's a bunch of items and factors that will lift that margin in the second half more so than the first half.

Okay. Great. I'm going to kind of go segment by segment and start with RMS. So one of the themes and inbound questions that we get is around RMS growth rate, in a way that portrays to me that folks kind of don't realize that this used to be a low single-digit grower and now is an upper single-digit grower because of how you reform the kind of the composition of that segment. And part of that was some investments in cell and gene therapy support capabilities. So maybe you could talk about the faster drivers of growth in RMS that are cell and gene therapy targeted, CRADL, et cetera, and what the outlook is for those businesses to continue to drive that higher growth rate in RMS.

Sure. And just to your point on cell and gene therapy, we have a couple -- we have cell and gene therapy work across our entire portfolio even in safety. And then we did a few acquisitions to your point. We had a self-supply business that the word says is about collecting cells that can then be used in manufacturing. That part of the business, as you pointed out, resides in the RMS segment. But then the bigger portion of our cell and gene therapy portfolio is actually the CDMO portion when we actually are manufacturing product for our clients and that actually sits in the manufacturing segment. That's the majority of our cell and gene therapy offering. Within the RMS business, I would actually say the biggest driver of growth acceleration is more the CRADL and services business more so than the cell supply that you alluded to. That cell supply business was negatively impacted by COVID. Donors couldn't go to the donor rooms, and we essentially had to sort of shut that business down for a prolonged period of time. In addition to that, since that acquisition and during this period, there's a little bit of a shift in the business itself, what is being produced and by whom. You got other players like cell banks coming into the market and sort of servicing the more commoditized part of the market. Similar to what we did in our CDMO business, where we retrofitted and created centers of excellence, focus on gene-modified cell therapy, plasmids and gene and -- viral vectors, excuse me, in the cell supply side of the business that resides in RMS, we also reconfigured our portfolio and sort of upgraded it from the more commoditized portion into kind of higher-grade GMP offering. So that is still in the works. I think that business is poised to having a better year this year, but it's not the primary driver of the RMS growth that you were talking about. That is really on the services, the differentiated services, whether it is CRADL and even our GEMS, our genetically engineered models that we provide. Those are more sophisticated models that are sold at a higher price, and we provide services in managing those colonies for our clients. And so it's really the expansion of the services business that I would say more so is driving that increase in growth rate in RMS. And just for those of you that are not familiar with CRADL, they've used the term think of it as a vivarium as a service. We provide capacity for anywhere from like one cage you might want to have to an entire room and all the services that are added to it, husbandry, the veterinary, regulatory and we have the facilities. When we started that business, sort of the assumption was going to be it was more of an offering for small biotech clients that didn't have infrastructure that didn't want to invest in infrastructure. But actually, it's been surprising to us in a good way, even large pharma is happy to adopt that model. And in fact, we have now sort of anchor clients that will take 50% of one of our CRADLs and just fully dedicate to one large pharmaceutical company, for example. So those are really the drivers in RMS.

Yes, that's great. That's a great segue, too, because I wanted to ask a specific question on CRADL. In the first quarter deck, there was discussion of focus in certain markets. So I think you've logically built or established these CRADL pins on the map in major biotech hub research areas like Cambridge, like South San Francisco, San Diego, et cetera. And you had some commentary in the deck about focusing, kind of maybe down playing, I think, it was South San Francisco because maybe it was a little crowded and kind of doubling down on Cambridge. So maybe talk about the regionality of demand or the competitive landscape.

You're spot on in how you are portraying our commentary. The market for this vivarium as a service for the CRADL is still robust. It's not immune to the slowdown in demand that we're seeing in general in the industry, but it's still robust. And in fact, we have plans to open new CRADL facilities this year, although at a slower clip if you will than it has been in the last couple of years. And to your point, these CRADLs are focused in the biotech hubs and even sort of micro geographies within like in Boston, it's not just Boston it's Cambridge versus other locations. To your point, in South San Francisco, we did an acquisition of Explora just before I started with Charles River in April of 2022 and with that acquisition, there was a robust footprint in the South San Francisco area between ourselves and what Explora had. And as some of those facilities, the lease on them expire, we're using that opportunistically to sort of optimize the footprint. But to your point, San Diego, Boston, still very robust, and we're actually opening new locations in these regions. So it's not that South San Francisco is being deprioritized, it's been strategically optimized, I would say, given kind of the overlap that we had in some capacity there.

Yes. I appreciate you're putting in context that Explora had a big footprint there. So that's interesting to know how that folded in and then some of the lease expiry. While we're in RMS, let's spend a minute on small animal model sales because that's historically been really the core of RMS, and it's a good kind of barometer on early research activity. So talk about model sales, please?

Yes. sale -- small models is sort of the most, I would say, basic effective research tool. I think we get questions over the last couple of years, especially in China, right, some of the tools companies have seen that being impacted, their business being impacted, and we have a models business in China as well, and we didn't see that. It slowed down from higher years but still healthy demand. And I think part of the reason is it is still the most effective -- cost effective and practical way for research to be conducted. So the business is still growing. This year going to benefit more from price growth than volume, which has been historically the trend in RMS in the small models part of the RMS business. But in Q1, we had growth across the regions China led, and we continue to see good demand academic, which is a unique part of the RMS portfolio, right? We don't really see a lot of academics buying safety or in manufacturing, but it's a big segment for -- the RMS business was solid in the first quarter. So still good demand there.

Got it. Let's move on to DSA, clearly important. We need to touch on that before we run out of time. On the first quarter call, and you referenced it earlier that funding had improved. There was a little bit of a sentiment improvement, and you mentioned proposals. So I might first of all clarify, your comment on proposals was a first quarter comment or a kind of quarter-to-date 2Q comment?

No. And thanks for asking to clarify that because as you know, Dave, and some of you that follow us, we do not provide really intra-quarter comments, month by month is things move around. And so we try to make sure that we have quarters under our belts when we provide guidance. And so we'll provide more color, more robust color, commentary for all of you after the second quarter. So I was referring to increase in proposals in the first quarter.

Okay. And then in that first quarter context and commentary first quarter call, Jim talked about using price in some. I get the sense it's more surgical but using price, talk for us about how Charles River is using that and where? Is it more NHPs? Is it more small animal? Where is that price being applied and maybe the competitive landscape that you're facing in doing that?

And you're almost doing the work for me because I was going to use the word surgical. So I think in the first quarter call, we talked about selectively discounting and that's important to qualify because I think you and others might do channel checks and get the information about a certain competitor or a certain body of work being discounted and then appropriately. So you're asking us our perspective. And it is not broadly based. It's not across the entire portfolio. In fact, in Q1, we still had positive price in the DSA segment. There's other parts of our business like RMS that we talked about. We've been able to take price year after year, and we have a lot of pricing power there. In DSA, obviously, it's not immune to a demand and supply dynamic. Over the last couple of years, we had a lot of pricing power. Obviously, if the demand softens us, we have less pricing power, simple math. But the thing, to your point, Dave, is surgical in the sense that the safety business is unique that there's not a price list. You don't go and you buy and it's a product and it's a price and then maybe you have a discount off of that. Every time you're quoting a study, it's a unique product, right? So every time we have a chance to price that and to price it based on the supply and demand quotient to how we are -- how busy or not our sites are, other people sites are but also the type of work. If you think about the industry and you ask about the competitive landscape, we have about 30% share in safety. The next competitor is less than half of our size, and then you have a lot of smaller players. And these smaller players, they are capable and qualified, but they have a much narrow portfolio, right? And so they are more focused on the general talk space rather than specialty. So for example, we really don't have and don't discount on the specialty side of the house. In the general talks, we might do it if it's a new client that we've never done work with, and we're trying to have a sort of trial offer for them. So that's what we mean by selective or surgical. And I get the question, well, why are you even mentioning if it's selective or surgical like that? One, because we get the question from you guys, well, I hear competitor A or Competitor B is discounting this much, are you guys doing it? And two, because I think, we have said the pricing power is not as robust as it had been 2, 3 years ago, right? So it's -- we want to be transparent and clear around what we are experiencing in the marketplace.

Got it. That's very helpful. So maybe coming back to the guidance question and my next question is around cost reduction. Certainly, some of the cost takeout that you talked about at the top applies in DSA, maybe you could comment on just how much.

Yes. We haven't broken down by business, but I think a good rule of thumb, right, DSA is 60% of our revenue and Manufacturing is 20%, RMS is 20% in round numbers. The actions that we've taken were across the entire portfolio. So there's going to be benefit across the 3 segments. It's not the 20-60-20 necessarily precisely but that's a good rule of thumb to try to figure out how to sort of apportion some of the savings between the businesses.

Got it. And then thinking about these 2 things converging. So it looks to us and I think kind of within your guidance, it's consistent that to get to the guidance as we talked about earlier, you need ramps through the year. I think DSA is one of those. DSA margin maybe in particular goes from 23.5 first quarter to something well into the upper 20s. To kind of get there through the year, cost reductions are going to help, but you also have this kind of surgical price discounting. Maybe talk about the relative balance of those influences on the margin and how that margin ramps through the year.

Yes. And I think the size and the impact of discounting is not profound because it's surgical that is going to have a major -- creates a major headwind on the margin acceleration that we see. The margin is really going to be driven by that additional volume that I talked about. One, because as I mentioned, we now have the staffing to take on work without having to add people because even though we rightsized to the demand environment, we didn't want to go too deep and then have to hire a lot of people and have a lot of people being trained and not be able to support that demand improvement that we are anticipating happening. So it's really the volume that is going to help drive that margin accretion in DSA.

I'm going to move to Manufacturing in the interest of time. So in our follow-up conversation, you had described to me, hopefully, that the microbial -- the kind of longtime businesses of Manufacturing had worked themselves back up to, what I thought I interpreted you to say, pretty normal margin. And so that kind of implies that the CDMO business is not all that profitable at the moment. Would you agree with that? And to the extent that Manufacturing is the driver to get you to your targets for Manufacturing margin what does it need to have?

Yes. And you are absolutely correct. If you get a focus on the 2 legacy businesses, I would say, that they are back to the legacy margin pre-CDMO acquisition. When we acquired the CDMO businesses, we did say that they will be margin dilutive. What I would say is, they were more dilutive than we had perhaps anticipated at the time of the acquisition because as we said over the last 2 years, we really completely reconfigured those businesses, right? Starting with creating these centers of excellence in plasmids, viral vectors and gene-modified cell therapy. There were facility investments, there was equipment, there's personnel that we had to add. So it was heavy investment in 2022. And then in 2023, those investments continued as we had 2 of our clients' products become commercial. So there was a lot of investment in quality systems, getting ready for commercialization and regulatory audits. That's all done now. So the expectation, assumption is you now have a cost structure that can absorb a lot of additional volume without any incremental investment. And so as the businesses the business continues to grow, and we're not going to have time to talk about cell and gene therapy, but it is a space that continues to be robust for us in terms of demand, booking -- proposals, bookings, the pipeline is nice. So we see that path to additional revenue in that business and with that revenue driving additional margin as you have a scalable business now.

Got it. We're getting the flashing zeros, but I'm going to sneak one in, and it's probably a big question, but maybe you could just point to one thing on biosecure, so where would you expect to derive the most benefit from that if that ultimately is passed and implemented.

So to your point, if it's passed and implemented. So let's assume that that's the case. We do think that it's positive -- it could be positive to Charles River. It's important to caveat though that you wouldn't see any immediate impact, right, because there's grandfathering both in the House and Senate versions of the bill. One is forever grandfathering. The other one is, I think, until 2034, '35, but over time, so those people that are doing work with WuXi today are going to probably continue doing work. But what we do thing could happen is additional new work that is going to be started, clients might be more risk averse about starting work with them, and they will look for Western CROs like Charles River. We think the biggest potential impact would actually be in the biologics and CDMO space. We do compete with Wuxi also in discovery, but a lot of that discovery work that they do is more chemistry, kind of lower cost, more commoditized, which likely will go to somewhere like India before it comes to a Western CRO. But we are actually seeing -- starting to see some inquiries into the CDMO and biologics space. We had a couple of bookings. They are not meaningful, but we're starting to see some of that.

All right. Very helpful. Thank you, Flavia. Thanks for being here, and thanks for the audience's attention.

Thank you very much.