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

My name is Eric Coldwell. I cover pharma services, some related outsourcing fields at Baird, and it's a great pleasure once again to have Jim Foster from Charles River here, also Todd Spencer in the audience can never convince him to get up here with us and share his wisdom, but always a great backstop behind the scenes. I think many of you are very familiar with this company. It's one that we've known for many, many years, a big fan of the company. A little bit more challenged in the fundamentals at the moment. We're going to spend some time on that, just the overall marketplace. But I want to make sure that if anyone has questions, feel free to send them up to the stage. And Jim, if nothing else, we can't maybe do our old intro that you and I just talked about, but I can say you were the most requested company at the conference. So there's a lot of interest in this name. So with that, I'll see if Jim wants to make any brief comments to open us up. And if not, we'll jump right into it.

Why don't we jump into it.

All right. We'll jump right into it. We can do that. All right. I'll start with some of the obvious stuff, primarily focused on DSA, Discovery and Safety upfront, but feel free to expand if you want to. The -- I think one thing is fairly well known that you're larger in the larger pharma client base than really any of your peers. And I think most of your peers have talked about anywhere from, say, 30% exposure to big pharma down to low single digits, close to 0 exposure to big pharma. So sometimes we see different trends across the peer group based on historic comps and/or their specific client mix. In your last call, you mentioned that biotech was still more than half, but could you be a bit more specific on the relative sizing and positioning with big pharma compared to the rest of the industry in the nonclinical side of the world?

I mean the split is probably closer to 40% biotech, 30% big pharma and the rest sort of academic and government activities. And yes, we have a disproportionate share of big pharma. We have significant relationships with most of the pharma companies. And I would say that, we're doing a lot of work for all of them. In some cases, we're doing all of the safety work, for instance, and have really close relationships. So the good news is that we have a disproportionately large share with big pharma because of the breadth of our portfolio. Difficult news is that pharma is pulling back at the moment. So that hits us harder than others.

Now that comment was at the enterprise level, correct? The 40-30 remainder. What about DSA specifically? I think pharma might be a little bigger in that segment...

It could be a little bit higher.

Because you wouldn't have as much government or academic...

It could be a little bit higher.

Yes. Are there any of the top 20 clients that you don't work with?

No. So we work with all of them. And as I said, many of them we are sole-sourced. I'd say all of them, we are at least one of their providers. Very few are doing the work themselves these days.

On the recent update, you highlighted that -- which I think not a surprise probably to most people in this room, but you highlighted that many, if not most, of the large pharmas, and frankly, more broadly than that, clients in general, have announced some kind of either belt tightening budget cut, pipeline reprioritization, some action that could retard the growth of spending or the need for outsourcing in the short term. How specific is that to the top 20? Is this just pretty much universal that those that aren't cutting R&D overall or focusing their efforts more to clinical in the moment? Or is it, no, really, there are a handful of the top pharmas that are -- to quote one of your clinical peers who recently said spending like drunken sailors. I think we know who a couple of those are. But is it just that there's a bigger group in the middle that are optimizing their budgets and then another group at the bottom that are actually cutting back pretty severely?

I mean we're finding them pretty much on mass cutting back their spending and hence pausing some drugs that they should have or wanted to file INDs for and emphasize in the clinic big time. So the concerns about the patent cliff and gap in their revenue stream. So they are pretty much all doing that. There's a couple of obvious exceptions of drug companies that may be making GLP-1s that are in a totally different place. I'd say we've had a couple of big ones that we have long-term relationships with that have meaningfully sort of reduce their forecasts. The rest of them is more sort of pausing than, I would say, any sort of major reductions. And the speed with which has happened was really sort of eye watering, right. Last year, pharma was the principal driver of our growth. First quarter of this year was very strong by big pharma. Second quarter started out very strong with a bunch of proposals and bookings and sort of manageable cancellation rates and then sort of at the end of the quarter, there was a fair number of companies that sort of pulled back. They don't talk to each other. They don't plan to do it this way, but I think it's patent cliff, it's IRA. It's the overall economy. It's sort of gaps in the portfolio, it's sort of all the above. So they feel like they're working on mass and the impact was that, but it was -- given the fact that we have very high-level relationships with all of the pharma companies often ahead of R&D and minimally the head of discovery and development, it's clear that a lot of the people that we're working with and talking to were blindsided as well by cuts in spending, consolidation of sites, reduction of workforce and just pausing some of the work that they were doing. I've had several people -- we had another conference last week and several people said, well, how do you know it's just not going to snap back? The answer is, we don't know that. I don't think that's going to happen. It sort of feels like the spending pattern will persist into 2025, but I don't know how long that will persist. Look, if they don't spend in discovery and in early development, then they've had nothing in the clinic in X number of years, right? So we know that it has to shift back the sort of optimal relationship that we have with our clients is when the spending is pretty balanced, right? There's a lot of spending on sort of early development or very early discovery and substantial amounts of toxin. And periodically, it does what it's doing now, ebbs and flows with either emphasis in the clinic or often emphasis in preclinical.

Do you have any sense what -- did you get any better feedback? I know you said most of the people you're talking to were caught off guard as well, but do you have any -- what culminated? What was that trigger? And it wasn't just you. I mean, we saw spikes in biotech cancellations at another company. We saw some lower book-to-bills in clinical. It felt like the conversation sometime in June just changed. What might have precipitated that? The patent cliff isn't new, IRA isn't new, high interest rates aren't new? Just one of those random walks that target...

No. I mean it was -- as I said, I'm sure the preparation took a long period of time, for some reason, it culminated all together, but it's definitely an attempt to lean out their infrastructures, which are pretty substantial. And they have to prepare for whatever uncertainty they have. I think the patent cliff has a lot to do with it. There's a lot of some big drugs that are going off patent.

A lot of biologics?

Exactly.

Smaller biotechs, midsize, smaller clients, you've expected some recovery that was a preamble of your original guidance for the year, and you saw some recovery. The market firmed up a bit. But maybe not quite at the clip you were anticipating. Do you think that is -- well, I should ask you, what do you think that was? Was -- I threw out there, possibly the strong start to the year with funding, but then the subsequent reduction in funding through August. I don't know if maybe that was one of the bigger drivers you're hearing, but...

So biotech starts slower than pharma for us. We anticipated it would grow much more aggressively in the back half of the year. I don't know, based upon assumptions on when the capital markets would open up and what would happen with rates. I don't think the election is really a big issue. So it's improving. So proposal volume is better, bookings are better, cancellation rates are down, and it's improving. And of course, the first half of this year, the funding to biotech was pretty good. First quarter was the fifth best quarter. Second quarter was good as well. July and August were slower. So, so much of this is psychology. I actually think that the biotech companies are pretty well funded. Access to capital hasn't been bad. But they worry about the sustainability of access. They did anticipate the IPO market opening up, which, of course, it hasn't. They anticipated, they do some secondaries, which they haven't been able to do. And so until the sort of a sustained -- and it's also very much tied to rates. I mean, the correlation between share price movement and talk about rate reductions is really sort of -- it's quite interesting. So I think that we will -- they're going to have to see a couple of quarters where they say, yes, access to capital is not going to be curtailed anytime soon. So we're going to go ahead. We had 5 drugs that we're working on for the specific target. We parked 3 of them. We're going to get back and work on a couple of them. I think we're going to see more of that.

Okay. Your backlog in DSA is still above the level that historically would have led to the revenue guidance that you have. In other words, historically, a $1 of backlog would generate $1.60 to $1.80 of annual revenue. That's what would ultimately transpire. Your guidance and your recent results would indicate that there is still more in backlog that either is longer term in nature, or I hate to say it, but possibly at risk of reduction because the ratios just don't align at all with history. Now again, before COVID, you were a 7-month backlog conversion company in that segment, and it's obviously been much higher. So I'm trying to get a sense on how much of the remaining backlog is truly work that you think is viable work to just has a longer duration or a longer start-up versus work that could be at risk of further cancellation?

So we feel good about the backlog. It can be a little bit misleading. So bookings and book-to-bill are probably a better indicator of what demand will be. We saw this real spike and increase in backlog sort of as the whole COVID thing really came to pass. And those were too long, so 18 months was definitely too long. I think that both the amount of backlog and the duration is interesting, can be a little bit misleading. I'm not sure -- we have a lot of questions about when it gets back to sort of its normal rate of 6 to 9 months. I'm not sure it's normal anymore. So 12 months is better than 18. It feels like particularly on the biotech side, since cancellations are down, that there's a lot more -- that they're booking real studies as opposed to just booking slots, which is what happened. It's a little less clear in pharma, but that's sort of a pullback. So we'll watch the bookings and the book-to-bill bookings are stronger in biotech and then pharma right now.

Are you going to give us an update through September 10?

Probably not.

I didn't think so. To minimize some of this drag, you've announced a number of cost actions and optimization programs, if you will. And it sounds like you've got another round of that coming, something bigger that you're going to highlight. Is that highlight coming with your third quarter update in -- that's November, right?

Yes.

That's how you'll give it?

Yes.

Can you give us some general sense of the types of things you're looking to do that -- I know you don't want to throw numbers around it today, but you've been a cost optimizer and an efficient organization for a long time. What's -- where's the additional value or extraction coming from?

Yes. So we always try to be efficient, obviously. But there are opportunities in G&A. There's opportunities in site consolidation. There's opportunities in greater digital footprint. There's opportunities in best practices across sites. Look, all of our clients are interested principally in speed. So anything we can do to speed up the process and take sort of white space out of the process has been very beneficial. So it's interesting -- we buy companies that have sites, obviously. And we never really have an opportunity to do any sort of consolidation when we buy them because the other operating businesses, they have decent growth rates and good margins. And so as we have some of these businesses for longer periods of time. And we have other sites that are growing and have more substantial infrastructures, it's just going to make sense to marry some of these sites up. So it feels like the best thing we can do in a period of slower demand than we would like is to get as lean as nimble as possible. And of course, that's a very -- it's a very difficult balancing test. And by that, I mean, when it comes back, not if it comes back, when it comes back, clients will expect us to have people in space and start the studies immediately. It won't be patient about it. So as we reduce head count in certain places and capacity in certain places, we will do that smartly, acknowledging the fact that we would anticipate that the business will come back at a certain point in time. But in the interim, we want to do everything we can to protect margin. We've always had a very high operating margin and great free cash flows and strong EPS and we want to protect that.

Historically, we've not seen the magnitude of impact in, say, discovery and safety that we haven't seen that play out in research models and services. And models historically were a bigger chunk than services. So maybe the business doesn't quite look the same that it did back in, say, the great financial crisis or go back 20, 30 years ago, of course. But -- first, just for those who may be newer, less familiar with the company, talk about why research models has historically at least held up better, seen less of an impact from some of the things that you're seeing in DSA?

Doesn't have those swings of the clinic and not the clinic, number one. Number two, nobody produces their own research models. Number three, we always have a substantial amount of price in that business from its early essence. And those are critical tools for early research and some talks, obviously, but early research. And the complexity and the sophistication of the models is being enhanced all the time. So -- and then we have slight differences or meaningful differences at the moment in the geography. So China is quite strong right now, notwithstanding some of the issues last year with the overall economy. That's a very -- obviously, a very large country, a lot of money being spent in life sciences and kind of awkward competition that doesn't really know what they're doing. They sort of trivialized the complexity of this business and they end up with all sorts of health issues. So the country has treated us well. We've built new facilities and the growth rate has been terrific. Europe is actually pretty good this year. Also, U.S. is less good. That's principally because of so many biotech companies that are pausing. We also have several strong service businesses that are growing really well. Some of them are paused at the moment because of biotech spending, but they're really important way for clients large and small to protect their own infrastructure and spend less internally, particularly that CRADL business, where they're utilizing our facilities and our people to do basic research. So RMS continues to be a strong business, both from a growth point of view and from a free cash point of view.

And China for RMS is around 10% of revenue? it's a little over that, right?

It's about 15% of RMS.

Of RMS, and it's 4% of the overall enterprise?

Yes. Exactly.

Yes. So that would help explain some of the mix difference as well. Now in cell solutions, human cell solutions, newer businesses that timing could have probably been a little different, right? You buy a human volunteer site in California, right before California locks down with the pandemic, but -- or during that. So what's the update on cell solutions? You did a couple of -- ultimately, you did a couple of acquisitions, maybe a one liner for people who don't know what you do there? And then what's the update on some of the optimization activities that you took over the last few years? And how is the business performing?

So the whole scientific impact of cell therapy, which is -- has great promise, requires you to have cells from patients. So we have people come in and they donate blood and we spin it down and we harvest the cells. And so that's an important part of the whole infrastructure of the CDMO business that we have. And as you say, we bought 2 businesses before COVID, they were shut down. That had a really significant impact on the growth and development of the business. And then during COVID, a bunch of not-for-profit blood banks got in the business. So we have tougher competition at lower price points. So what we've had to do is sort of refine the infrastructure of that business. By that, I mean, a better methodology to recruit. They're not really patients to recruit, donors is the right word. And more importantly than that, we have a portfolio of highly complex cell types. For instance, people with diseases that give their cells and then people who are normal, whatever, give their cells, and we have GMP production of cells and some that are only research grade to try to distinguish ourselves from the blood banks, which we're beginning to do. But it's a tougher slog than we had thought.

CRADL. Talk about CRADL. You're up to almost 30 sites. I think, in the Zip Code of 30 sites, you have some openings announced, but you've also announced recently some narrowing of the network in San Francisco, for example. So is this the right time to be expanding that business given the excess office and lab space out?

Yes and no. It depends on where you expand. So really important business. So we're providing incubator space for companies large and small. Surprisingly, we have a bunch of large pharma utilizing the space as well. But -- so we have animal rooms that are fully staffed. We're available to do -- actually do the studies for the clients if they want that, and that's something that we're working on. That we had them all over the world close to major biohubs, as we call them, big concentration in Cambridge Mass and Cambridge U.K. and South San Francisco and then we did an acquisition 2 years ago. So we're a pretty big player in this space. It's a very important kind of recession-proof business for our clients, if they want to -- if they're worried about their cost, outsourcing has worked for us, is really helpful for them. South San Francisco, we had a bunch of our own sites and did this acquisition and acquired some additional sites. So we just have too much capacity there in the time when some of the biotech companies are pulling back. Having said that, we have plans, and we'll execute them as you say only if the demand continues, we have plans to add some additional sites in current locations and also some new locations. This business has the potential to really drive our -- to engage with the clients as early as possible and really drive growth through the life cycle of a drug. So if you start with them while they're doing basic R&D and then they move into discovery and safety and biologic testing, whatever we can stay with them for the whole life cycle of the drug. So we like this business a lot. It's had very high growth rates, and it's got stunning operating margins. So I'd say it's a little -- some of the locals, particularly South San Francisco, have paused a bit just because of the biotech slowdown.

I want to hit on manufacturing services quickly. Your manufacturing solutions business has 3 different lines. What is the latest update on biologics testing your CGMP business? And with BIOSECURE at least passing the house last night might this not be an opportunity that could be a bit of a kicker there. Maybe talk about the competition and where they are?

Yes. So there's a fair amount of work being done in China in Biologics, as you say, but also in discovery, safety and CDMO business. So there's a lot of work. People go there because the prices are very, very low. The work is good. And with all this tension between the U.S. and China, it looks like that's going to change. It looks like this legislation might be approved. We've had a couple of VC firms that we do -- that we work with that have instructed their portfolio companies to no longer do any work in China. So you can see it's starting to happen. We just don't want to get ahead of ourselves in terms of this dialogue. We've had a couple of trivial conversations with clients. We have a trivial amount of work that definitely has moved to us because they told us because of tension with China. There's no question that if and when this is approved, there's not a lot of places they can go. They can -- some of them can go to India, but they're not set up for that. Some of the discovery work is already in India. But safety won't, biologics won't, at least won't now. So a lot of this work is going to come back to the West. It's going to come back fast. Begs the question on what the capacity -- available capacity that we have and others have, but so we're anticipating that it will be beneficial. It just isn't yet.

It has. Does it have to get through the Senate first and see if it's an 8-year moratorium or a 2-year, 1.5, 2 year? Is that the issue? I mean I would think that in a risk-averse world, clients would already be thinking, let's just pull this risk off the table?

I think they are, and I think some will be risk averse even if it's not approved because the potential of being approved at another time or the continued tension between the U.S. and China, will persist. So we anticipate it will be meaningful. A little bit surprised we're not hearing more conversations. I think a lot of people are waiting to see what happens with the legislation and whether -- how long they're grandfathered. Obviously, nobody is going to pull an ongoing study and move it out of China. But they would pause on putting something new into China.

And then in CDMO specifically, some correlate with that human cell supply business that we spoke about in research models, but also a unique situation where you moved back into CDMO, you briefly were there a while ago or something quite different. You come back into CDMO specifically focused on cell therapy than gene therapy. And you now have, I believe, 3 commercial products, 2 that have launched, maybe the third is launched as well, or close to it. And the revenue stream there has to be growing more dramatically now because -- and in the future because these commercial launches are going to be materially bigger than doing pilot scale and early stage research.

I mean it's a really important business. It was challenging for us. As you know, it took us a couple of years to get this right. I think that was a combination of -- it was a new -- totally new business for us, but also new science for everyone. I think the facilities are extremely well run now. The production capabilities and regulatory prowess that we have is really great. We've had regulatory audits by all the regulatory authorities. We have these 2 commercial products, one with Vertex, which is getting a lot of press, sickle cell anemia drug. And I think that kind of validates our capability in this space. So we have really nice growth rates in this business, which we anticipate will continue. Everybody that has a clinical stage drug assumes it's going to be commercializable at some point. So talking to a lot of clients about what they anticipate the scale will be when the drug is approved.

Is the business back to or above the revenue stream you projected in your first full year of ownership? I'll try to ask it in a way that I'm not pinpointing you down too much.

It's growing faster than anything else that we're doing, and it's growing at rates that are approaching what we originally felt a little bit slower, but I think that's the whole cell and gene thing is -- it's quite robust, but not growing at the rate that we had thought. So...

Well, it doesn't have to if you get a bunch of commercial launches versus the history of having done...

Exactly. So it's accretive to the Manufacturing segment, big time, and it's accretive to the company as a whole, just given its growth rate.

From a top line, what about from a bottom line?

It's going to be a while, but the margin profile, which is nowhere near where we want it to be, is improving. So it will be accretive to the manufacturing.

Profitable today?

Aspects of it are.

Okay. Big picture, last 2 minutes. I don't see anything from the audience at this point. Bear with me, this isn't me playing devil's advocate or bad cop here. But there are a number of people that we speak to who say, tell me why this isn't 2008 all over again? Why this isn't the GFC period all over again? You know I believe it's not. I can think of a number of things that have changed in the industry. But how would you define the marketplace in Charles River today versus where we were, say, 2008?

Yes. So everything has changed. So in 2008, you probably had twice as many pharma companies as you do today. Many of whom could and did do work internally, even work that they had anticipated, they were outsourced, they brought it back in-house, a; b, you had a fraction of the biotech companies that you have today. So we have a proliferation of so many new clients. Additionally, in those days, we and everybody build too much space. So in the [ music stuff ], we just had -- we had 1 million square feet of space, it was empty. We were a very small company then. So we're a much larger company. We bought a bunch of our competitors. So, so much of the work has to come to us these days. And then you have a whole host of new modalities that they may have been in their infancy then, but RNA stuff, cell and gene, monoclonals, of course, have sort of ebbed and flowed all the immuno therapies, all it goes and on and on. So a more robust scientific market, a better competitive dynamic, and we also have a much larger portfolio, not just in tox. And clients that really want the science to be done well and want it began quickly, want to stay with us through the life cycle of the drug. So it's just fundamentally different than it was in those days.

Jim, thank you very much. I want to just announce here quickly. We'll have Gilead, PTC Therapeutics, ORIC and VitalConnect in the next 4 sessions. And with that, Jim, thank you very much for the time today.

Pleasure.