Charles River Laboratories International Inc. Q3 2008 Earnings Call Transcript

| About: Charles River (CRL)

Charles River Laboratories International Inc. (NYSE:CRL)

Q3 2008 Earnings Call

November 6, 2008 8:30 am ET


Susan Hardy - Corporate VP of IR

Jim Foster - Chairman, President and CEO

Tom Ackerman - Corporate VP and CFO


Dave Windley - Jefferies & Company

Adriana Kalova - Goldman Sachs

Douglas Tsao - Barclays Capital

Isaac Ro - Leerink Swann

Ricky Goldwasser - UBS

John Kreger - William Blair

Sandy Draper - Raymond James

Doug Schenkel - Cowen and Company

Brandon Couillard - Banc of America Securities


Ladies and gentlemen, good morning. Thank you for standing by and welcome to the Charles River 2008 third quarter earnings conference call. At this time, all lines are in a listen-only mode. Later, there will be an opportunity for your questions and instructions will be given at that time. (Operator Instructions). As a reminder, this conference is being recorded.

At this time, I would like to turn the conference over to our host, Corporate Vice President of Investor Relations, Ms. Susan Hardy.

Susan Hardy

Thank you. Good morning and welcome to Charles River Laboratories' third quarter 2008 conference call and webcast.

This morning, Jim Foster, Chairman, President and Chief Executive Officer; and Tom Ackerman, Executive Vice President and Chief Financial officer, will comment on our third quarter results and review guidance for 2008. Following the presentation, we will respond to questions.

There is a slide presentation associated with today's remarks, which is posted on the Investor Relations section of our website, at A taped replay of this call will be available beginning at noon today and can be accessed by calling 800-475-6701. The international access number is 320-365-3844. The access code in either case is 963696.

The replay will be available through November 20. You may also access an archived version of the webcast on our Investor Relations website.

I would like to remind you of our Safe Harbor. Any remarks that we may make about future expectations, plans and prospects for the company constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by any forward-looking statements as a result of various important factors, including, but not limited to, those discussed in our annual report on Form 10-K which was filed on February 20, 2008, as well as other filings we make with the Securities and Exchange Commission.

During this call, we will be primarily discussing non-GAAP financial measures. We believe that these non-GAAP financial measures help investors to gain a meaningful understanding of our core operating results and future prospects, consistent with the manner in which management measures and forecasts the company's performance. The non-GAAP financial measures are not meant to be considered superior to or a substitute for results of operations prepared in accordance with GAAP.

In accordance with Regulation G, you can find the comparable GAAP measures and reconciliations to those GAAP measures on the Investor Relations section of our website through the financial reconciliations link.

Now, I will turn the call over to Jim Foster.

Jim Foster

Good morning. As you read in our release, despite the fact that we are reporting another good quarter, we are being cautious about the near-term outlook for our industry and our company. The reasons are primarily macro in nature. Nonetheless, they are affecting our forward-looking guidance.

Let me begin by summarizing the third quarter results. We reported sales of $342.2 million in the third quarter of '08, a growth rate of 9% from $314 million in the third quarter of '07. Research Models and Services or RMS increased 14.1% to $165.7 million. Preclinical Services or PCS increased 4.6% to $176.6 million. Foreign exchange contributed 4% to RMS, but reduced PCS growth rate by 70 basis points.

Operating income for the quarter was $77.6 million, a 9.5% gain, and the operating margin was 22.7% compared to 22.6% reported in the third quarter of '07. The 10 basis point increase was primarily the result of higher sales and stable corporate costs.

Although the fully diluted share count was higher than in the third quarter of last year, this year's third quarter operating income gain resulted in a 10.1% increase in earnings per share, which rose to $0.76 from $0.69.

Consistent with our strategy of making bolt-on acquisitions, we acquired NewLab BioQuality AG and MIR Preclinical Services in the third quarter. We are very excited about these acquisitions, which broaden the portfolio of services we can offer to our clients to help them accelerate drug development.

As you know, we are reducing our '08 sales guidance to a range of 9% to 10%, primarily as a result of changes in the preclinical market, which are impacting our business. 1% to 2% of the decline is due to foreign exchange, because the dollar has strengthened significantly since we gave guidance on August 5.

Primarily as a result of lower expected sales, we are reducing our '08 EPS guidance to a range of $2.83 to $2.87. I will speak more about the trends we are seeing in a moment, but first, I will provide a more in-depth review of our segment results.

Sales for our RMS segment rose 14.1% in the third quarter to $165.7 million. When adjusted for foreign exchange and the acquisition of MIR, organic growth was 9.9%. Overall, the production businesses reported strong sales growth, with the US and Europe providing the largest contributions.

Biotech companies and academic institutions drove the sales increase, and we also benefited from a stable pricing environment and market share gains. We are in a unique position in the industry because with one of every two research models sold anywhere in the world coming from Charles River, certain trends are apparent to us.

In the third quarter, double-digit sales growth for inbred and immunodeficient mice indicated our client's emphasis on drug discovery and early development. The latest data from Pharmaprojects supports this interpretation because it documents a 20% increase in the number of compounds in early development, the first such increase in five years.

We also noted that sales of CD rats slowed. Because these are the models of choice for safety testing, slower sales suggest that pharmaceutical and biotechnology companies are placing greater emphasis on late-stage development rather than on early development studies. This aligns with slower Preclinical Services sales, on which I will comment shortly.

Sales to the service businesses were up in the quarter, driven by Consulting and Staffing Services. Our Genetically Engineered Models and Services or GEMS business was down from the third quarter of '07. Sales in the US slowed due to more measured spending by pharma and biotech clients.

We continue to be very excited about our in vitro business, which again delivered growth above 20%. There are a number of sales drivers which we think gives this business long-term growth potential.

First is the continuing success of the PTS. Growth increased due to higher sales of both devices and cartridges. Because of the attractiveness of the PCS, we are able to take market share. We find that new customers purchase both the standard LAL test kits, as well as the PTS, using the portable PTS to ensure that the manufacturing process is clean and the standard test kits for lot release testing.

Some clients have converted to the PTS for lot release, but we are still early in that process, leaving us a large conversion opportunity.

In addition, we are continuing to purchase small foreign distributors, improving our ability to sell direct in those markets. Based on these opportunities, we believe this very profitable business will continue to deliver strong growth for some time to come.

The RMS operating margin declined to 31.1% compared to 31.6% in the third quarter of last year. The two factors which affected the margin were the increasing influence of services and higher operating costs.

With our expanded portfolio of high end services to support the use of models and research, clients increasingly turn to us for our help in developing and utilizing genetically engineered models, maintaining the health status of their research model colonies and the vivaria in which they are housed, and non-GLT efficacy and safety testing.

As we have said before, services generally carry a lower operating margin than products. So the increased level of service sales limits margin growth.

We also experienced higher energy and commodity costs in the quarter, as we have all year. We are managing these costs well, but their impact was a factor in the margin results.

The RMS business remains a consistent driver of our sales and earnings growth as was demonstrated again in the third quarter of '08. Our Research Models and Services are critical components to our client's ability to successfully launch new therapies.

We provide the largest number of widely used models and have the most extensive range of scientific services to support our client's use of models and research. We are continuing to add to our capabilities, both through internal development and through strategic acquisitions, such as MIR Preclinical Services, which we announced on September 15.

We were very pleased to welcome MIR's senior management team, all of whom are remaining with Charles River. These well regarded scientists have extensive large pharmaceutical company experience in oncology, the largest area of pharmaceutical research and development, and also inflammation. These two therapeutic areas expand our existing discovery services expertise in cardiovascular and metabolic diseases.

In addition, MIR's core competency in a wide array of high throughput and efficient imaging technologies positions us for growth in a new area of outsourcing for our clients. We believe imaging is a growth opportunity, because it permits noninvasive quantitative analysis of both efficacy and mechanism of action.

The result is acceleration of the drug discovery process and more precise evaluation of client's drug candidates than is possible with traditional methods. We will continue to expand our RMS portfolio strategically, adding products and services, which enhance our ability to support our client's drug discovery and development efforts.

The PCS segment reported sales of $176.7 million in the third quarter, a growth rate of 4.6% over the third quarter of '07. Foreign currency translation changed course from a positive to a negative, reducing the sales growth rate by 70 basis points, which was effectively offset by the contribution from the NewLab acquisition.

Our North American preclinical business reported growth in the high single digits, led by Nevada which benefited from new capacity and strong demand for large model safety testing. There has been an excellent response to the new facility by our clients, who have quickly transitioned from the legacy facility.

We stopped placing new studies in the legacy facility early in the third quarter and expect the transition to the new facility to be completed as planned.

The PCS growth rate was lower than expected due to a rapid emergence of a number of factors. As you know, our preclinical growth for the past few years has been driven by demand for outsourced services, as large pharmaceutical and biotech companies have endeavored to drive down the costs of drug development.

The unprecedented restructuring of so many of them is interrupting normal spending patterns. So while our clients have continued to spend on outsourced services, they are doing so in a very deliberate and measured manner. They are reprioritizing their development pipelines.

As a result, a significant number of studies, which were originally booked in the third and fourth quarters of '08, are now scheduled in '09. This was particularly evident in Edinburgh, where demand for Europe based pharma companies has slowed considerably.

As they attempt to reduce the cost of drug development, our clients are instituting much tighter cost control, which is driving an increased emphasis on price. Many of our clients now have centralized procurement functions through which they are negotiating better prices.

As a result of study slippage and delays, there is more available capacity for outsourced preclinical services, enabling clients to exact more favorable pricing. We expect this condition to persist into '09, although we believe price pressure will lessen as pharmaceutical companies refocus on early development.

Funding for small biotechs is another factor which we believe will affect demand going forward. Approximately 20% of our revenues are derived from these clients, and although much of their funding comes from large pharma, the sustained inability of small biotech companies to access the capital markets will have an effect. It was not significant in the third quarter, but we expect it to be more pronounced in the fourth quarter of '08.

With the major expansion programs in Massachusetts and Nevada completed, we are focused on wrapping up the smaller projects. We have evaluated all of our in-process projects to determine when and how much capacity should be brought online.

Our Shanghai facility opened on October 15 and we expect it to fill throughout '09. Sherbrooke will be completed in early '09 as scheduled, in order to ease capacity constraints in Montreal. However, we have decided to delay expansion in Ohio until 2010.

Based on our evaluation, we expect our capital spending should be in the range of $200 million to $210 million this year, well below our previous estimate of $220 million to $240 million. Further capacity expansion will depend on market demand, but we are very unlikely to undertake any significant projects in '09, which should lead to a substantially lower capital spend than in the three previous years.

The PCS operating margin was 21.4% in the third quarter. Although sales growth was lower than expected and operating costs associated with the ramp-up of the new Nevada facility were higher, sales mix and cost control enabled us to deliver an operating margin just 40 basis points below last year.

For the fourth quarter, we expect the PCS operating margin to be below the third quarter result. The market trends which I discussed earlier are accelerating with more steady slippage and delays. We continue to manage costs carefully, but given our expectation for lower year-over-year PCS sales in the fourth quarter, we believe the PCS operating margin will be in the high teens.

At the end of September, we announced the promotion of Dr. Christophe Berthoux to the newly created position of Executive Vice President, Global Sales and Marketing and Chief Commercial Officer. In this role, Dr. Berthoux is leading the global realignment of Charles Rivers' sales and marketing organization, the goal of which is to further enhance the company's interface with its customers.

This action is an extension of the process we began two years ago to cross train our sales force and achieve sales synergies between RMS and PCS. Since that time and particularly now, our clients are undergoing rapid change in order to address the efficacy of the drug development pipeline. They are continuing to embrace strategic outsourcing because it allows them to take advantage of external expertise and reduce internal infrastructure.

We saw its adoption first in Preclinical Services and have witnessed it more recently in RMS services as well. The missing piece was Discovery Services, which is the bridge between discovery and development. Discovery Services are employed to establish the efficacy of drug compounds. Just this year, we are seeing more clients outsource these services, having determined that they are non-core.

We are positioning our portfolio to meet this need. So it was logical that we would structure our sales and marketing efforts to sell the entire spectrum of our unique portfolio, the only one in the industry which can support the drug development process from early research through IND.

We believe that our client's restructuring efforts and the funding constraint on biotech are leading our clients to focus on drugs, which are in the latest stages of development in an attempt to bring those drugs to market more quickly. This belief is borne out by the research model sales trends and by the Pharmaprojects data, which suggests that although the current environment is likely to persist in '09, it is transitory.

As our clients push compounds through to market, they will again focus on the earlier stages and we have no doubt that the virtualization of big pharma and biotech will continue as our clients strive for more productive and cost efficient drug development.

While our client's transition takes place, we are tightly managing expenses and capital spending, while maintaining an intense focus on supporting our clients with our unique portfolio of products and services, which spans the development pipeline from early discovery through proof of concept.

Our balance sheet is strong, with $213 million of cash on hand and a favorable debt to equity ratio. So despite this period of softer demand, we are confident that we will maintain our position as a premier provider of essential products and services to the drug development industry. I would like to thank our more than 9,000 employees for their exceptional work and commitment and our shareholders for their continuing support.

Now I will turn the call over to Tom Ackerman.

Tom Ackerman

Thank you, Jim, and good morning. Before I recap our third quarter financial results, let me remind you that I will be speaking primarily to non-GAAP results, which exclude acquisition related amortization, asset impairment charges and other items.

Sales and operating income grew at 9% and 9.5% respectively in the third quarter, led by continued strong sales growth in our RMS business, partially offset by slower sales growth in the PCS segment.

EPS grew 10% year-over-year to $0.76 as a result of a 10 basis point improvement to operating margin, a lower tax rate and lower net interest expense.

The benefit to sales from foreign exchange was reduced to just 1.5% in the third quarter, down from just over 4% in each of the first two quarters of 2008. By segment, this equates to a 4.1% third quarter benefit to RMS, partially offset by a 0.7% reduction in PCS sales growth, due primarily to the impact of the weakening British pound on our Edinburgh facility.

As you can see in the chart, the impact of foreign exchange over the last 10 quarters has ranged from a 400 basis point benefit to a 30 basis point drag on topline growth. However, given the dramatic strengthening of the US dollar over the past several weeks, we expect that the negative effect of FX will reduce fourth quarter sales growth by an estimated 4% versus last year, based on current exchange rates with a more pronounced effect on the PCS segment.

In the third quarter, foreign exchange provided only a nominal benefit to operating income. Typically, our earnings exposure to FX is not as great as the topline impact. When foreign currencies move in tandem, the impact of FX on operating income of our naturally hedged facilities tends to be partially offset by a counteracting effect on PCS Montreal, where we are not naturally hedged.

FX did not have a material effect on the PCS operating margin in the third quarter because the Canadian dollar exchange rates were comparable to the prior year.

Sales declined 2.8% sequentially with nearly half of the decline coming from foreign exchange rates. The consolidated operating margin did improve by 100 basis points sequentially versus the second quarter, driven by lower unallocated corporate expenses. However, margin gains were offset by a higher tax rate and share count, which led to a 3.8% sequential EPS decline.

Unallocated corporate costs of $11.7 million remained stable compared to last year's third quarter, while declining $3 million sequentially. The expected increase in costs related to global IT initiatives was offset by lower performance based compensation expense and other general corporate costs.

Non-GAAP unallocated corporate expense excluded $1.1 million in costs associated with the evaluation of bolt-on acquisitions. These expenses represented due diligence and related costs associated with two potential acquisitions that we decided to terminate, while in various stages of negotiation.

Given the current macroeconomic conditions in the credit markets, we have decided not to proceed. In the fourth quarter, we expect unallocated corporate expense to be slightly higher than third quarter levels.

Lower interest rates compared to the third quarter of last year led to a year-over-year decline in net interest expense to $1.3 million. However, interest expense increased slightly on a sequential basis as a result of additional borrowings under our US revolver.

We expect a sequential increase in the fourth quarter net interest expense as a result of three factors. First, we expect lower interest expense income because we used cash to fund the NewLab acquisition in September; second, we have higher average debt balances; and third, interest rates were higher in October. As a result, we expect net interest expense of $5 million to $6 million for the year.

Other expense also increased $1 million sequentially, principally due to a loss of investments associated with our deferred compensation plan. Based on the weakness in the financial markets in October, we expect to record a loss of approximately $3 million related to these investments in the fourth quarter.

Our third quarter tax rate of 28% declined again year-over-year as it has each quarter in 2008, primarily due to corporate tax law changes enacted in certain foreign jurisdictions in 2007. As anticipated, the tax rate rose 150 basis points sequentially, driven by several discrete benefits in the second quarter, which were not expected to recur, as well as tax law changes in Massachusetts.

Our third quarter GAAP tax rate also included a $2.9 million revaluation of a deferred tax asset related to the impact of the Massachusetts tax law changes on our convertible debt, which was excluded from non-GAAP results. We continue to expect the non-GAAP tax rate in a range of 27.5% to 28% for 2008, which incorporates a modest sequential increase in the fourth quarter due to discrete items.

In the third quarter, we repurchased approximately 474,000 shares of common stock at a cost of approximately $31 million. As of the quarter end September 27, we had approximately $212 million remaining under our current buyback program.

In the third quarter, dilution from our convertible debt totaled nearly 1.8 million shares, plus additional dilution of approximately 500,000 shares from the warrants issued in conjunction with the convert. This dilution was based on an average share price of approximately $65 for the third quarter, but based on current stock price levels, we do not expect to incur any dilution from the convert in the fourth quarter. We also expect less dilution from unexercised stock options at our current stock price.

In light of the recent concerns over the credit market, I would like to provide an update on our capital structure and liquidity. We believe that we are well positioned to weather the storm in the financial markets, with strong cash balances, robust operating cash flow and a conservative capital structure.

In terms of our debt structure, we had approximately $543 million in debt outstanding at the end of the third quarter with approximately $150 million available under our credit facility. Our outstanding debt as of September 27 can be summarized as follows.

The $350 million of 2.25% senior convertible notes do not mature until 2013. We did meet the $63.62 stock price trigger for 20 of the last 30 trading days in the third quarter, which gives holders the right to convert during the fourth quarter.

Although we have not had any conversions to-date as a result of these conversion rights, we were required to classify $203.5 million as short-term debt under US accounting rules during the third quarter. We have a total of $143.6 million outstanding under our $50 million and $115 million, $6 million US term loans, which mature in 2010 and 2011, respectively.

We have a $200 million US revolving credit facility which matures in 2011, with an outstanding balance of $48 million at quarter end. We have drawn on the revolver primarily to fund our US capital requirements, including capital expenditures and the MIR acquisition.

The interest rate in our term loan and revolver is typically LIBOR plus the spread, which is currently 0.625%. However, at our option, we can apply the prime rate, which we opted to do in early October when the LIBOR rate jumped.

With shareholders' equity of over $1.9 billion, we maintain a conservative capital structure with a low debt to equity ratio of approximately 28%. We believe that our ability to generate cash flow in our existing credit facility will provide sufficient funding to limit our reliance on the capital markets.

Shifting to liquidity, cash and equivalents including short and long-term marketable securities declined to $233 million at the end of the third quarter from $289 million at the end of last year. The lower cash balance was driven by cash used to fund the NewLab acquisition, which was completed in September.

The majority of our $213 million cash balance is held abroad in liquid investments including cash, CDs and money market funds. We are currently assessing opportunities to repatriate cash held by our international operations to enhance our access to capital in the US.

Marketable securities totaled $20.5 million as of September 27 and consisted entirely of auction rate securities. These securities are AAA rated and US government-backed, but there continues to be a lack of liquidity in the auction rate market. We plan to diversify this position when liquidity in the market improves.

Accounts receivable declined slightly from the second quarter to $237 million, but increased from $214 million at the end of 2007. DSO increased to 41 days compared to 38 days in the second quarter, but was favorable to 43 days at the end of the third quarter last year. The sequential increase was driven by lower deferred revenue, which offsets accounts receivable and the DSO calculation.

As a result of higher net income, free cash flow increased to $45 million for the first nine months of 2008 compared to $34 million last year. CapEx was also higher at $150 million year-to-date versus $138 million last year.

In an effort to be more prudent with our capital spending, we have reevaluated smaller projects such as Ohio. As a result, we now expect CapEx for the year to be $200 million to $210 million versus our prior guidance of $220 million to $240 million, and expect to generate free cash flow at the high end of the $50 million to $75 million range.

Based on current FX rates, we now expect depreciation of approximately $63 million for the year, $2 million below our original estimate. Full year amortization expense remains at approximately $31 million, or $0.30 per share.

In addition to the charges I have already mentioned, there were two other items which were excluded from non-GAAP results in the third quarter. We recorded a $0.4 million charge related to the disposition of our legacy preclinical facility in Worcester, which we sold at the end of September. We also incurred a $0.3 million charge related to divestiture of our vaccine business in Mexico, which was completed at the end of the third quarter.

Turning to guidance, based primarily on lower expectations for our PCS segment and current foreign exchange rates, we have reduced our 2008 sales and EPS outlook. We now expect sales growth to be in a range of 9% to 10% versus our previous range of 12% to 14%.

Approximately 1 to 2 points of this reduction was driven by the unfavorable impact of FX since our last update in August, with the remainder attributed to slower sales growth in the PCS segment. FX is now expected to provide only a 1% benefit to full year 2008 sales growth.

Our guidance includes the acquisition of NewLab and MIR, which were completed in September, and the disposition of the vaccine business in Mexico. These transactions in aggregate are expected to contribute just under 50 basis points to the full year sales growth rate, and will not have a material impact on EPS.

Non-GAAP EPS is expected to be in a range of $2.83 to $2.87. This is below our guidance from August of $2.94 to $3.00 due to a number of factors.

First, earnings will be reduced compared to our previous guidance by $0.08 to $0.10, primarily due to lower sales volumes in our PCS segment, mitigated by the benefit of cost savings actions. We have already begun and will continue to take the appropriate actions to manage our expenses proactively without sacrificing future growth opportunities.

In addition, we expect an estimated $0.01 net reduction related to unfavorable changes in FX rates since August and a loss of approximately $0.04 on investments associated with our deferred compensation plan. This will be partially offset by an estimated $0.02 benefit from a lower share count in the fourth quarter.

In the fourth quarter, RMS organic sales growth, which excludes the negative effect of foreign exchange and the divestiture of Mexican vaccine business, is expected to be moderately below the third quarter organic growth of 10%. The RMS operating margin is expected to decline sequentially due to normal seasonal weakness in the fourth quarter.

As Jim discussed, we anticipate fourth quarter PCS sales will be below prior year levels and operating margin in the high teens.

While our outlook for the end of 2008 appears to be more challenging than anticipated, we intend to manage the business appropriately and execute effectively on opportunities for future growth. We plan to provide 2009 guidance on December 10, followed by a conference call on the morning of December 11.

That concludes our remarks. We will now turn to your questions.

Question-and-Answer Session


(Operator Instructions). And we will open today with a question from Dave Windley with Jefferies & Company. Please go ahead.

Dave Windley - Jefferies & Company

I wanted to, I guess, start on the PCS side. Jim, you saw a little bit of softness in 3Q, but it seems from your comments that demand is softening maybe fairly precipitously. I don't want to over read that, but I wondered if you could reflect to us a little bit more the feedback that you're getting from clients kind of in real time that give you the sense that the fourth quarter will be softer still.

Jim Foster

I'd say that's a fair characterization. We saw some softness in the last quarter. We had some study slippage and delays. We had essentially commented and guided on the fact that we thought that we would have a similar growth rate in the third quarter. As you saw, it was slower.

We certainly have confirmation and are living through continued study slippage and delays, somewhat on an accelerating basis tied probably to a whole range of factors from the overarching economic situation in the country, particularly as you get into the fourth quarter, which had been preceded by lots of restructuring and still lots of restructuring going on by many clients, both US and abroad.

There's been a constant reprioritization of drugs to be developed a lot of this year, and clearly, an emphasis on the late-stage aspects of the drug development process, even though, as I've said in my remarks, there are a larger number of molecules actually in early stage waiting to be developed. So I think the looming patent expirations are also pushing people to the sort of more on the late-stage focus.

So, clearly, we have a large international infrastructure on both sides of the ocean, very small facilities, and very large ones, different types of toxicology work, both highly specialized and more general in nature. We have, notwithstanding the fact that the North American sales were up in the high single digit ranges earlier, we're definitely seeing accelerating movement.

We saw studies in August move to January rather than to October, for instance. A lot of the studies that were "booked" in the fourth quarter have slipped as well. So slippage is a fundamental part of the preclinical business. It's always been there and it's always been relatively modest. The drug isn't quite ready and we've reprioritized it and the backlogs are sufficient to sort of fill that in.

This is a different type of slippage. This is certainly more fundamentally premised on their ability to afford it, their ability to want to pay for it this year, to try to push it out and wait until next year, and really to sort of forego some of the earlier work so they can focus on the later stage work.

So it's clearly intensifying and accelerating. We're merely a reflection of what's going on in the client base. That's what we're reporting to you today. And we think that it's a realistic look in the mirror as to what our clients are up to.

Dave Windley - Jefferies & Company

Okay. One maybe more specific and I'll jump out. The GEMS business, did I understand that you said that the third quarter of '08 was down from third quarter of '07? And if so, that sounds like it would be down quite a bit sequentially. I wondered if we are back into kind of cutting the number of genetically engineered models that you are housing for clients, are they rationalizing again.

Jim Foster

We have seen some softness there. It seems to be fundamentally different than the last time. The last time was very much about the quality of the models themselves, and whether they really genetically altered in a way, that was an accurate predictor of how the drugs would work in humans.

I think that the models themselves are quite good. So rather than a rationalization and reduction of colonies that we've been housing, which is what we saw for about a year and a half earlier, we're just seeing this as part of sort of the overall sort of pausing in spending additionally on, for instance, giving us new models and sort of intensifying their efforts with us.

So we don't think it goes to the core scientific essence of them, but part of the overall careful spending trend that we're seeing.

Dave Windley - Jefferies & Company

Okay. Thank you.


And we'll go to Randall Stanicky's line representing Goldman Sachs. Please go ahead.

Adriana Kalova - Goldman Sachs

Good morning. This is Adriana for Randall. I just wanted to clarify something further on the delays that you're mentioning. I recall also a quarter the delays were in Montreal and Edinburgh and now we are mentioning delays again in Edinburgh.

I mean, is it fair to assume most of the issues that you are seeing there are related to Europe? And the North American demand for Preclinical Services hasn't been impacted as much by such delays, or are you seeing that trend also shift into North America as well and is particular to you guys?

Jim Foster

We would say as an overall statement the delays in the study slippage unusually severe versus what we've seen in prior years on a worldwide basis. Having said that, they're definitely more pronounced in Europe. They have been for a fair amount of time now and we did point to that last quarter.

So, clearly, we have greater restructuring activity, greater emphasis on late-stage work, more deliberate massaging of the development pipeline and more cost consciousness at the present time in Europe, affecting our Edinburgh site, which, of course, is one of our largest sites, than we've seen historically. Not only is it one of our larger sites, I should also say that historically Edinburgh has been one of our most consistent performing sites.

So it's very large, extremely well managed, a whole range of products and services, a large number of repeat clients, and yet, is certainly feeling a more pronounced pulling back. I do think that Europe is worse than North America.

Adriana Kalova - Goldman Sachs

When you are talking about some of your client's impact, I mean are you referring more in terms of pharma or are you thinking more in terms of biotech, looking at the way they are actually outsourcing some of the services, or are you looking at a delay across both pharma and biotech?

Jim Foster

Obviously, our client base cuts across all of the sectors. The sort of major restructurings that we're seeing, I'm clearly talking about big pharma and very big biotech, and I don't think the distinction of what you call them is all that relevant. I mean, they are large, really large pharmaceutical companies.

So I'd say that's the primary impact. What we are feeling, at least moving forward for the back half of the year, for the fourth quarter is the continued lack of access to capital for the smaller biotech companies, who are in part funded directly by big pharma. But that's probably not sufficient to allow them to outsource and grow at the rates that they have been growing. So we're seeing some weakness in biotech and we anticipate it will be greater.

Adriana Kalova - Goldman Sachs

I'll just ask one more question and I'll jump out of the queue. Regarding dedicated capacity, earlier in the year, you mentioned that you were targeting about 10% of PCS revenue to be from dedicated deals. We're just wondering were you able to achieve that target. Have you guys had any conversations with clients who are signing dedicated agreements, because we are hearing from some of your even smaller competitors, they're in such kind of dialogues with some of the larger clients that they currently have, so trying to figure out whether you are having similar discussions with clients as well?

Jim Foster

We have had discussions and continue to. Some are getting closer to fruition. I would say that the current economic situation and market conditions are actually going to cut both ways. It may push some large companies that are giving up internal infrastructure to be more interested in signing these types of agreements. But I actually think at the margin, it's going to push off some of those discussions.

I think people are so concerned about the cost that the notion -- unless you can demonstrate dramatic savings to them, which in some instances we all can, but even in that case, signing up longer term agreements vis-à-vis uncertainties that are facing the drug companies in particular and the overarching issues in the economy, I do think are adversely impacting the trajectory of a lot of those conversations.

Adriana Kalova - Goldman Sachs

All right. Thank you very much.


Moving on, we'll go to Douglas Tsao's line representing Barclays Capital. Please go ahead.

Douglas Tsao - Barclays Capital

Jim, I'm just hoping you could provide some additional detail. I mean it seemed me from your comments there was a little bit of a disconnect for me. Earlier in the RMS discussion, you noted an increase in early-stage projects in the Pharmaprojects database, although when we were talking about PCS we obviously are talking about sort of a delay in the advancement of studies and a focus more on late-stage pipelines. I was just wondering if you could, at least, qualitatively sort of reconcile that for me.

Jim Foster

Sure. What I was saying is a couple of things. The research model business, we're continuing to see pretty steady and strong purchases of animal models for the use of discovery. I think that's a commentary on the relative cost of animal models as a percentage of the total cost of producing a drug, which is quite trivial. It's also continued focus and knowledge of the drug companies that they have to invest early on in order to potentially invigorate the pipeline.

What sounded like a disconnect is really just -- which I don't think was, it's just a fact that while these compounds have been and are being developed and exist in their early development portfolios, there's greater emphasis on the backend of the pipeline to get drugs to market, because I think that as they weight the two needs, the drug companies weight the two needs, I think they have a greater need to offset the impending patent meltdown, which we're going to see in the next couple of years.

So the animals were used to produce those models. Obviously, some of them are working and are moving through the development process, just not as many as we would hope and anticipate at the current time. But the shift back, either on a balanced basis or even a greater emphasis basis on early development, I think is inevitable. I think the shift is transitory and there's no way that these drug companies will develop the molecules and let them languish.

So it really does follow. We wouldn't expect that the drug companies would ease up on the early creation of the drugs. It's really about which ones they drive through development and what's the priority basis upon which they choose which ones to move through that process.

Douglas Tsao - Barclays Capital

Okay, thanks. And then, Jim, I know you indicated that the Quebec facility is still expected to come online. You have indicated in the past that you expect that capacity to be filled through dedicated capacity agreements and you had sort of two clients in particular. I just wanted to get some additional sort of an update on that process. Are those clients still planning on occupying the Quebec facility?

Jim Foster

We're in constant conversation with them both now. They both will take the available space in that building. We're talking to them right now about what new compounds they will move in there. It will also free up some space in our current Montreal facility, which, of course, is capacity bound. So that situation is developing as we originally had anticipated in quarter two.

Douglas Tsao - Barclays Capital

Okay. Good. Finally, in terms of the sales reorganization, I know that on the research model side you often sell into some of your competitors on the preclinical side. I was just wondering if that was going to make a Chinese wall, if you will, between the two divisions. Will that continue to exist? I mean, are you going to reflect that in the new structure that you sort of outlined today?

Jim Foster

I don't think that will change. We're talking about getting greater leverage across the Preclinical and RMS parts of our business because I think as clients want larger relationships, want to buy more and have us be more responsive to them from a cost point of view, that that's beneficial to us. While we've done, I think, very good cross training of the sales forces and how we structurally brought them together, I think that would be difficult.

I mean, we obviously have to respect the information that we have about sales to our clients in a way that allows us to effectively service them and provide their product needs, but without using that inappropriately. And we never would do that, haven't historically of course, and this structure won't change that.

Douglas Tsao - Barclays Capital

Okay. Thanks a lot. I'll jump out.


And moving on, we'll go to Isaac Ro's line with Leerink Swann. Please go ahead.

Isaac Ro - Leerink Swann

Thanks for taking the questions. First off, on the RMS business, you guys have obviously had a strong year there to-date, and I'm wondering if you look kind of at the longer term trend, three to five years, it seems like this year has been trending a little bit above that sort of high single digits growth rate that we've seen historically. I'm wondering, is this sustainable double-digit growth market now in your eyes, and secondarily, maybe is there an element of share gain that's helped your business there this year?

Jim Foster

No question that there's been an element of share gain that's helped that business, not only this year, but I'd say for the last three years or so. We certainly hope that that persists. While we have enjoyed very much our double-digit growth rates, at least in the first two quarters and we are around 10% on organic basis in the third, we have been consistent in saying that while we aspire to get there; we still think this is a high single digit growth business. We're still in the process of sorting out our own plans. We don't want to comment on that.

But directionally the mix between products and services, market share opportunities, growth in PTS and sort of the essential nature of the products for sure and the outsourcing trend in services, I guess all I would say is we would expect to continue to see this be a strong performing segment of the company, both in terms of strong operating margin, excellent free cash flows and respectable top line growth.

Isaac Ro - Leerink Swann

Okay. Thanks. A follow-up on the market share, I always used to think a couple years back that you guys controlled maybe half the market for models. Would you care to share a number that you think you have today in models?

Tom Ackerman

It's probably slightly larger than that, but there's been a contraction in certain parts of the market in terms of available units. So we've made a lot of that up in mix. We have made some of it up in units as well. But, our market share gains overseas are in most cases well north of 50%. Our market case in Japan is below that. Market case in the US is around that level.

So, I think we're still comfortable saying that we're slightly above 50%.

Isaac Ro - Leerink Swann

Okay. Great. Lastly on pricing pressure. I'm wondering that you mentioned a handful of customers have centralized procurement plans. Is that really the large driver of pricing pressure or are there a handful of competitors that you have that are taking price as a weapon when they go to market?

Jim Foster

I think that it's a combination of factors. I mean I think a lot of the pricing issues are coming as a net result of the delay study slippage making some capacity available. It sort of forces -- I'll just speak for ourselves, but I think it's probably reflective of the rest of the industry, I think it forces people to be more creative and adaptive and flexible on price. So it's really a combination of both of those factors.

Isaac Ro - Leerink Swann

Okay. Thanks a bunch.


And we have a question from the line of Ricky Goldwasser with UBS. Please go ahead.

Ricky Goldwasser - UBS

Good morning. A couple of questions. In the prepared comments, you mentioned that 4Q margins for the PCS business are expected to be in the high teens. If you head into next year, you did say that you expect the softness to continue. Are these kind of the levels we should be thinking of for margins for next year?

Second question relates to RMS. If you think about the macro environment changing in a marketplace, what are your volume expectations for the animal business?

Jim Foster

What was your last question, what are the volume expectations?

Ricky Goldwasser - UBS

For the animal business. I mean, do you think that given everything we're seeing on the macro level that we could see some slowdown there or you just expect steady state into '09?

Jim Foster

We would expect continued strong sales of units, pricing power and probably some share gains. I would expect that as a direct result of the overall economic markets and the challenges and pressures on our clients that the unit growth may moderate somewhat but probably not dramatically. We're seeing a little moderation at the moment.

So, again, we're still working through our '09 plan and working closely with our customers and getting feedback from them on what they see for the next year, notwithstanding the fact that many of them are in transition from a structural point of view. But, again, we find that the core animal purchases are affected less by those things just because of their relatively small value in the whole drug development process.

Tom, you want to take the margin one?

Tom Ackerman

Yes, thanks. As Jim said, we will provide more comprehensive guidance in December. So I don't want to get into too much detail. But in fairness to your question, in response the pressure on the margin in PCS in the fourth quarter is really primarily a function of the sales volume. So, for all the reasons we've just talked about, we are seeing pressure on sales growth, and therefore, that's really backing itself up into the margin itself.

In the near-term, with a lot of projects slipping as you think about Q1 and having had seen an accelerating trend of slippage and some of it by surprise, it's obviously a little bit difficult for us to exactly forecast Q1 at this point. But I think it's fair to say we'll probably continue to see some headwinds earlier in terms of sales growth, and then we would hope that longer term the fundamentals of the marketplace would retain.

So I guess what I would say to sum it all up is that I think we're going to continue to see pressure on the margin in PCS in the near-term. Primarily as a function of pressure, we'll probably continue to see growth on the top line in the near-term. I think based on where we are in our planning process and with the guidance call coming up next month, that's probably about as much information as we could give at this time.

Ricky Goldwasser - UBS

That's very helpful. Thank you.

Jim Foster

Thank you.


And we will go to John Kreger's line with William Blair. Please go ahead.

John Kreger - William Blair

Given your long history in the disease model side, have you seen historically a link in the demand trends between that business and the tox ?business, or put another way, as you are seeing some of these accelerating slowing trends in tox, would you expect that to eventually impact demand for models?

Jim Foster

There is a link. Not only have we seen it, but we are seeing it. That was in my prepared comments. So we are seeing and have seen for a little while now a slowdown in out bred rat sales. Those are the animals used predominantly for tox. I would say that Charles Rivers out bred animals are the industry or world standard. Not that we're the only people who sell them, but certainly we sell more than anyone else.

So there is a causal link, notwithstanding that slowdown. We're still very pleased with our results for the third quarter. We would expect that for as long as the demand is less robust on the preclinical side that that would have an adverse impact on outbred rat sales.

John Kreger - William Blair

All right. Thanks. And then, Jim, I'm not sure if this is a question that will be easy to answer, but as you see some of the slowing in clients, particularly from the larger clients that you're dealing with, are you of the impression that these are more kind of pushing '08 work into '09 for budgetary reasons or more longer term just reductions in activity levels?

Jim Foster

I mean, it's clearly the former and it's interesting. As we move into the fourth quarter and towards the end of the year, just like we are watching our spending very, very carefully and aggressively, so are our clients. So, you're seeing this sort of ?missing word we will delay the study until next year. When we have a new budget, we'll reprioritize things then, we have to sort of batten down the hatches now, we have to make our earnings this quarter, all of that stuff I think probably plays into it.

As I said earlier, we saw modest evidence in the summer, people waiting until the next year. So we certainly are seeing that in the fourth quarter. So I think it's very much budget related and our clients figuring out how they're going to function with the new world order, number one, and some of the difficulties they have specific to their own companies and their industries.

John Kreger - William Blair

Great. Thanks. And then, just finally, I think last quarter you talked about a negative mix shift in Edinburgh and Montreal. I believe at that time you said you thought that mix probably wouldn't improve much in the third quarter, but perhaps in the fourth. Can you just sort of update us on what you're seeing with the general versus specialty mix in those facilities?

Jim Foster

I think what we said is we would expect to see some shift there particularly in Montreal because of the nature of the long-term work that we had previously booked there. So we're beginning to see some improvement there, although I think clients are also being very careful about specialty work, given the costs associated with that.

I would say we haven't seen any fundamental improvement in Edinburgh at all. That location seems to be particularly impacted by the buying patterns of many large pharma companies, in Europe, in particular, which is their primary client base. So you have different market drivers for that location.

John Kreger - William Blair

Thanks very much.


(Operator Instructions). And we will open up Sandy Draper's line with Raymond James. Please go ahead.

Sandy Draper - Raymond James

Thank you very much. Maybe it's a follow-up to one of John's questions. Jim, if you could talk a little bit about -- seeing this as a transitory issue, as you see the market coming back, would you expect to see a bolus of work that -- you try to get a catch-up mode for a couple of quarters, or is it slow and steady that you would build back up to what you would think to be as more of a normalized growth rate?

Jim Foster

The way it comes back is somewhat unpredictable. We had a similar situation -- of course, totally different market drivers and totally different markets and we were a different scale company, but we did have a similar situation at the end of '02 and so much of '03, where there was a significant slowdown, I'd say, for three quarters. Then, the work came back very quickly, like in one quarter. So that would support the bolus theory.

These market conditions are so difficult, it's really impossible to predict the rate and speed at which it will come back. It's only possible to predict, I think, with an extremely high degree of assurance that it will come back. It has to be transitory. Unless one fundamentally believes that the drug companies have given up on drug discovery and development, which, of course, none of us do. It's really a matter of priorities and what they can afford and where their emphasis is now in the pipeline.

So, we're extremely confident that it's going to come back. It's very difficult to call, although, we obviously have to call it and are trying to call it as we're putting together our '09 plan in conversation with clients. We have a lot of work that's moved out to the first quarter for instance. It's highly probable that that work will be executed in the first quarter given that they will have new budgets, and of course, they've delayed them for in some cases a quarter, in some cases two quarters.

But, again, we'll have to see what the overall economic situation is for the country and the world and also what sort of prioritization process they're going through then, because they tend to sort out what molecules they will keep internal to themselves and what they will outsource in the first quarter. But I think that we would be disappointed, at least, not to see it begin to come back gradually through '09 and I think there's some possibility it could come back very quickly.

Sandy Draper - Raymond James

Thank you.


And we will go to Doug Schenkel's line with Cowen and Company. Your line is open.

Doug Schenkel - Cowen and Company

A couple of questions on capital spending for next year. Could you provide some detail on how much of the capital spend is going to be allocated to increasing your square footage in PCS?

Tom Ackerman

In PCS. To a certain extent, as both of us have commented in the scripts, but just to go back and recap a little bit, most of our larger projects are either completed projects that were underway or nearing completion. So Sherbrooke is pretty well near completion. Our larger projects, obviously in Massachusetts and Reno, really finished up this year and we haven't started expanding out in any of the other facilities. So as we look toward '09, we see some completion. Our Chinese Shanghai facility is open in October. There might be a little bit of expenses carrying over into '09.

So as we look out at '09 and based on the conversations we've just had about demand and our existing capacity, we really don't see any big projects starting up, unless there's a dramatic shift in demand. Our view is that we have enough capacity to take us through what would be a reasonable growth rate for next year. So we'll predominantly see the finish up of some projects and maintenance CapEx, which will actually be a little bit more prudent on.

So, if you look at this year's guidance of $200 million to $210 million, we would be substantially below that next year, with most of it being focused on maintenance CapEx.

Doug Schenkel - Cowen and Company

Okay. Understood. I guess really what I'm trying to get at here is when we think about drivers to PCS sales growth, how should we think about the combination of mix, pricing and capacity next year? I mean, I think what you're saying is there's not going to be a big focus on boosting capacity next year beyond what's already in the works. So I'd like to get a better understanding of what kind of growth we can get if we're really just focused on mix and pricing.

Tom Ackerman

What kind of growth we can get in sales or EPS or…

Doug Schenkel - Cowen and Company

PCS sales.

Tom Ackerman

PCS sales? Well, there is adequate capacity for us to grow through next year at -- even our prior assumptions would grow. So I think where we were thinking the market was growing, our capacity would take us well through next year. So I think if we were to have started capacity in '09, it would obviously be for sales in 2010 and beyond, those types of things.

So I think where we are today, we're thinking we really don't have to start projects in '09, but if we do see an up tick in demand with having brought on Sherbrooke and some of our other expansionary activities, we feel like we still have plenty of room in our facilities to still give us nice sales growth, should the market return more robustly in the near-term. Does that help?

Doug Schenkel - Cowen and Company

That does help. Just one more question. You commented that part of the near-term challenge is the increased focus of pharma on later stage projects. Given that, would it be wrong to assume that this probably diminishes the possibility of Charles River entering into an agreement similar to what Covance and Lilly entered into earlier this year?

Jim Foster

I wouldn't say so. I mean, I think there's certainly an opportunity for us to enter into a similar transaction. Certainly, there are going to be a lot of discussions about transactions like that. In our case, it will be more on the very early discovery through proof-of-principle portion of the drug development spectrum. We would have to either partner with someone in the late-stage or the drug companies would contract separately with them.

I mean, my understanding of the Lilly-Covance deal is that there are actually multiple parties involved in that. I suspect that drug companies probably don't want to -- particularly large drug companies, don't want to contract soup to nuts with any particular client at the current time, although that might change in the future.

Doug Schenkel - Cowen and Company

Okay. Thanks, Tom. Thanks, Jim.


And we'll go to Jon Wood's line with Banc of America Securities.

Brandon Couillard - Banc of America Securities

This is actually Brandon in for Jon this morning. Can you remind us or give us some sense of how restrictive the tax implications of repatriating those cash balances held abroad are?

Tom Ackerman

Well, we haven't fully vetted all of that, but we're obviously trying to do that in an efficient way. We wouldn't bring back a substantial amount of cash if the tax impact was steep, let's say. Of course, everybody would define that a little differently. So we think we have some opportunities to do that in an efficient manner. And if we can, then we will.

Brandon Couillard - Banc of America Securities

Okay, and just one more. Can you remind us what the restrictions on your revolving credit facility are? And as we look into 2009, how you view your priorities for excess capital between buybacks or debt reduction, given where the stock price is?

Tom Ackerman

Well, without going into all the coverage ratios and things like that, based on where we are in terms of profits and leverage and things like that, there's really no restrictions on us, for instance, utilizing the revolver, if that sort of goes to your question. I mean it is available to us.

In terms of 2009, as we talk about we do expect capital expenditures will come down quite a bit. We haven't put a stake in the ground in terms of operating earnings and things like that. But assuming good, positive cash flows, operating cash flows, we would expect free cash flow at this point in time to be actually higher than it is in '08, notwithstanding the other conditions that currently exist.

So I think it will give us good flexibility to either build cash, be opportunistic with some small acquisitions that would have good valuations and/or look at what we want to do in terms of our stock authorization and whether we would want to buyback more shares than we are currently buying or maintain cash. I think we'll take all those things into consideration.

Brandon Couillard - Banc of America Securities

Okay, thanks.


Our final question today comes from the line of Dave Windley representing Jefferies & Company. Please go ahead.

Dave Windley - Jefferies & Company

Thanks for taking the follow-ups. On the PCS side of the business, you commented about not adding capacity. I'm wondering in Reno, for example, if demand is going to be a little soft, would you continue to view keeping the older facility open for quarantine as an appropriate thing to do or would it be better to consolidate, and if there are any other levers that you can pull to mitigate margin impact from fixed and/or variable costs that are in place today?

Jim Foster

Dave, I think that it would be an extremely poor use of the new facility, given its cost per square foot and sophistication and design to be as efficient as possible for studies to use a space for quarantines. So the space in the other facility is at a much lower cost. Actually as our large animal business grows for the new facility, increased quarantines space would be available.

So, I understand the basis for your question to try to consolidate it all in one place. But we really want to use the new facility to increase revenues for in-live studies.

Dave Windley - Jefferies & Company

And any other levers in PCS that you could pull? Staffing is obviously one? I guess, staffing is obviously one I guess.

Jim Foster


Dave Windley - Jefferies & Company

I was just saying staffing is obviously one to manage that to your demand. But I just wondered are some of your smaller facilities fully utilized?

Jim Foster

I mean, our utilization, particularly in the small facilities are utilized. They all have different personalized capabilities. So I actually think that one of the strengths of the portfolio is both the geographic proximity to the facilities and the type of work that they do and the nature of the client base. We want to maintain that leverage. While, obviously, capacity utilization at the moment isn't where we would like it to be, directionally we're confident it will get there. We're also confident that actually we have enough capacity to continue to grow for a while.

So that's a good place to be. And I think that taking space out would be a severe knee-jerk reaction to what we believe will be a relatively short-term phenomenon.

Dave Windley - Jefferies & Company

Okay, thank you.


And at this time, we'll turn the conference back over to Susan Hardy for closing remarks.

Susan Hardy

Thank you for joining us today. We look forward to speaking with you in the near future. And this concludes the conference call. Thank you.


Ladies and gentlemen, that does conclude our conference for today. We thank you for your participation and for using the AT&T Executive Teleconference service.

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