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

Good morning, everybody. I guess we get started. My name is Luke Sergott. I cover Life Science Tools and Diagnostics here at Barclays. Today, with me, I have Jim Foster, longtime CEO of Charles River Labs. You're a fixture here. And it's always good to have you.

Good to be here.

There's always landmines in the market right now for -- that you guys always kind of deal with and have good lead into. So the topic du jour, obviously, is on the academic government side, the NIH cuts. Talk about what you're seeing there from that customer base. Are projects -- we hear projects being wound down or like just being paused. Obviously, new project starts aren't going on. But talk through about what you're seeing there? And conversations with customers on if, when, timing, when the demand starts to come back?

Not seeing anything yet or hearing anything yet. We have about 6% of our revenue, and it's mostly in our RMS business that's sort of academic or government and only 2% of our revenue associated with NIH. And we have a lot of long-term government contracts. A good example would be with the National Institute of Aging for literally aging animals for neurodegenerative disease research like in Alzheimer's. Could they cut that back? I mean, they have the right to do that. That would be very shortsighted. And then those animals wouldn't be available. So a lot of the stuff I talked about is overhead reimbursement. And most of the work we do is product related as opposed to service related. So it's possible, but unlikely. And on the academic side, it takes a while for this money to trickle down to the academic institutions. So we're in touch with these people all the time. I just got an update on the government stuff yesterday, I asked the guy that runs that business. We've heard nothing from the government with regard to any of those contracts. So that's a positive. And as I said, most of them are long term, meaning 5 -- one of them, I think, is 8 years long. So we've had them for a long time. I think they're quite important and I don't think they could supplement what we were doing with anybody else or restart those later. So we'll see. I mean, it seems just a lot of chaos. So it's tough to predict, but I'd be surprised that it's meaningful to -- adversely meaningful to us at all.

Okay. And then like from a government contract like vaccine research or BARDA contracts been that's been positive to be -- that's probably on the chopping block there. Do you guys have any elevated exposure or -- associated with that? Or is it just so small?

I think that during COVID times, we did a lot of work. We did all the work on all the COVID vaccines. So I'm not going to say that we don't do work in that area. For sure, we do. It would be tough to tease it out right now. So we're not hearing anything specifically about vaccine development projects that have been stalled or canceled.

Okay. And then the overall fear around the cuts and everything. It's like there's just going to be a broader contagion. Will this start bleeding into the drug discovery market? Will it start impacting the biotechs? And obviously, we're so early days, but I mean you've been doing this for a very long time and have a really good finger on the markets and how these things can impact that type of demand environment? So -- is there a risk that you can see broader contagion kind of bleed in later on?

I mean, very little of that money, if any, goes into pure drug development on the commercial side. So I'd be surprised if that have any impact. I mean you do have people coming out of academia and starting biotech companies, but that's really pretty subtle. So I would imagine it stays contained in some of the government agencies more on the service side.

Yes. All right. And then another hot topic on tariffs. Can you just update us here what your exposure is, what you guys are planning kind of impacts there. Any updates from what's baked in and guide?

Yes. Again, not hearing or feeling anything from a concern point of view. On the tariff side, our business is of around 80% services. So you're not going to have tariffs -- on services. I suppose you could have them on animals and some of the other products that we have. I think that's unlikely. So we think that if there's any sort of minimal amount of tariff impact, we can offset that with upside in other parts of the business.

Okay. And what would the upside -- I mean, what -- just talk about some of the levers that you guys have available?

Yes. I mean there are definitely some service aspects of the research model business that we think are going to perform really well this year. Also in some of our manufacturing businesses, services should be robust as well. So I think we get some good upside.

And then, I mean, I thought we were done talking about NHPs -- last year, I mean you were on an NHP tour. Talk about the sites proposal and the restrictions there, kind of walk through the dynamics that you can kind of see how that kind of plays out.

Yes. So there was a meeting about whether shipments out of Cambodia would be curtailed. And that was not a very thoughtful agenda, by the way. So they didn't have any scientific input. And I'm not going to go into how I think that was developed. But that was premature. Anyway, it's been delayed until, best case, the end of the year -- calendar year. And in the meantime, there will be lots of scientific input developed and submitted by countries because you have a bunch of countries weighed in, Canada, Japan and the U.S. And there aren't alternatives for NHPs. So large molecule drug development, those are essential elements. And if there's any sort of shortfall while that will obviously have some impact on, Charles River will have a chilling effect on drug development generally. So I don't know what the punch line is going to be. I think it's -- we're godly optimistic that when the proper input is provided, that there won't be a shortfall there also. And there are other sources of supply, one of them we own in the Island of Mauritius, and then there's Vietnam and other places. So we're -- we will be fine for 2025 for sure. And we'll do everything we can to both anticipate and back-stop potential problem next year if it doesn't go our way to make sure we have a sufficient number of NHPs to do the work. I think that's all we can do.

Yes. So '25 should be fine about breeding capacity, but it's just more out year type stuff and breeding cycle. And then so within your 1Q, you talked about there being some NHP headwinds there from a pricing dynamic. Can you just kind of walk through how that's played out? Can you quantify any of this? And just walk us through there, too.

Yes. So there tends to be big shipments of NHPs, it's impossible to predict the quarter. We had some stuff that happened in the fourth quarter in lieu of it happening in Q1. So that's a bit of a headwind in the first quarter. Having said that, in the back half of the year, NHP sales in China and NHP sales by our Mauritian business, having so much to do with the gestation period of the animals happens every year and will happen again. So we know that, that will sort of balance itself out in the second half.

Just more of a seasonality and...

Totally seasonality, really. And tough to call.

Yes, breeding seasonality stuff. And so the DSA business, turning over to that, you've had some of the pricing issues that have been going on there. Guide should be relatively stable, still a little down here. Demand is a little bit frothy. So give us a sense of how the DSA business demand is kind of shaking out versus what you guys were seeing from a guide? And how that recovery is -- what your timing is on that recovery?

So our assumption is that demand from big pharma will be stable that will have -- the price will be a headwind and that there'll be opportunities to have incremental volume and to take share. So that will be our focus on the big pharma clients, which were the principal driver of our growth in 2023 and for the first quarter and most of the second quarter of last year, and that was kind of pulled back suddenly. Biotech is also stable and slightly up -- was slightly up in the fourth quarter. We anticipate it will be slightly up again for the balance of this year. Again, pricing headwinds because as the work comes out of backlog, it will be at lower prices. The kind of $64,000 question is what happens in the capital markets in terms of access to capital for the biotech folks who have been -- a lot of it, I think, is psychological because the fund raise from the capital markets actually were quite good last year, but not as good as '20 and '21, which is sort of the COVID guidepost that people keep comparing themselves to. So if and as and when the capital markets open up for some sustained period of time, I do think we'll see more biotech spending, which is still the preponderance of our client base. They ironically tend to be less price sensitive than big pharmaceutical companies who have very sophisticated procurement organizations that are pretty rough on us. And they're all in a race to market. The small biotech companies, it's sort of binary. They're going to get a drug to market and has terrific revenue or they're not -- or they're going to get there late and go bankrupt. So speed is everything for those folks. So it feels like the demand quotient has stabilized and is not further deteriorating. I know that's not an exciting description, but it feels positive right now. The opportunity for incremental growth, I think, is positive. What Washington is going to do is a big question mark. They've been talking about making some changes in the FDA to speed things up. We'll see whether that is realistic whether that happens or not. What do they do to the CDC? What really happens with NIH is all this sort of bluster and not reality. I mean, I think we have to see what these things happen. In the meantime, we think we have a terrific portfolio that's better than the competition that pretty much every drug company, large or small, needs. They don't have to work with us, but most of them do. And so as the demand invigorates and they have more workload, they'll outsource them more. The other ironic thing is as the pharmaceutical companies work to reduce the cost structure. One of the ways that they can do that is to outsource the work because we do everything, I don't know, 30% to 50% less expensively than they do. So if you really want to save money and you want to enhance your speed to market and you don't want to invest in the people in the space yourself, then you have to outsource it as opposed to slowing down the work entirely. Because the legacy of that for some of these companies is that they're going to have less drugs available to go into the clinic 2, 3, 4 or 5 years from now. So the other thing that's happened that's quite interesting is we're seen a slowdown in pharmaceutical buying patterns from the clinical CROs as well, which sort of says to us that they're sort of pulling back and looking at the whole ecosystem and probably about to have more balanced spending between preclinical and clinical, but we'll see how that all develops.

And then from -- I mean, I understand more of the biotech is a bigger preponderance of your customer base. But you have large pharma continuing to pull forward some of these restructurings, you announced incremental. So what's going on with that part of your segment? And you called it like if you're trying to save money, this seems like an opportunity for penetration. So -- where do you think the in-sourcing versus outsourcing penetration is on the large pharma? How do you look at that opportunity?

So the opportunity for more outsourcing is significant, about 60% plus is outsourced now. We think it will get to at least 80%, it could get to 90%. So that's going to continue. It's a little bit difficult to tell how much of the cost reduction activity the pharma companies have already done. Our best case is that maybe 30% to 40% of that's done. Some of that, they're in the midst of doing, some of that they haven't finished. So it's kind of dangerous for us to have a prognosis on what they're going to do until they tell us that. So we're watching the bookings very carefully. Cancellation levels have plateaued. Proposal volume is pretty robust. It's all about bookings. And as we -- and it's probably couple of quarter delay between bookings and revenue. So as we see the bookings increase, then we'll know that sort of back from a spending point of view that they bought all of this cost reduction stuff behind us, biotech will feel -- if we see it from both client bases, biotech will feel that they're pretty well financed. By the way, biotech is funded by the capital markets, of course, by big pharma, of course. And the inflows to the venture capital firms is still quite significant. We're seeing new funds developed every 2 to 3 years as opposed to every 5 to 7 years. So they're pretty flush with money right now. They have to put in more capital than they historically used to because it's been more difficult to get companies public. But that should also ameliorate over time.

Yes. And so when you're thinking about that recovery and how that like you said, on the private side, we see a lot of -- there's still a lot of dry powder waiting to be deployed. And you're seeing the flight to quality. And so as you're thinking about the capital markets of the biotech segment recovering, is that more of a back half of this year? Or are you thinking more of that kind of more you think in '26, '27?

Tough to tell. I mean on the biotech side, we think it's going to continue to improve subtly throughout this year. If the capital markets open up in a meaningful way. I mean, there's been some IPOs in the first quarter that priced well. You also see more biotech acquisitions by big pharma. I'm surprised there haven't been more, but I think those are coming as well. So that could accelerate, that's not in our guidance. A subtle improvement is in our guidance, but a meaningful acceleration isn't. You also could see more of an acceleration from big pharma if they get the cost reduction behind them. It's also not in our guidance. So we're not going to make it up. We're not going to guess on it. We're not even going to just listen to what our clients are telling us because they told us at the beginning -- at the middle of last year that things would be fine and they pulled back. So we're watching the bookings like a hawk and our book-to-bill has to get above one.

Okay. And on that comment, you mentioned that cancellations plateaued. Are you still seeing it is plateaued at an elevated level? Or are you seeing that more towards that normalized level that you have?

I think it's moving towards a normalized level. There will always be cancellations. We accommodate for that. You want to have a decent backlog, so when things cancel or slip, we also watch slippage, you want to have other studies to slot right in. So out backlog is probably 10 or 11 months. That puts us in a pretty good space also. It's not so long that clients are just booking slots without corresponding studies. That also was a problem a couple of years ago. They were so worried about that they would not get a spot that they were just booking a slot. There was also a wonderful pricing power in those days. So solid backlog and increased demand will also have a corresponding improvement in pricing.

Okay. And then on the -- so like from a -- you talked about the bookings getting back to 1. So the net bookings by our calc was around 0.75 for the quarter, but gross, let's say, it's closer to that 1 level. As you're thinking about this recovery, should this kind of be considered ultimately the trough of your bookings and kind of suddenly improving from there as you're talking about the biotech coming back? Or is it just going to bounce around this level for some time?

It's hard to say -- it's hard to imagine that it will be lower than this. I think we are at a stable trough. So the stability and the lack of further deterioration is quite positive. And you can feel clients, they've got drugs that were developed, both by big pharma and biotech, drugs that were developed and never filed their INDs, so these drugs are paused. And you can sort of feel an impending demand quotient developing with these clients. So they want to get these things back into the market. They want to get the IND filed and they want to get stuff into the clinic. I mean the [ irony ] with all of this is that the preclinical spend is only 20% to 25% of the cost of developing a drug. So it's not something that they should shortchange for much longer.

Yes. And as you think about that type of recovery and we move into the manufacturing side, you had some contracts there on some commercialized drugs, you lost one. Talk about was that related to, I guess, the 483 that you guys got in the facility, that seems like a pretty benign 483 from a CDMO perspective. What happened with the contract, when we talked to you on the 3Q call, it was about just diversifying their supply chain and then it ended up taking that whole piece of the business. Just it's created some type of air pocket for the CDMO side. And by the way, this is only like 10% or 15% of that part of the business, but this has been a key point that everybody has been focused on.

Yes. It's been a challenging business for us. We moved into an adjacency with new science, and it's been complicated. I think the companies were less well managed than we had thought when we bought them. I think we've done a great job in totally retooling all of them. In terms of staffing facilities and operational efficiency. The loss of that client was a bit of a surprise and somewhat painful because the dialogue. I had a lot of the dialogue myself, dialogue was quite positive. It definitely didn't have to do with the FDA audit at all. I think it had to do with the amount of drugs that they need that they -- the marketplace needed, they had several suppliers. They went with one that had -- we don't know exactly who they went with but the speculation is that they went with one that had a longer-term history in the contract manufacturing business that they felt more comfortable with. And so that stuff happens, could have happened. We could have gotten that work as well, which we frankly thought that minimally, we would hold on to it. So the client base in that business is quite good right now. We have a lot of clinical clients, several are in late-stage clinical that are starting to talk to us about commercializing their drugs. Obviously, it creates a bit of a headwind because we thought we would have more significant revenue from that client. We'll have some, by the way. And by the way, it's still a very big client of Charles River's, do a lot of other work with them. So we still have a very good relationship with them. We're just going to have to build back the internal client base.

Yes. And from a -- when you think about the margin on that and from the additional cost-out programs you guys announced, the fear you go back to when there was other capacity issues or within that CDMO business or the manufacturing business and the margin on that dropped down to like the mid-teens. You guys are talking about actually being able to grow your manufacturing margins this year. Talk about why we're not going to hit that level again? What you've done to improve the operations? And then what you're doing there to offset any of the decrementals from the volume leverage from obviously the CDMO side?

So the mid-teens was sort of a one-quarter phenomenon. Manufacturing ended up last year in the high 20s, I think, 27.4% to be exact. So pretty profitable. Now the manufacturing segment, which I think is the essence of your question was for years in the mid-30s, we had stunning operating margin, 35% year after year. We had a couple of years of 36% or 37%, so incredibly profitable. So the other 2 businesses in that segment, particularly the microbial business, but also the biologics business. Biologics business has jumped around a little more the microbial, which has been quite steady. So we think it definitely has the potential to get back, certainly to 30%. And the CDMO business, which, as you said, is a small proportion of that business should be less of a headwind increasingly. We think we can continue to drive margin in the rest of that segment. And we'll continue to be accretive -- it should be accretive to Charles River as a whole as we go forward.

Okay. And from a strategic perspective and the CDMO, you moved into that space, like I understand the vertical integration and the horizontal integration also that you're going for. How strategic is this asset for the overall business? Like how much are you able to cross-sell and gain additional wallet share just from that CDMO side because that's always been a very siloed part of biopharma.

Yes. I mean we went into that business because we had client demand for us to go into that business. And all the drugs that we manufacture, we also test. So with this big test in the biologics testing business. So there is a fair amount of pull-through. So I would say it is -- I would say, it is strategic. But as I said earlier, it's moving into an adjacency, which is complicated. So we're going to do everything we can to retool that company and have it contribute both from a margin point of view and a scale point of view, but we're going to watch it closely.

All right. And then last minute here, we're talking about the stock has been down quite a lot. You guys announced a repo, the $350 million. Any timing on when that's going to -- is that happened in 1Q? Or additional repo that you guys have to support the stock here?

So when we announced a $1 billion authorization for a buyback, we said that $100 million would be to offset dilution from options, which we were doing. It's very contextual. So we look at M&A targets, we look at our debt load. We look at what the stock price is. It's been hideously low, as you said. And for me, it's all math. So we have some M&A targets, but they're small to modest size and nothing immediately on the horizon. We have a committee of the Board that looks at this every quarter and we felt that when we made the decision of whatever it was a few weeks ago, given how low our leverage is that, that was the best -- it's slightly accretive, the best use of our capital at the moment. So we're happy to do $350 million. We'll get done by this quarter. At least we're working to do that. And in terms of -- and so that will use up about half of the authorization. What we do next year, we'll see. And as I said, it's very contextual and we'll look at what the best use of our capital is at that time.

Awesome. Thanks. We flew through the half hour, I appreciate the time here.

Always a pleasure.

Yes. Thanks. Thank you.

Thank you.