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Charles River Laboratories International (NYSE:CRL)

2013 Guidance Call

December 12, 2012 8:30 am ET

Executives

Jim Foster – Chairman, President, Chief Executive Officer

Tom Ackerman – Executive Vice President, Chief Financial Officer

Susan Hardy – Corporate Vice President, Investor Relations

Analysts

John Kreger – William Blair

Greg Bolan – Sterne Agee

Tycho Peterson – JP Morgan

Dave Windley – Jefferies

Sandy Draper – Raymond James

Tim Evans – Wells Fargo Securities

Doug Schenkel – Cowen & Co.

Garen Sarafian – Citigroup

Ricky Goldwasser – Morgan Stanley

Stefan – Goldman Sachs

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Charles River Laboratories 2013 Guidance conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. Instructions will be given at that time. If you should require assistance during the call, please press star then zero. As a reminder, this conference is being recorded.

I’d now like to turn the conference over Ms. Susan Hardy, Corporate Vice President of Investor Relations. Please go ahead.

Susan Hardy

Thank you. Good morning and welcome to Charles River Laboratories’ 2013 Guidance 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 provide initial guidance for 2013 and review guidance for 2012. 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 ir.criver.com. 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 code is 320-365-3844. The access code in either case is 272842. The replay will be available through December 26. You may also access an archived version of the webcast on our Investor Relations website.

I’d 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 statement 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 27, 2012, as well as other filings we make with the Securities and Exchange Commission.

During this call, we will be primarily discussing results from continuing operations and 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’ll turn the call over to Jim Foster.

Jim Foster

Good morning. I’d like to begin by discussing our view of our end markets, the efforts we have made to position Charles River to be successful in those markets, and our view of both 2012 and 2013 in light of those perspectives. We have spoken repeatedly about the changes in our large biopharmaceutical client, (audio interference) as they approach the patent cliff in their efforts to create a more efficient drug development model. These efforts have manifested themselves in numerous changes including reduction of therapeutic areas, elimination of molecules earlier in the process, closure of capacity and headcount reductions, and also a readiness to embrace the outsourcing model for the expertise that they no longer believe needs to be maintained in-house.

We see this readiness in a number of areas. Large biopharma companies are accelerating their investments in biotechnology companies which have long been a source of new models. They are investing in academic research, which provides another avenue for new therapeutics, and in addition to the continued outsourcing regulated safety assessment, they are now also outsourcing non-regulated discovery testing. The patent cliff has been approaching for some time and as it has gotten closer, discussions we are having with large biopharma companies have accelerated.

You already know that we signed a strategic partnership in late 2011 with a major global pharma company and a second with AstraZeneca in October of this year. We have numerous discussions underway with other large biopharma companies in various stages of progress. We are confident that some of these will result in new partnerships as we continue to win business on the basis of our broad portfolio of early-stage products and services, our scientific expertise, our information technology platforms, and our flexibility in structuring partnerships which meet the specific needs of each individual client.

The reason we are able to be flexible in the way we structure these partnerships today has to do with the actions we took to streamline our infrastructure beginning in 2009 and continuing to the present. Early on, we began to reduce capacity and align our headcount to match the reduced demand for regulated safety assessments. We reorganized PCS in a matrix framework which enabled us to harmonize and standardize our operations and our reporting processes. We reorganized the sales force to sharpen our focus on the three client types we defined – global biopharma, mid-tier pharma and biotech, and academic and government. We strengthened our management and scientific expertise by hiring key personnel from the biopharmaceutical industry. We invested in information technology platforms, first in an ERP system and then in new scientific data systems and portals to enable our clients to access their information in real time.

At the end of 2010, we intensified our focus on four key initiatives in order to deliver value to shareholders: operating margin expansion, improved free cash flow generation, disciplined investment in existing businesses with the greatest potential for growth, and returning value to shareholders. We have held steadfast to those initiatives and in 2012 introduced a profit improvement program to identify additional top and bottom-line drivers. We have limited our capital spending to approximately $50 million per year, utilizing approximately half for expansion and half for maintenance. In 2012, we invested capital in new state-of-the-art facilities for our research animal diagnostic services or RADS business, our biopharmaceutical or BPS business, our endotoxin and microbial detection or EMD business, and our CNS Discovery Services business. We also acquired Accugenix to expand our EMD microbial identification service offering and have announced an agreement, subject to regulatory approvals, to acquire Vital River. This will give us a footprint in the China market for research models and related services. These acquisitions and the capacity expansions I just mentioned will support our growth in 2013 and beyond.

In total, these efforts have enabled us to manage through a very challenging period when our largest biopharma clients have undergone significant consolidation and restructuring; and now as they more urgently grapple with the patent cliff, we are exceptionally well positioned to support them.

All the factors I’ve just discussed are the basis for our reaffirmation of 2012 guidance: constant currency sales growth of approximately 1%, earnings per share in a range of $2.68 to $2.73, although likely at the low end to midpoint of that range, and free cash flow of approximately 160 to 170 million. Furthermore, these factors underlie our guidance from continuing operations for 2013. Building on the stability of ’12, we view 2013 as a year in which sales growth continues to strengthen and we maintain operating margins.

We anticipate that on a constant currency basis, 2013 sales will increase between 3% and 5% from 2012 levels. Also, in constant currency we expect PCS sales growth to slightly outpace RMS sales growth. The consolidated operating margin is expected to be in line with 2012 results. The benefit of higher sales and our continued focus on our profit improvement initiatives are expected to offset increases due to employee costs and inflation as well as the start-up costs associated with the ramp-up of the strategic partnerships we were awarded in the last year. We expect EPS to increase at a higher rate than sales to a range of $2.80 to $2.90 in 2013. Operating cash flow is expected to be in a range of 220 to 230. We anticipate that capital spending will be approximately 50 million with approximately 40% of that amount invested in our growth projects; therefore, free cash flow is expected to be in a range of 165 to 175 million, slightly above the range for 2012.

We expect to continue to repurchase stock in 2013 in a range of approximately 1 to 1.5 million shares. From the inception of our repurchase program in August 2010 through the third quarter of 2012, we have repurchased a total of 19.4 million shares or nearly 30% of the shares outstanding.

We are very pleased with our expected sales growth for 2013, especially because the growth is relatively broad-based both from a portfolio and a client perspective. The most significant contributor to the growth rate is the partnerships that we have won with global pharmaceutical companies. These partnerships represent large tranches of work, much of which had not previously been outsourced. Biopharmaceutical companies are under tremendous pressure to find new ways to accelerate the drug discovery and development process and to drive innovation of therapies for unmet medical needs. As a result, our research and development model is changing dramatically. Outsourcing is now being evaluated for expertise that was considered unique or proprietary just a few years ago. Our strategy – to build our in vivo portfolio and structure relationships flexibly to support each individual client’s needs – has resonated with global biopharma companies who are increasingly choosing to partner with Charles River.

We will see this in our PCS sales growth in 2013, which we expect will be in the mid-single digits. This is the first time we expect to report PCS sales growth since 2008, and it is the direct result of our market share gains. We are very encouraged by the fact that the growth will be driven by a combination of non-regulated discovery services and regulated safety assessment as our clients refocus on moving molecules through the development process. Non-regulated discovery services are contributing to growth in both RMS and PCS since, as you recall, we report these services in both segments. Because we provided regulated safety assessment to so many large biopharma clients, we were able to observe firsthand the accelerating demand for non-regulated discovery services. As a result, we acquired discovery assets in oncology in CNS for two therapeutic areas which represent the largest investment of R&D dollars and created a significant body of expertise.

To further enhance our capabilities, in 2012 we invested in a new CNS facility with state-of-the-art imaging equipment. When you combine this discovery expertise with our existing expertise in research models and regulated safety assessment, we can provide clients with an early-stage value proposition which no other CRO can match. Our portfolio enables clients to reduce the number of suppliers with which they work in favor of a strategic research partner who can offer and end-to-end in vivo biology solution. This is particularly important now that large biopharma companies are making earlier go/no-go decisions as to which molecules will progress to regulated testing. It’s critical to have the best information possible to make these decisions, and working with a strategic partner who has a deep understanding of the client’s drug candidates is a significant advantage.

Working throughout the early stage spectrum with Charles River enables our clients to reduce time and costs while maintaining the high quality scientific expertise they require. This was the reason that we were selected by the major global pharma companies to provide their discovery capabilities in addition to the regulated services we were already providing.

We have no doubt that we are at an inflection point with regard to outsourcing by large biopharma companies. Discussions concerning additional strategic partnerships are ongoing as our clients work through the logistics of how and what to outsource. This is a moment in time when we can take significant market share and maintain it for the next three to five years and possibly longer. The effort required by both partners to transfer protocols, create a governance structure, and establish a trusted working relationship is a strong deterrent to changing providers. Our goal is to prevail in the majority of these opportunities, exceed the clients’ expectations, and manage the relationships so that we generate higher sales and improved operating margin.

In the short term, many of these partnerships, though not all, do exert pressure on the operating margin. We price our proposals very competitively based on the volume of products and services we expect once the business is fully ramped. During the start-up period when we initially transition the protocols, sales can be low. When this occur, it impacts the margin; however, we expect the margin to improve over time as the volume of services increases. We have also found that as we work more closely with our clients on the same side of the table, our clients identify opportunities to expand the work we do with them. There is an incentive for them to do so not only because of favorable pricing but also because of the advantages of buying more products and services from the same provider. This reduces the time required to manage multiple suppliers and improves their overall efficiency.

As a result of the partnerships and other business we have been awarded, we are already experiencing improved capacity utilization with two of our PCS facilities operating at peak levels. As we continue to win business, we expect capacity utilization to improve further, which will also help expand the margin. Although PCS pricing overall is expected to be flat in 2013 due to the impact of the larger agreements, we expect to slightly increase spot PCS pricing for the first time since 2008. The RMS segment sales growth in 2013 will be driven by nearly all of the business units. The EMD business will be the largest contributor in almost equal parts due to the acquisition of Accugenix and organic growth; however, we also expect growth in the models, services, and avian businesses.

For research models, we expect Europe and Japan to drive the growth as we continue to take market share in those locales. Our North American business is expected to grow at a slower rate. Although we believe we continue to take share in academic markets, ongoing capacity reductions by large biopharma clients are limiting growth. The strategic partnerships also affect research model sales because under these partnerships, commercial sales are reclassified to inter-company sales; however, we are very pleased that we are maintaining our position as the leading provider of high-quality research models.

Sales of research model services, which include GEMS, RADS, discovery and IS, are also expected to grow in 2013. Discovery, which I’ve already discussed, is the strongest driver of the four service businesses, and our avian business is also expected to deliver another strong year as the approval of nasal flu vaccine in Europe and increased production of animal vaccine has resulted in increased demand for SPFA. The EMD business has been an exceptional performer for the last two years and we expect that performance to continue in 2013 and beyond. Our strategy is to become the premier provider of rapid microbial and endotoxin detection products and services to the biopharmaceutical industry. Over the next several years, we intend to enhance our capabilities through both product extensions and acquisitions such as Accugenix, an acquisition we completed in August. We believe that execution of this strategy will advance our position as a market leader in endotoxin and microbial detection and enable us to continue to drive growth for the EMD business.

The PTS franchise has provided a strong foundation on which to build and we continue to take market share as clients recognize the value and efficiency that the devices can bring to the manufacturing process. The multi-cartridge system, or MCS, is enabling us to improve our penetration of the high-volume labs, and we expect the robotic MCS, branded Nexus, to be another tool in our arsenal to drive higher cartridge sales. The Nexus made its debut at the Global PDA Microbiology Conference in November where it generated significant interest with our clients. We expect to begin shipping the Nexus in the first half of 2013.

With no meaningful competitive response to our PTS franchise, we are moving aggressively to expand our global capabilities. The acquisition of Accugenix in August is the basis of our microbial identification service offering and we expect to identify additional capabilities which would make our portfolio more valuable to clients. To leverage the Accugenix business, we are expanding our laboratory capabilities in Europe and Asia, and to meet the growing demand for our endotoxin reagents we are expanding our production capabilities in the U.S. and China. As pharmaceutical manufacturing becomes more regulated worldwide, these new capabilities will enable us to support the demand more effectively.

I devoted much of my commentary today to our global biopharma clients, but the success of our sales efforts has not been limited to these clients. We have taken market share in the mid-tier and academic accounts as well. These two client groups have contributed to growth in 2012 and we expect them to drive meaningful growth in 2013 as well. We have forged new or stronger relationships with mid-tier companies, many of which are benefiting from funding by large pharma. Most of these companies maintain limited in-house capabilities and require the services of a CRO like us to help them through the preclinical development phase. For these clients, many of which outsource all of their work to a single provider, our value proposition is equally compelling as it is for global biopharma. We are a partner who can provide the necessary scientific expertise that they require and the ability to help them navigate the regulatory process. Turnover in the mid-tiers is considerable because of smaller pipelines; however, these clients tend to stay with the same partner, which means that we see them return to work with us when their next molecule enters the in vivo process. Therefore, we view the mid-tier as a significant opportunity to drive sales growth.

Academic and government clients have been important contributors to growth in 2012 and we expect they will continue to be in 2013. A considerable portion of our sales to this segment are based on long-term contracts which mitigate the effect of funding constraints. Although we don’t know what effect the fiscal cliff will have, the fact that research models are a very low-cost tool compared to large equipment and represent a small percentage of the research spend makes these products less likely to be a focus of funding cuts.

We believe we can continue to drive sales growth in 2013 as a result of focused sales efforts which highlight our advantages over the competition: the highest quality products and services at a marginal price premium, access to unmatched scientific expertise, and greater company stability than some of our smaller competitors. We have spent the last few years building for the future, focusing on both internal and external goals. From an internal perspective, we have focused on enhancing our in vivo biology portfolio to provide the broadest support throughout our clients’ early stage drug development process. We have acquired select assets that either expanded the products and services we can offer our clients or gave us a footprint in new geographic areas, or both. We have honed our operating efficiency through restructuring, rationalization of capacity, and implementation of best practices. We believe that the information technology platforms and data portals we have implemented are best-in-class and that they will provide enhanced data capability for us and for our clients.

From an external perspective, we have focused on gaining market share by offering scientific excellence in innovative and flexible arrangements that meet each client’s specific needs. We are listening to our clients and forging stronger relationships as a partner, one they can trust to support their requirement for science, efficiency and cost effectiveness. For all of our clients, we believe these relationships are the foundation for improved performance in 2013 and beyond. We have dedicated ourselves to execution of these internal and external goals and are confident that as a result, we have positioned Charles River to be successful in a dynamic biopharma market. We believe that success will drive the four key initiatives and enable us to deliver increasing value to shareholders.

In conclusion, I’d like to thank our employees for their exceptional work and commitment and our shareholders for their support, and now I’d like to turn the call over to Tom Ackerman.

Tom Ackerman

Thank you Jim, and good morning. I will be speaking primarily to our non-GAAP outlook from continuing operations, which excludes acquisition-related amortization expense, non-cash interest expense, and certain other items in 2013. As noted in our press release, our guidance also excludes acquisitions until the transaction has been completed. For 2013, we have not included the pending acquisition of Vital River, which is expected to close in the first quarter of 2013.

Our outlook for 2013 represents the next step in a multi-year process that has generated more partnering opportunities with our clients and an intensified focus internally on improving operating efficiency. As we exit 2012, we are on track to generate the first year of constant currency sales growth since 2008 and deliver non-GAAP EPS of $2.68 to $2.73. As I said in our third quarter call, many clients had indicated that they expected to restrain spending in the fourth quarter, which has intensified as the quarter has progressed. Based on our current expectations, we believe our 2012 EPS guidance is trending towards the midpoint to lower end of our $2.68 to $2.73 range. This will still be at the high end of the guidance range that we initially provided last December.

This progress, while modest, confirms our belief that our end markets are beginning to show signs of improvement and we continue to enhance shareholder value. In 2013, we believe that sales growth will accelerate, approaching mid-single digit growth, and earnings per share will grow slightly faster than sales to a range of $2.80 to $2.90. We expect a slower start to 2013 as a result of the same trends that are causing clients to restrain spending ahead of year-end. We believe clients are increasingly cautious about spending their remaining budgets in 2012 due in part to the global macroeconomic uncertainty, and we expect this uncertainty will also impact their spending in early 2013. We also anticipate that the first quarter will be affected by the normal lag in preclinical study activity at the beginning of the year, as well as start-up costs related to large client agreements. As a result, we expect first quarter EPS to be similar to the first quarter 2012 level.

Jim commented on many of the fundamental drivers behind our full-year 2013 outlook, and I will now provide some additional details. Our constant currency sales guidance of 3% to 5% growth assumes that unit volume outpaces price increases in 2013. Pricing is expected to contribute 1% to 2% to RMS sales growth while PCS pricing is expected to be relatively flat again in 2013. Price gains will be moderated in 2013 as a result of the increasing number of strategic partnerships and other business arrangements we are forming with large biopharmaceutical clients. Through enterprise agreements, these expanded relationships incentivize large clients to purchase more across our entire early stage portfolio. The result is driving greater volume across our businesses, which is beneficial to both Charles River and the client, but there is an impact to realized pricing in both RMS and PCS. We believe that our broad flexible arrangements allow us to become more embedded on the same side of the table with our clients and, as a result, often receive incremental and ancillary work beyond the initial scope of the agreements. These agreements also enable us to gain market share and maintain it for extended periods. We believe that ensuring a stable base of larger clients is integral to achieving our longer term financial goals and positions us well for continued commercial success in the coming years.

Jim discussed many of the areas where we expect to see the greatest sales growth in 2013, including EMD and discovery services. We also expect accelerating growth in our core safety assessment business driven in part by incremental work under the AstraZeneca partnership as well as other new business arrangements which we won or retained for 2013. Overall, sales volume is expected to contribute 200 to 400 basis points to sales growth in 2013.

Foreign exchange is expected to have a more muted effect in 2013. FX is expected to reduce reported sales growth by approximately 0.5% based on current rates compared to an approximate 2% headwind in 2012. On a reported basis, we expect sales to grow by 2.5 to 4.5% in 2013. Given our geographic sales mix, we continue to expect FX to have a greater impact on the RMS segment than on PCS.

We expect the consolidated operating margin in 2013 to be similar to the anticipated 2012 level as contributions from higher sales and process efficiency initiatives will be offset by annual cost increases. Price and volume should benefit the margin by 100 to 150 basis points in 2013 despite the impact of strategic partnerships and other new business arrangements. During the initial transition period, sales under these expanded agreements are often lower and start-up costs are more significant. We expect these metrics to improve as volume increases, but they create a near-term margin drag.

We also expect to see additional benefits from the ongoing efforts under our profit improvement program in 2013. The program is on track to achieve our cost savings goal of over 25 million in 2012, and we expect to generate incremental cost savings of approximately 20 million in 2013.

As I discussed last year, the key elements of this program are process efficiency and global sourcing. The largest contribution in 2012 has come from process efficiency projects. For example, we have implemented projects to harmonize labor utilization. We are using enhanced KPIs captured in the ERP system to analyze labor utilization trends by product or service type and are adopting best practices across the organization. In addition to operational projects, we are leveraging the ERP system to streamline certain corporate support functions such as more fully automating our accounts payable process and consolidating certain billing, collections and payroll activities.

We are also evaluating projects to streamline and further optimize our global footprint. As I mentioned on our third quarter call, we began the process of consolidating two small RMS facilities in Europe as part of these ongoing efforts to improve efficiency and profitability. We can provide the same products and services from our other European facilities in the region and reduce the overhead by closing the smaller facilities.

We have introduced programs to introduce benefits from global sourcing where we are well underway with the process of consolidating procurement activities in areas ranging from lab supplies to utility contracts. One new initiative that we are using to maximize the savings from our procurement activities is e-optioning, where prequalified vendors bid to provide us with certain products, including disposables, caging, and raw materials in an online auction setting. In 2013, we expect to further enhance our process efficiency and global sourcing savings as we continue to expand to additional areas.

These favorable contributors are expected to be offset by annual cost increases primarily related to merit-based salary increases averaging 3% to 4% in 2013, and general inflationary cost increases of 2% to 3% for items such as feed, bedding and utilities.

On a segment basis, we expect PCS sales growth to be slightly higher than RMS growth in 2013. Similar to the consolidated margin, we expect the RMS and PCS operating margins to be consistent with their anticipated 2012 levels. Unallocated corporate expense is expected to be approximately 6% of 2013 sales, which remains at or about the same level we have experienced since 2010.

I will now discuss the outlook for certain non-operating items in 2013, many of which are expected to remain at levels similar to 2012. Net interest expense is expected to be relatively flat in 2013 compared to our outlook of 18 to 19 million for 2012. Our 350 million of 2.25% convertible notes mature in June. We have assumed that our cost of debt remains relatively consistent throughout 2013, including in the second half of the year after the convert matures. We continue to finalize plans to refinance the convert but intend to keep interest rates low under any financing alternative.

We also expect our 2013 tax rate to be consistent with 2012 in a range of 26.5 to 27.5%. We currently expect our 2012 tax rate to be at the low end of this range primarily as a result of a Canadian tax settlement related to R&D tax credits that will not recur in 2013.

With these below-the-line items and the consolidated operating margin expected to remain at similar levels to 2012, top line growth is expected to be the primary driver behind the EPS growth in 2013. We also believe that stock repurchases will contribute modestly to EPS growth in 2013, but less so than in previous years. We currently intend to repurchase between 1 and 1.5 million shares in 2013. While we do anticipate a slightly lower share count at the end of 2013, stock repurchases are expected to be partially offset by dilution from equity awards, options, and the vesting of restricted shares. At the end of the third quarter, we had 73.5 million outstanding under our current stock repurchase authorization.

In addition to stock repurchases, we also expect to continue to allocate capital in 2013 to a combination of debt repayment and acquisitions. Our debt repayment activities in 2013 will include refinancing the convert and scheduled payments on the term loan. Our goal is to maintain our leverage at approximately 2.5 times EBITDA.

We also continue to evaluate acquisition candidates and intend to pursue M&A opportunities in 2013. Our strategy is to expand our business in several areas, including upstream as our clients seek to outsource earlier stages of their R&D programs, expanding the capabilities our technological expertise of current growth businesses. The acquisition of Accugenix of last August, which is tracking ahead of our plan, is a prime example of how we expanded our EMD business by adding premium microbial identification capabilities, and identifying opportunities to further expand our business geographically as we intend to do through the acquisition of Vital River.

As Jim mentioned, we continue to make progress on the four key initiatives that we reemphasized in 2010. Two of the underlying strengths of the shareholder value proposition are our strong free cash flow generation and investing this capital in projects with the greatest potential return. We expect to generate 165 to 175 million of free cash flow in 2013, an increase from our 2012 outlook of 160 to 170 million. We expect capital expenditures to be approximately 50 million again in 2013. As was the case in 2012, the spending will be focused on both growth projects and maintenance. Growth projects are expected to represent approximately 40% of CAPEX in 2013, including the expansion of our EMD footprint and investments to enhance client data portals.

As part of our overarching goal to enhance shareholder value, we continue to make progress on improving free cash flow based return metrics. We are poised to generate free cash flow of 3.30 to 3.50 per share in 2012, growing to an expected 3.40 to 3.65 per share in 2013. As I discussed last year, we also closely monitor performance and evaluate projects using return metrics that are focused on cash profitability in comparison to the funds invested in the business. These metrics include free cash flow to net operating assets to track business unit performance, and free cash flow to invested capital to measure company-wide returns. These returns have continued to improve since 2008 and we expect to generate improvements in 2012 and 2013, as demonstrated by our free cash flow to invested capital return. This metric is expected to increase from 12% in 2011 to approximately 13% in 2012, and further improvement is expected in 2013.

We believe that the actions we are taking today, from improving operating efficiency to aggressively pursuing large partnership opportunities, not only enhance shareholder returns in 2012 and ’13 but better position Charles River to accelerate sales, earnings and free cash flow growth over the longer term. Thank you.

Susan Hardy

That concludes our comments. Stacey, would you please take questions?

Question and Answer Session

Operator

Sure. [Operator instructions]

And our first question will go to John Kreger with William Blair. Please go ahead. Mr. Kreger, your line is open.

John Kreger – William Blair

Sorry about that. My question relates to strategic deals. Could you just expand a bit more as your experience level builds. As you move into Year 2 and 3 of these deals, what kind of organic revenue growth do you expect, and are you seeing margins generally comparable to your traditional non-strategic business?

Jim Foster

So each deal is clearly going to be different in terms of the type of work that we do and the structure and the growth rates, but they do tend to be significant and obviously they give us a meaningful revenue pop in the first year. The ones so far typically are kind of getting to annual run rates by the end of a year. There’s obviously some start-up costs that drag the margin from protocol development to hiring and training people, et cetera, and the volumes start lower but continue to expand throughout the year.

The other really interesting thing about most of these deals is that invariably we end up doing additional work with the client outside of the four corners of the specific agreement because we’ve really become partners, and they look at us to solve a lot of their scientific and operational needs. That’s obviously a very positive thing, both from a top line and a margin contribution point of view.

In terms of the margin, besides the early drag, I think all we can see is that we have competitively bid them related to the volume that we are able to secure, and we believe that once up and running on a steady state basis, particularly as capacity fills, that they certainly won’t continue to be a drag on margin and should help in the entire process of continuing to build margins back to where we would like to get them. Our latest prognosis is trying to get the margins for preclinical back to the mid-teens as soon as we can.

John Kreger – William Blair

Great, thanks very much.

Operator

We’ll go to Greg Bolan with Sterne Agee. Please go ahead.

Greg Bolan – Sterne Agee

Okay, thanks. So did I hear correctly that excluding the headwind from partnerships start-up, that consolidated margin should improve 100 to 200 basis points based on volume improvement?

Tom Ackerman

Correct.

Greg Bolan – Sterne Agee

Correct?

Tom Ackerman

Yes.

Greg Bolan – Sterne Agee

Okay, great. That’s very helpful. And then just one last one – is it correct to assume that Vital River will contribute about 100 basis points to consolidated revenue growth in ’13, and I’m kind of thinking one or two pennies of accretion as well?

Tom Ackerman

Yeah, what we said when we announced the transaction was slightly more than 1%, I believe, on a full year and slightly accretive.

Greg Bolan – Sterne Agee

Okay, got it. Thanks, guys.

Operator

And we’ll go to Tycho Peterson with JP Morgan. Please go ahead.

Tycho Peterson – JP Morgan

Hey, good morning. Jim, I wanted to follow up on your comments on utilization. Obviously you’re calling for PCS pricing to be flat, but you did talk about spot price increases. So maybe talk about how you think about this trending throughout the year, talk about how you think about maybe opening up additional bunkers or rooms if needed, and are there any preliminary discussions on dedicated space or is that a thing of the past?

Jim Foster

I wish there was discussions on dedicated space again. I don’t think we’re there yet, but I can foresee that happening again in the future. I actually had a conversation the other night with a client about historically the importance of that to our clients as space fills—the potential likelihood, I should say, of reinvigorating those.

Capacity is filling nicely, as we indicated. We have two sites that are fully utilized and we anticipate we’ll start the year. They are now and they will continue to be during the year, and we’ll work hard to continuously try to improve the mix of long and short-term work and specialty versus general. The other sites that aren’t as fully utilized, we believe will continue to fill nicely as well. And you know, I suspect that probably a year from now we’ll be approaching optimal capacity utilization for the full system. We probably won’t be there yet, but we’ll be able to see it.

As you know, we do have several small additions at three of our locations, that two of them are built are—one’s built and not open, one we have additional space that we opened and aren’t using, and the other we have a little bit of construction to finish. Certainly as we get close to seeing sort of optimal capacity utilization all around, we’ll begin to open those sites commensurate with client demand, species demand, and geographic demand. But we feel really good about the way the space is filling; we feel really good about the larger deals giving us slightly better visibility, slightly better consistency, and better knowledge as we start each quarter of at least a portion of what the revenues should be. As we said, we think we will continue to be able to sign these deals. Whether we get to announce them specifically or not depends on the client, but we’ll continue to give you all indications, if not specifically on a general basis.

Tycho Peterson – JP Morgan

And can you just clarify the comment on spot price increases?

Jim Foster

I’m sorry. So we’re directionally seeing that we’re going to get slightly better pricing on individual studies pretty much throughout the system for 2013. That’s somewhat muted by the larger deals, obviously, that cause some margin drag; but we’re quite optimistic by that. It’s been years since we’ve seen any price opportunity. It’s also been years since we’ve seen the sort of growth that we’re projecting for next year, and obviously historically we haven’t had the solidity and stability that will come from some of these larger deals.

Tycho Peterson – JP Morgan

Okay, thank you.

Operator

We’ll go to Dave Windley with Jefferies & Company. Please go ahead.

Dave Windley – Jefferies

Hi, thanks. A couple questions. I hope they’re small. The acquisitions that you’re making, Jim, I’m wondering what you are doing in these cases, perhaps learning from history to ensure leadership stability and the solid integration and long-term contributions of the acquisitions that you’re making.

Jim Foster

We’re very focused on our acquisitions. We’re sort of looking at three things simultaneously. One is to continue to build out our unique upstream portfolio, and so we’re looking at additional service offerings that we’re hearing from our clients that they would like to see being part of Charles River. We’re looking to fill out our current portfolio of businesses that we’re already in that have nice growth metrics and good demand curves and where we are competitively strong, and that would be like Accugenix fleshing our our EMD business. And then we’re clearly looking to expand in several of our current businesses geographically, and Vital River would be an example of that vis-à-vis China.

We’re being very tough with prices that we pay and the returns that we want to see with these deals immediately, and we want to do deals that are worst-case neutral and preferably accretive out of the box, that give us some top line growth, that absolutely fit with what we’re doing so we’re not taking our eye off of any ball. We have typically 90-day integration plans for these businesses that we start literally the first day that we acquire them, and we have teams that are focused on ensuring them.

I guess going back to your question, we always bet on people, so we won’t buy businesses unless the quality of the people and particularly the quality of the science and the customer interface and responsiveness is up to our standards. And if we think that the company generally is but its leadership can be enhanced by someone who already works for Charles River being put into that role, we obviously would consider doing that as well.

Dave Windley – Jefferies

And if I could just slide one in on the endotoxin business, you made some comments in your prepared remarks about expanding production, and I just wanted to make sure that there’s not, say, a rate limiting step or if you’re reaching kind of a peak in your access to LAL for your testing, your MCS and PTS kits.

Jim Foster

Yeah, we’re continuing to build increasingly more efficient and sophisticated production methodologies to do more with less manual labor and to have larger runs. Principally we’re talking about cartridge production, and that’s something we do really well. We’re staying way ahead of the anticipated need, so we’ve done that in the U.S. and of course we’ve rebuilt our facility in China to accommodate the need there as well. So these are necessary efficiency moves to keep up with market demand.

Dave Windley – Jefferies

Great, thank you.

Operator

We’ll go to Sandy Draper with Raymond James. Please go ahead.

Sandy Draper – Raymond James

Thanks very much. Just a question, Tom – when I think about your comments about margins, and I know this has been partially asked before, but if I think about your top line growth as sort of 3 to 5%, parts of that costing sort of 3%, so maybe that’s the offset, so you’ve got the cost savings. Is it fair to think about the cost savings are going to be offset totally by the initial impact of the partnership, and so those are equal puts; and then the top line growth and the cost inflation equal puts. Is that a fair way to think about it?

Tom Ackerman

I wouldn’t say completely. So we obviously have cost increases that we talked about. We do have a number of cost savings. We did talk about initial sort of headwinds on ramping up these strategic partnerships and the costs associated with them. We also talked a little bit about the realized pricing because of some of the strategic partnerships where we are being competitive to win these awards. I would say that it’s a combination of all of those things.

Sandy Draper – Raymond James

Okay, great. That’s helpful. And then just—I guess that’s my main question, so I’ll jump back in the queue. Thanks.

Operator

We’ll go to Tim Evans with Wells Fargo Securities. Please go ahead.

Tim Evans – Wells Fargo Securities

Hi, thanks. Tom, on the foreign exchange piece of it, if I just look at the current exchange rates, it looks like the dollar is weaker relative to most of your major currencies, maybe with the exception of the yen; and so I would have expected to see a little bit of a foreign exchange tailwind rather than the headwind that you’re looking for. Is there some sort of mix shift there that I’m missing?

Tom Ackerman

No, I don’t think so. I mean, we can kind of run through it a little bit more offline, but of course as we said, we don’t really see a huge impact from exchange versus a couple of points in 2012. The rates, of course, moved around a little bit over the last couple of weeks. I think the dollar was weaker when it opened this morning if I remember right, so we’re expecting a modest 50 BP headwind from foreign currency at this point in time, which again depending on which spot rate you pick, could be a little bit more or a little bit les.

So no, not really. I mean, you kind of know where we are. The euro, the pound and the Canadian dollar are the biggest impacts to us. I think that’s been pretty predictable and pretty consistent. The yen has an effect also, but that’s smaller than the others.

Tim Evans – Wells Fargo Securities

Yeah. Could you maybe just give us the specific assumptions on what exchange rates you’re using there in the guidance?

Tom Ackerman

Well for plan, it’s in line with the spot rates, although each one is not specifically geared to where the spot rate is today. We haven’t really provided those specifically in the past, so I’d prefer not to do it now. But they’re generally in line with where the rates are today. We don’t do too much prognosticating on where we think the pound will be in the middle of the year because it’s just almost impossible to predict, right?

Tim Evans – Wells Fargo Securities

Okay, great. Thank you.

Operator

And we’ll go to Doug Schenkel with Cowen & Co. Please go ahead.

Doug Schenkel – Cowen & Co.

Hi, good morning. So the progress you are making with strategic partnerships is clearly very encouraging. With that said, keeping in mind two things – first, as you talked about, the start-up costs associated with these partnerships are expected to limit margin expansion in 2013, at least they are one contributor; and second, that you expect more partnerships over time. What’s really the right way to think about the outlook for PCS margin improvement over the next few years as partnership momentum continues to build? It seems like PCS margins are improving with utilization but this is getting masked by some of the start-up costs, so I guess really what I’m getting at is do you gain some ability to leverage the start-up costs that you’re making now and next year across future partnerships, and is that one way that you could basically get a handle on the fact that, over time even as you have a higher mix of partnerships, the margins should improve?

Jim Foster

We would think they would continue to provide a slight drag, but as we have a more sort of ensconced base of partnerships that are operating efficiently and as the space is very well utilized and as we get more experience, and as they continue to add to that mix, we would hope to get the benefit of better capacity utilization, better knowledge of—better visibility of the work that we have in advance of it starting up, and that the install base will be much larger than—it’s hard to talk about the rate, but we had two large deals we signed in the last 12 months. Let’s say for argument’s sake that there’s one a year, we would anticipate that that would have an increasingly smaller drag on the total margin, particularly as space becomes increasingly dear and hopefully we can get some additional pricing going forward.

So you know, it’s a patchwork but definitely going in the right direction. We’re starting these deals with a much more efficient infrastructure, both in terms of staffing and our IT interface and how we utilize the space, and what the expectations are of our clients. It’s a lot clearer if you have enough of the large deals, you have less churn and you have less of a lack of knowledge of how you’re going to start each quarter. That should enhance the efficiency as well. It ought to smooth out the inherent volatility that is part of the way that drug companies do business – they’re always changing and reprioritizing their drugs and having formulation problems or not. But again, the larger the number of molecules that we’re working with and the larger the number of clients, and particularly as the number of deals gets larger, we should increasingly smooth out that process.

I was just talking to a client about this this week. I think we’re able to smooth it out actually better than they are able to do it internally, because we are able to do it over a large number of companies. So we will have some intermittent, hopefully shorter term drag on the margins. We still think we’ll be able to improve them and increase them over the next few years.

Doug Schenkel – Cowen & Co.

That’s really helpful, Jim. And really just a quick one for Tom, and thanks to all of you for all the detail and effort, as usual, that goes into this call. So with that said, sorry if I missed this, Tom, but did you guys provide a specific expectation for M&A contributions across the business?

Tom Ackerman

Now, we didn’t. What we said, Doug, was that our guidance doesn’t include M&A that’s not completed, so of course Accugenix is in our prepared remarks but Vital River is not, and what we had said when we announced that transaction was that on a full-year basis, it would contribute slightly more than 1% to sales and be slightly accretive, and we expected it to close in the first quarter. With respect to the other things that we talked about more generally in terms of targeted areas, no, we of course would not include anything from those areas.

Doug Schenkel – Cowen & Co.

But Accugenix is probably closer to something like 50 BPs – you know, less than 1% across the business?

Tom Ackerman

Well, probably—let’s see. What we said when we acquired it was that it was about 1% of sales—

Doug Schenkel – Cowen & Co.

It is about 1 – okay.

Tom Ackerman

And of course, we had four months in 2012, so it’s really just arithmetic.

Doug Schenkel – Cowen & Co.

Yeah, okay. Thanks again.

Operator

We’ll go to the line of Garen Sarafian of Citigroup. Please go ahead.

Garen Sarafian – Citigroup

Hi, thank you for taking the question. My first question is regarding partnerships again. You mentioned a pipeline of conversations, and I think in prior years that you had quantified it in the past in half a dozen conversations or so. So could you quantify in ay way the pipeline of partnership conversations that you’re having right now?

Jim Foster

Yeah, we still have several conversations ongoing right now with multiple large clients who are all interested in certainly pursuing discussion about outsourcing work. Some have closed facilities and some are clearly thinking about that, and they’re all thinking about the pressure that the patent cliff has put them under and how they are going to be more efficient. So I think it’s sort of a foregone conclusion that all of the major drug companies – that includes a couple of really big biotech companies that we consider drug companies – will at some point over the next few years do deals like this. They just—it’s the new business model, it’s the new paradigm, and these partnerships are really important. So it’s not only about finding a place to get the work done at a favorable proposition. They’re really outsourcing the science, and so when you’re looking at the preclinical work, they’re outsourcing a lot of the decisions on whether to continue to develop a drug. That’s a major responsibility for us and one we take seriously, and one that really makes it a strategic and scientific partnership and not just kind of a vendor supply deal. We don’t consider ourselves vendors at all. We consider ourselves a research partner.

So I think they will all entertain large deals. I don’t think any of them will be exclusive. I think in most cases there will be a prominent player and a less prominent one – they’ll have a couple of big players. As we’ve said countless times, our goal is to be the predominant player in a majority of those deals, and we’re working hard to make that happen. And we are well on our way – we have a couple of earlier deals that we weren’t able to announce because the client didn’t let us use their name, and in the future we won’t always be able to use the client’s name. I think in most cases we won’t, so we’ll try to report on that as accurately as we can given the difficulties in being totally specific. But I do think that a larger portion of our pharmaceutical revenue will come from these deals, and increasingly it will cut across the whole portfolio of what we do.

Garen Sarafian – Citigroup

Got it. And if I can just slip in another one, you mentioned in one of the slides which – again, we all appreciate all the detail, thank you very much – in one of the slides that Charles River’s expertise is available at a marginal premium. But the price increases for RMS that you expect in the upcoming year of 1 to 2% seems to be lower than last year’s price increase, which I thought was 2 to 3%. So just wondering if you could add more color as to the pricing strategy within RMS this year versus last year, and how the margin—you know, the premium for Charles River is trending.

Jim Foster

Tom and I could both probably take a shot at that from different vantage points. So the actual price list price increase is not fundamentally different in ’13 versus ’12. The effective price increase across the globe, though, will be so much smaller. There’s sort of two issues there. One is a reduction in volume in the North American animal business that has to do with continuing shutdowns of space. That’s sort of a negative impact. Kind of a positive impact or a non-obvious impact, which we did say in our prepared remarks, is the fact that as we do these big deals and we’re doing these big tox studies or discovery studies for our clients, non-regulated studies for our clients, we’re sort of selling ourselves the animals so they get reported in inter-company rather than external commercial sales.

I would say that from a premium point of view, we’re sort of still 5 to 15% higher than the competition, although in some cases at parity with the competition. I think any situation where our prices get that close is a very good thing for us from a competitive point of view because the quality of the infrastructure and the science and the service they get far surpasses the competition.

Garen Sarafian – Citigroup

Thank you very much.

Operator

And we’ll go to the line of Ricky Goldwasser with Morgan Stanley. Please go ahead.

Ricky Goldwasser – Morgan Stanley

Yes, hi. Good morning. I have one follow-up question just on the improved spot pricing on the PCS side. Is that something that you are seeing across the industry or it is more specific to Charles River now that your capacity is filling up with the help of all these new deals and partnerships?

Jim Foster

Ricky, it would be hard to even guess as to whether our competitors are seeing any pricing. Perhaps the ones that have better utilization of capacity or the ones—we do have some competitors that are only niche specialty players, so it’s possible that they’re getting a small amount of price as well. I mean, I think there’s some inevitability in the model that pricing is very much related to volume and how well our capacity is utilized, and our facilities are critical to the clients particularly as they close theirs and I do think that in an appropriate and professional manner as time goes on and space fills, we will get more price, subject to the caveat that we also want to do more large deals. As long as we feel that those are fairly priced, I think those will work very well for us from a visibility and predictability point of view.

So we’ll have a combination of both, and I think there are probably some competitors of ours that are getting no price in fact that are aggressively bidding on every study just to sort of keep their heads above water, and probably some others are getting some very modest pricing, as we are.

Ricky Goldwasser – Morgan Stanley

Okay, thank you.

Operator

And we’ll go to Robert Jones with Goldman Sachs. Please go ahead.

Stefan – Goldman Sachs

Thanks, guys. It’s actually Stefan calling for Bob. Just wanted to touch on RMS, a couple quick ones. How has the trend of increased non-GLP work impacted sort of the GLP demand and the need for models? And then quickly on the academic and government, it seems like you guys are confident in the outlook there despite any potential pressures. Are there volume minimums or pricing floors in those long-term contracts that gives cause for confidence in that client base? Thanks.

Jim Foster

Yeah, the academic and government marketplace has grown nicely over the last half-dozen years or so for us. Some of that is related to the fact that our price increases have been less than our competitors’. We do have a lot of long-term contracts that have specific financial parameters attached to them. Will the government modify those? We have no idea.

I guess our overall feeling is that most of the contracts have to do with selling smaller research models and that both the price points and their critical importance to basic research is such that we just don’t think they’ll get the scrutiny that other things may or may not get, and we also just don’t think that the government is going to intervene in a way that would adversely impede the development of future life-saving drugs. So yes, we feel pretty confident about that.

Your first question was about discovery versus GLP tox and the impact on units?

Stefan – Goldman Sachs

Yeah, so non-GLP versus GLP, and if there’s any change in demand for models just given how the differences in studies are.

Jim Foster

Maybe you’re referring to the types of models. If you are, certainly the non-GLP, the in vivo pharmacology work, which is very specialized in several therapeutic areas, tends to have more specialty models, many of which the client creates themselves and/or we get a hold of and provide to them. I think both sides, regulated studies and not, will continue to support the demand for research models going forward, and as more and more of that work goes outside, we’ll have a larger role in continuing to supply those animals basically to ourselves.

Stefan – Goldman Sachs

Great, thanks guys.

Operator

And our last and follow-up question will come from the line of Sandy Draper with Raymond James.

Sandy Draper – Raymond James

Just a quick follow-up. On the price increase on the cost for people, Tom, was there any catch-ups? I feel like a year or two ago, you were holding back on the salary increases. (Audio interference) percent type of range and just sort of embed that into a long-term (inaudible) model.

Tom Ackerman

Sandy, you blacked out a couple of times during your question, so I did hear that it was about costs and whatnot, and merit increases. I didn’t get all of it.

Sandy Draper – Raymond James

Can you hear me now?

Tom Ackerman

Well, right now, but I can tell it’s a weak signal. All right, we’ll try to follow up--

Susan Hardy

Sandy, why don’t you give me a call later and we’ll handle it that way.

Sandy Draper – Raymond James

Okay, thanks.

Operator

I’ll turn it back to you for closing comments.

Susan Hardy

Thank you. Thank you for joining us this morning. We look forward to speaking with you all soon, and that concludes the conference call.

Operator

Thank you. Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.

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