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

All right. Good morning, everyone. I'm Tejas Savant, and I cover the life sciences sector here at Morgan Stanley. Before we begin for important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, do reach out to your sales rep. So, it's my pleasure to host Charles River this morning and speaking on behalf of the company, we have Chairman, President and CEO, Jim Foster. Thank you, Jim, for joining us.

Pleasure.

Maybe just to kick things off, let's start with the biopharma funding environment. A lot of focus there. You called out sort of a period of rapid and unexpected deterioration on the global side of things and you attributed it basically to the IRA and the patent clips. When we last spoke, Jim, you sort of call these changes as profound, right? And you have a lot of credibility in the space. You've been at Charles River checking when you joined. It's longer than I have been on the planet. So when you say something like that. So people take note, right? So walk us through what changed? And what are you currently hearing from your customers?

So it's an interesting tale of 2 cities, right? So last year, pharma was a source of significant growth, more than they had been for a while. So biotech has been driving our revenue growth for at least a decade. And pharma has always been an important client base, but last year is particularly strong. And then the sort of abrupt deterioration in demand this year somewhat surprising. No one's really asked, but I think people are saying, well, how come you didn't know that, that was going to happen, right, since we talk to these people daily? And the reality is that if a company is going to dramatically reduce its kind of infrastructure and workforce and whatever, they're not going to wear that on their sleeve. They're going to plan for that for a substantial period of time, and then they're going to execute it. And the folks that we deal with, which are often the head of R&D, pretty senior person doesn't -- isn't necessarily participating in that. So was sudden. So we're seeing definitely a hesitation and pullback on the part of big pharma, reduction in their infrastructure, reduction in their portfolios, some concern about a whole bunch of things. I think, it's probably the most significant. I don't know, but I don't think the election is necessarily a huge deal for them, and IRA is not new. And this whole notion that the drug companies would work on less small molecules because of IRA is actually not true. They say that, but reality is that whatever is druggable against the target, that's what they're going to run with. So you still see a proliferation of small molecules. And biotech is very much tied to interest rates, crazily tied to interest rates. You can just -- you can feel when we talk to them, what the Fed says and what happens to both our stock prices and what the clients say is quite interesting. So they're tied to that and they're tied to access to capital markets. And so what's a little bit unusual about what's going on with biotech because the funding is actually not bad. I think the first quarter this year was the fifth best quarter in the history of biotech. It feels like the last couple of months maybe weren't as good. So there -- I think biotech is quite off balance, right? There's a fair amount of volatility in their viewpoint on the spending patterns. Having said that, it's definitely improving, but more slowly than we had anticipated. Who knows? I think at the end of last year, we thought the capital markets would come back strongly the back half of this year. It certainly doesn't look like that's happening. So before an IPO or a secondary point of view you can validate that. And so they're quite cautious. I do think that as interest rates come down, which we'll see. And if the IPO market opens up and if the election is relevant at all and that's behind us, I do think there's an opportunity for biotech to accelerate.

Got it. So Jim, how much of this is just customer psychology around access to capital down the road versus anything that you can see in their financials today.

I think a lot of it is psychology. I think most of the psychology. I mean we've been having questions from our shareholder base for at least 10 years, sometimes annoyingly when biotech's spending was at an all-time high, every question I get and every one on one is when is that going to slow down? So this is sort of overwhelming concern that the rug is going to get pulled out from either them and capital is not going to be available. And so I do think they worry about that a lot. But the science generally across biotech and pharma has never been this significant. The modalities that we're dealing with are extremely exciting. And I think there are a lot of, potentially, very impactful drugs that have been parked. But -- my Boston accent have been paused. And they want to get back to those as soon as probably you have INDs that we know they want to file that have been paused and they file the INDs. So we have a major emphasis in the clinic right now by biotech and pharma. But I do think it's very psychological and sort of set upon itself. And even as things have improved, albeit what I said about the first quarter, there's still concern about, well, what if it slows down next quarter, what if they raise interest rates again? Or what if the IPO market closes or what is the war in the Middle East blows, whatever. Right? So they're quite cautious.

Fair enough. On that note, I mean, would you be surprised if what you saw in June and July sort of percolates to other areas of the life sciences end market? I mean one of the questions we get is, are you the canary in the coal mine? Or is it just that your assumptions at the start of the year were a little bit too optimistic versus what translated in terms of either these pipeline reprioritizations, or the interest rate environment and so on?

I think to some extent, we have the canary in the coal mine. To the extent that we talk to pretty much every pharmaceutical and biotech company with some regularity, both here and abroad. So when things heat up or slow down, we tend to hear about it earlier. Now we have a lot of questions about of either canary in the coal mine with Discovery leading into safety, I think the issue there is that a lot of the drugs have been discovered. And as I said, I think they've been parked for a while. So knowledge about that, I don't think it's going to be beneficial to us in terms of how we work with these folks. But there's clearly a lot of pent-up demand with both pharma and biotech. And the emphasis in the clinic is practical and logical to get drugs into the clinic and ultimately we get them into the market. By the same token, you can't starve discovery and development for too long because then you have no future, you have no clinic. You have no drugs in the market. And so for the last 10 or 12 years, at least as the world has occurred for us, some pretty balanced spending. A fair amount in both areas. And so not only has that been good for our business, but you've got to sort of plethora of stuff going into the clinic. So I do think that our clients, both large and small, are looking forward to getting back to that as soon as they can. And that's a different time frame for pharma than it is for biotech.

Got it. Perfect segue into my next question, more on the segment side of things, starting with Safety Assessment. Just given the diverging trends you called out, right, Pharma being incrementally softer, biotech, softer but still improving and with the potential for 1 maybe 2 rate cuts by year-end and how tight that is to how they behave. Walk us through how that translates into just your book-to-bill metric. And at what point can we see the recovery there?

Yes. We've been eating through our backlog. So we had this extremely long backlog of at least 18 months, which is sort of good news and bad news. It was great because we felt that we had some level of predictability. The problem with it was clients were concerned about getting our slots and they were booking slots were not necessarily having the associated studies to go along with it. So I think that's a good thing. We're kind of back to, whatever, 9 months, maybe 12 months, and I think it's a much more rational situation. So they're booking studies that -- booking slots or studies that are real. So I do think that we have -- our gross book-to-bill is above 1. Our net book-to-bill is below. As we stop eating through the backlog, that's obviously going to change. I mean I can't tell you how soon that's going to be, except to sort of reiterate the fact that biotech is improving, albeit more slowly than we had anticipated for the back half of this year, but we think it will continue to improve, and it's the preponderance of our client base and revenue. And the question is at what point does pharma come back strongly? I think that's a bit of an imponderable. It feels like they -- I mean, for us, the deterioration and the pullback was quite abrupt. I'm sure they were working on it for a long period of time, except for 2 companies that are making the GLP-1 drugs. It's almost every drug company, right, that's reducing their infrastructure, reducing their portfolio and pausing. By the same token, they still have a lot of cash, and they are the folks that are buying biotech companies, buying the drugs, often buying preclinical or Phase I assets. So there are another source of funding, we said that for years. So the funding is coming directly into the VCs, directly from the capital markets, but also from pharma. So I think that's an important element in the overall psychology both for big pharma and biotech.

Got it. What fraction of your RFPs involved head-to-head bids? And what gives you the confidence that the headwinds that you're seeing on the safety assessment side are attributable just to market dynamics versus share loss? And on a sort of somewhat related note, you've talked about having to offer deeper discounts on a case-by-case basis. Can you just talk about how the pricing environment continues to evolve there? And just what's the red line for you in terms of when you decide to walk away from a bid?

So the competitive scenario has changed dramatically over the last x number of years. And so while we respect all of our competitors, they are much smaller, including the largest one is half our size, and then it gets very small from there. So the principal ammunition that our competitors have is price. They don't have the depth of science. They don't have the geographic proximity that we have. They don't have a large portfolio of other services to offer, which I do think is really relevant to why we've been able to build our business so well. And ironically, even going back to 2022, which is only 1.5 years ago or 1 year and 9 months ago, price was there for the taking, and kind of the last thing clients asked about. So I think a lot -- some of the folks we don't go head-to-head with at all. So if you're going to go to China, you're probably not asking for bid from us. You just want to cheap and you're willing to risk the fact that maybe it's not the best quality work and maybe they're not going to help you with regulatory oversight. There are some clients that will be okay with it -- just being okay. This is good enough to get my IND filed. So they're okay with that. The reality is that people who know better, which is certainly all the big pharma companies and most of the more substantial biotech companies want the quality of science that we have and want the infrastructure and want us to be able to help them get it there. So pricing, we're very selective. We're very strategic, we're very surgical on that. If it's a new client, sometimes, if we're trying to gain share or sometimes protect share, we will do that. If it's someone that will give us a study really soon, maybe. We have more pricing power with specialty toxicology than we do with general toxicology. By the same token, all of our competitors in the aggregate are smaller than we are. So there's just not much volume there and they can't provide the services that we can. So we're at this really interesting point of time we've been here before. This too will pass. It's not if, it's when. And it's classic supply-demand phenomenon that's going on here. So as the -- as pharma strengthens and as biotech is more comfortable with the funding paradigm, the demand will increase and so will pricing, and we won't have to do any discounting. So we do some of it, I think, appropriately and strategically, but we use it very thoughtfully.

Fair enough. So if prices stabilize exiting this year, will pricing still be a headwind to 2025?

Yes. So we're booking studies now at lower price points than they were a year ago, and some of those are going to move into 2025. So yes, I think prices are declining and will probably start the year with a pricing headwind. We'll do everything we can to get as much price as possible, but we'll be all about -- we are always all about this anyway, but will be all about share gains at that point. And as I said, as the demand increases, that will shift. But yes.

Got it. That's true. Fair enough. Segment margins in DSA, Jim, I mean, just in light of the sluggish demand environment, including on the discovery piece, the incremental price pressures we just spoke about, how are you thinking about that mid- to high 20 sort of 27 target for off margins in DSA?

We're thinking that over the long term, that's certainly possible. Obviously, we have some pressure now with declining sales in DSA and we're working arduously to streamline our costs and lean out our costs and do everything we can to protect margins. And I think that will be our task for the foreseeable future. But I do think that we've been able to get increasingly more efficient in that business all the time across multiple sites with more digital capabilities, for instance, less manual activity, taking more white space out of the whole phenomenon, and we've been able to improve the margins nicely. So we'll be able to do that. I just can't tell you at what point they'll accelerate again.

Got it. Switching to the Manufacturing segment and specifically the CDMO business, right? Last year, when we have this chat, there were a lot of questions around Cognate and Vigene and whether you've bitten off more than you can chew. Since then, the business has started to recover very meaningfully for you. Can you just give us an update on what proportion of those leads on the CDMO side are coming from your DSA segment today?

Some. I mean, we're doing everything we can to sell across the whole portfolio I mean that's the competitive advantage that we have. And so wherever the client enters, there's an opportunity to hold on to them. And sometimes it goes backwards and sometimes it goes forward. So I would say a lot of our clients are coming from Discovery and from safety and probably more from biologics than any other place for the CDMO business and the raise on debt that we got into the CDMO business was because the biologics business was so strong, and clients were saying, you're testing our drugs before and after they go into the clinic, would like you to manufacture them as well because you're slowing us down by having us go outside to talk to somebody else and negotiate additional prices. So we're really pleased with that business right now. We've got some commercial clients, which is very exciting. We have a host of new clients in the clinic. The fact that we're making this big drug for Vertex, I think, has sort of validated a lot of what we're doing. And I think folks have taken notice of that. And so cell and gene therapy is an important modality. The competition is limited. So I do think we have an opportunity to be, if not the leader, certainly a leader and potentially the leader in the space. So gene-modified cell therapy production is something that it's going really well right now.

Got it. What's your backlog mix at the moment in light of the third client you highlighted receiving commercial approval between the commercial side versus clinical stage work. And does your existing backlog essentially give you confidence that cell therapy, which is an area of strength you highlighted remains insulated from any sort of IRA-related headwinds, reprioritization of work towards later stage stuff.

Not sure if anything is insulated from anything but much more insulated than other things that we do. So that work is all in the clinic or about to be commercial, they hope. And so as we talked about 15 to 20 minutes ago, there's a preponderance of focus and emphasis by the drug companies large and small in the clinic. And so getting a cell therapy or gene therapy drug into the clinic, even though there's only been, I think, less than 20 approved, it's not easy to get one of those drugs approved, but there's a lot of drugs, both in preclinical and clinical space that there's a lot of emphasis and focus and money being spent there. So I do think, to that extent, if you want to use your parlance, it's somewhat insulated because it's in that clinical space. Everybody thinks that the drug that they have in the clinic is going to get to market, every single one of them, right? So we're talking to a fair number of them about what happens when it gets to market and how much space will they need and what the pricing paradigm will be and what kind of gear do we need to manufacture it. And there's a fair number of those conversations right now and a whole bunch of new clients that are in the clinic. So yes, it feels like we have very good visibility and predictability about how that business will unfold for the balance of the year.

Got it. There's been a lot of talk about medium-term benefit from the onshoring of pharma supply chains in light of BIOSECURE or similar legislation. Is it sort of coming up very regularly in your funnel conversations now?

Yes. A lot of talk about BIOSECURE ACT. It would be extremely surprising if that isn't beneficial for us. So we anticipate that it will be. I've said publicly a couple of times that we have these large venture capital relationships. Two of our big venture capital partners have said that they've instructed their portfolio companies to not do business in China. So I thought that was quite interesting, right? They didn't suggested they instructed them. So there was some concern about whether the legislation happens or not, there'll be continued tension between the U.S. and China and maybe, that's not a great place to do their work. Having said that, we have a trivial amount of conversation right now and a trivial amount of business that we've secured as a result of this. So we don't want to get ahead of our skis, but we do anticipate that it will be beneficial.

Got it. Switching to Microbial Solutions and Biologics safety testing, Jim. Those businesses did well in the last quarter. Why do you think the recent weakness you cited on pharma spending doesn't weigh on demand trends here, particularly for instrumentation on the microbial piece? And on the other hand, are you seeing signs of share gain from your Chinese competitor within BST in light of these BST concerns? in light of secure concerns.

Yes. I mean those are totally different businesses, right? So those businesses, you're doing quality control testing for drugs that are either going into the clinic or have been manufactured for commercial sale. So they're at a totally different part of the drug development spectrum, right? And so by law, they have to be tested and the microbial stuff in particular. And those -- in the biologics business was hampered a little bit by COVID. And so is microbial to some extent. So those businesses feel like they're back quite strongly, margin profiles are very good in both of those businesses, one of them more than the other. We think that they'll have meaningful growth rates. We have some pricing power there. And from a technical -- technological point of view, we are well advanced over our competition in the microbial business. The biologics business is an interesting one. We have 4 competitors who are at least our size or larger, we're all doing fine. It's just that much work. It's all large molecule working obviously, there's a ton of large molecule work. So we feel quite good about the future of those businesses.

Got it. Switching to RMS. First on the research model side, I want to zoom in on China. The RMS business there has been pretty resilient, especially given some of the macro headwinds that the broader life sciences industry has seen in the region. What is the mix of small models versus NHPs in your research model business in China? And what do you think is insulating you from the softness in the region? Is it essentially the share gains that you've called out in the past more than offsetting any pricing pressures?

Yes. I mean it's been a very good -- it continues to be a really good market for us. It's obviously a huge market. Competition is limited and entirely Chinese and not as sophisticated as they need to be. So they have a lot of fits and starts and problems. So folks that want to do serious research will utilize Charles River. I mean our prices are lower there, but so is our cost structure. So the margins are quite good. We continue to build new facilities. And as we build them, there's a pretty quick uptake just in terms of demand. So the preponderance of the work, there are small animals and associated services. NHP sales there are -- that wasn't our original intention. We own a small breeder over there. The intention was to get the NHPs into the U.S. and Europe for safety assessment work and of course, the Chinese onlining NHPs out of the country. So we sell them in country. The numbers sort of fluctuate and the quarters fluctuate and it causes a little bit of lumpiness in the RMS business. In some ways, I'd prefer if that stopped, and we could just use them entirely for our own purposes. I don't see that China is going to ever open up though.

Got it. Fair enough. Sticking with animal models. On the NHPs, you've noted sort of the longer-term nature of the Noveprim customer agreements and pricing being relatively stable there. Can you just give us a sense for how long these contract lengths are, how have customer conversations been with the ones that have come up for renewal since the acquisition? Is there a possibility of some price degradation there?

That's the best source of NHPs in the world and has been forever. So we're really pleased with that acquisition. It's a business that we intend to continue to grow. There are some pre-existing contracts, as you say, which are good and bad, good because they generate revenue and the prices are good, less good because we just prefer to use the animals ourselves for our own safety assessment work, which at some point, we will. So the price points are quite good there out of Mauritius.

Got it. I did apply to be a site manager but you turned me down. All right. So switching to research services. Just GEMS Insourcing Solutions, Jim, how do you view the opportunity for both against the tougher macro backdrop given the ability to drive efficiency for customers?

Yes. I mean those are 2 really important businesses for us and 2 really important services that have grown dramatically and actually have really good margins. So we always thought that they would be dilutive because the margins are so high on the core animal business. If you think about the Cradle business, the Insourcing Solutions business, it's the most effective tool that a client can use if they're worried about cost structure or recession or CapEx or whatever. So utilizing our space and our people to do their basic R&D work is really powerful. Our goal for that business is much larger if you think of that business on a see-through basis, that should see discovery work and safety work and should -- and as the molecules progress, we should be able to work on it all the way through our portfolio. And also, additionally, to the work that we're doing now, where we're working with them to do their basic R&D studies, I think there's an opportunity to actually do the work for them instead of the drug companies doing it themselves. The other interesting thing about that insourcing Solutions business, particularly the Cradle business, which we have -- we have a lot of sites now because of the acquisition that we did a couple of years ago, we thought all of our clients would be small biotech? And we have midsized biotech and big pharma companies who have either run out of space, they don't want to build new space that have taken a significant amount of space from us. So that's going to be a very good business going forward on a worldwide basis, the genetically engineered models business, that's one of the most effective and important research tools because you have animal models that replicate human disease conditions. Margins are very good in that business as well. I think both of those businesses are a little bit stunted right now just because of the softness in biotech funding, but they'll reaccelerate at some point.

Got it. And do you still see room for margin improvement in RMS from that 25% -ish is level?

We do.

Got it. Fair enough. On the margin point, I mean, you've announced some cost actions. Are you tracking to deliver the $100 million savings this year? And then outside of head count and site closures, what gets you to the $150 million in annualized savings you're targeting next year?

Yes. So there's $150 million that we've identified that will -- $100 million will hit this year and the balance will hit next year. There's some small site closures. There's 50 -- at least 50% of our costs are people. So there's workforce reductions as well. We're working now on sort of a multiyear plan, which we'll announce in November Which should -- which will be significant, and that will be more infrastructure consolidations. That will be more digital work, that will be more sort of offshoring cost structures that will be working on G&A. That will be a significant leaning out of the business, something that we should be doing all the time anyway, regardless of the demand on the top line. So we're quite confident we'll deliver the $150 million that you can take that to the bank. We don't have a number yet for the larger multiyear situation, but we hope to have that, as I said in a couple of months.

Got it. Would it be fair to say, Jim, though, that the multiyear plan will be less meaningful than the $150 million, just given the nature of what you're targeting there?

I wouldn't say.

Okay. Got it. So between these 2 plans, is your target of achieving 150 bps of margin improvement by '26, still on track despite the top line shortfall, even if that 6% to 8% organic growth target seems to have involved a pretty robust recovery in the next couple of years?

I think we have to take a step back and take a look at the world that we're living in now, which is different than the one we were living in when we said 6% to 8% on the 150 bps. And we'll recast those numbers at the appropriate time. But -- so I think it's probably unlikely that we can make those numbers in the same time frame. Having said that, we've always been able to improve our operating margins and we're one of the highest in the industry and something we're always focused on at all levels in the company, and we, for sure, will get back to that once we get a better beat on what the growth rate will be over the next 3 to 5 years.

Got it. You recently implemented a $1 billion repo authorization. Are you still on track to begin the share repurchases by the end of the month? And then how are you thinking about the ranking of your capital allocation priorities, the buybacks, the debt pay down, especially given the upcoming rate cuts and M&A?

So we did buy back some stock already as we indicated that we would in the third quarter to offset dilution from options. And look, capital allocation is something that we take quite seriously. We have a committee of the Board that I'm on, that we looked at this at least 5 times a year. It's all math, right? And we try to get a balance between debt pay down. By the way, our leverage is coming down nicely. It's around 2x now. So debt pay down, what we're going to spend on capital, depending on the share price and interest rates and all of that is buying my stock, a smart thing to do, is that an appropriate thing to do with the shareholders' money. We have always believed that strategic acquisitions are the best use of our cash. So I think -- I don't think -- we still believe that. We're focusing on some other things at the moment, like cost reductions and trying to understand what the pharmaceutical industry is going to do next year and how we accommodate to that. But we definitely have a list of businesses that we would like to buy that would continue to enhance and expand our portfolio and in ways that continue to distinguish us from the competition. So -- and if you go back and look at the work that we've done and whatever it's been 65 or 70 acquisitions, a lot of our growth rate has come and our ability to compete more effectively. So we look at all of those things all of the time. I mean the things change constantly. If you look at interest rates, for instance, I mean, it's changed the calculus on a lot of what we do. So probably some of all of it, nuanced differently depending on what's going on in the world, what's going on with our company and the competition. And as I said, that's -- we do that at the board level.

Got it. Any lessons as you sort of rev up that M&A engine down the road from the cognate and Vigene through processes and integration?

Yes. Well, I mean the lesson is that the adjacencies are tougher than you think they are. And so that moving into the CDMO space was a logical and appropriate adjacency for us. I'm happy that we did it. It was new science, it was new to us, but it was new to everybody. It was new science, is new to the regulators. It's new to our clients. So in retrospect, I would have given us more time, and I would have talked to the shareholders about more time to integrate that business and when it would be accretive. So I think you have to be -- you have to have an element of caution when you're moving into adjacency even if it fits like a glove and is important. So acquisitions that we've done, which is right down our alley, like when we bought a bunch of Safety Assessment businesses. We know that business. We are the largest player in that business. And so synergies, both cost and sales are pretty straightforward and how you manage them is quite different. So yes, assuming we move into another adjacency, we will be a bit more careful and give ourselves more time to integrate it.

Fair enough. To close, Jim, underappreciated aspect of the Charles River story today. It's been a tough year for the industry in general. You've had uneven performance. But as you look to 2025, what would you really want investors to focus on?

I mean yes, the simple fact that we -- notwithstanding the demand curve, which is less robust than we would like it, we have an extremely powerful portfolio, more powerful than any of our competitors. And there are no biotech companies that do any of the work that we do. So they have -- they don't have to use us, but they probably will. And farmers they outsource will as well. And so the situation that we're in now is not a long-term situation. It's not if this is coming back. It's when it's coming back. So we have to figure that out. We have to plan for that. And I think our shareholder base, the potential shareholder base needs to understand that as well that this is sort of a momentary pause in time that we will work through this hopefully soon.

Perfect. Great place to leave it at. So thank you so much, Jim for coming.

It's always a pleasure.

Appreciate it.