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Charles River Laboratories International, Inc. (NYSE:CRL)

Q4 2008 Earnings Call

February 10, 2009, 8:30 am ET

Executives

Susan Hardy - Corporate VP, IR

Jim Foster - Chairman, President and CEO

Tom Ackerman - EVP and CFO

Analysts

John Kreger - William Blair

Douglas Tsao - Barclays Capital

Eric Coldwell - Robert W. Baird

Dave Windley - Jefferies & Company

Ricky Goldwasser - UBS

Randall Stanicky - Goldman Sachs

Tycho Peterson - JP Morgan

Isaac Ro - Leerink Swann

Greg Bolan - Wachovia Capital

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Charles River 2008 Earnings and 2009 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. (Operator Instructions). As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Corporate Vice President of Investor Relations, Susan Hardy. Please go ahead.

Susan Hardy

Thank you. Good morning and welcome to Charles River Laboratories' 2008 earnings and 2009 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 comment on our fourth quarter and full-year 2008 results and provide guidance for 2009. 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 number is 320-365-3844. The access code in either case is 981036.

The replay will be available through February 24. You may also access an archived version of the webcast on our Investor Relations website.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 which exclude among other items the goodwill impairment we reported in the fourth quarter of 2008. 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. I would like to begin by reviewing the '08 results and we will then discuss our '09 guidance with you. We reported sales of $311.4 million in the fourth quarter of '08, a decline of 2.1% over the fourth quarter of '07, while an increase of 2% when adjusted for foreign exchange. The increase was driven by the Research Models and Services or RMS business segment which increased 5.3% to $152.8 million and increased 7.4% in constant dollars. Preclinical Services or PCS increased 8.3% to $158.6 million. We are excluding the effective foreign exchange which reduced the PCS growth rate by 600 basis points in the quarter, the decline was 2.3%.

Operating Income for the quarter was $59.2 million and the operating margin was 19% compared to 20.7% reported in the fourth quarter of '07. The operating margin decrease was primarily the result of lower sales growth and higher operating cost associated with our RMS and PCS expansions.

Earnings per diluted share were $0.59 in the fourth quarter compared to $0.65 in the fourth quarter of last year. Fourth quarter of '08 was a difficult period and we like most others didn’t anticipate the extent to which the global economic crisis and the pharmaceutical market challenges would impact us. That said, even in this period of macroeconomic slowdown, we did post some impressive gains for the year. RMS delivered organic sales growth of approximately 10.5% resulting in total company net sales growth of 7.4% for '08, primarily as a result of higher sales.

EPS rose 10.3% to $2.89, despite an increase in the average number of shares outstanding. We generated $82 million of free cash flow and are financially strong with a sound balance sheet. This is the significant advantage during a period of economic turmoil.

I am also pleased to say that we completed the final leg of our three year major capital expansion plan at the end of '08. As a result of that plan, we have two brand new state-of-the-art facilities located on the East and West Coast of the United States, which in addition to our existing facilities in Montreal and Edinburgh position us extremely well to accommodate the global demand of Preclinical Outsource Services when it intensifies.

Before reviewing our outlook for '09, I would like to briefly summarize the business segment performance. Sales for our RMS segment rose 5.3% in the fourth quarter to $152.8 million when adjusted for the negative effect of foreign exchange to sale of the Mexican Vaccine business and the acquisition of MIR, organic growth was 7.8%.

The production business held up very well in the quarter, although, constant dollar sales growth slowed somewhat in Europe The bellwether U.S. business again reported 10% sales growth. As a result of the case in the third quarter, strong sales growth for immunodeficient and other mouse strains, offset slower sales for CD rat. Sales through academic, government and biotech clients drove the growth which supports our belief that drug discovery and early development are ongoing, and the resulting compounds' biologics will ultimately make their way through the government process.

Sales for the service businesses were up in the quarter driven by our consulting and staffing services business and the acquisition of MIR. Our Genetically Engineered Models and Services, or GEMS business was down from the fourth quarter of '07. This was a result of more measured spending by pharma and biotech clients particularly in the United States. Our in vitro business delivered strong growth in the quarter due primarily to sales in the PTS product and the new multi-cartridge reader or MCS.

We exceeded our goals for this business in '08 both in terms of units sold and new customers added. We have an opportunity to take market share with this exceptional product-line and are focusing our attention on that goal. The PTS has been a great competitive differentiator for us because it’s exceptionally well positioned to address the market for lot release test. The FDA and other regulatory agencies are increasing the regulatory guidelines for manufacturing whether they address specific markets such as nuclear pharmacies or global requirements such as the PAT initiative, the PTS is the ideal product to assist drug manufacturers in meeting the guidelines.

Based on the strength of the PTS product line, the competitive landscape and our plans for continuous innovation, we continue to believe this very profitable business will deliver strong growth for sometime to come.

The RMS operating margin declined 30 basis points to 27.3% compared to 27.6% in the fourth quarter of '07. As was the case in the third quarter, the two factors which affected the margin was the increasing influence of services and higher operating costs.

The facility expansions in California and Maryland impacted operating costs as did commodity and energy prices. Fortunately energy prices moderated towards the end of the year as did some commodities. The growth in services and particularly our consulting and staffing services business puts pressure on the RMS margin because although many of the service margins are robust; they are not comparable to the product margin.

As we continue to expand our portfolio of high-end services to support the use of models in research, it is likely that this pressure will continue. However, in vitro margins are also quite high, so if both the services and in vitro businesses grow, they effectively offset each other. This leads us to believe that we will be able to maintain the RMS margin in the 30% range over the longer term. The RMS business remains a consistent driver of our sales and earnings growth as was demonstrated again in the fourth quarter of '08. Our Research Models and Services are critical components of 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. We will continue to expand our RMS portfolio strategically adding products and services which enhance our ability to support our clients, drug discovery and development assets.

The PCS segment reported sales of $158.6 million in the fourth quarter, a decline of 8.3% from the fourth quarter of '07. When adjusted for the negative effect of foreign exchange and the NewLab acquisition, the net sales decline was 4.9%. This is a high fixed cost business. So, lower capacity utilization quickly translates to a lower margin.

In the fourth quarter of '08, PCS margin declined to 18.2% compared to 20.6% in the fourth quarter of '07. The decline was primarily due to the PCS market weakness, but also to cost associated with our capacity expansion program, particularly in Nevada and China. As we discussed with you in November when we reported the third quarter, we were experiencing a rapid deceleration of market demand for outsourced services, as large pharmaceutical companies reprioritized pipelines and restructured their operations in order to drive down the cost of drug development. These unprecedented actions of so many of our clients interrupted normal spending patterns, so while our clients continued to spend on outsourced services, they did so in a very deliberate and measured manner.

With capacity readily available, clients continued to postpone placement of studies and pricing was still a negotiating point for many. We also began to experience weakness in the biotech sector as these companies were increasingly unable to access capital. These patterns persisted through the end of '08 and into the first quarter of '09, which has led to a slow start to the year. And as is usually the case, some pharmaceutical companies finalized their purchasing decisions for the year in January, and are just beginning to commence the studies. As a result, demand has began to strengthen in the last few weeks which would suggest a slightly better second quarter. We expect to have better visibility as we move to the balance of the first quarter. But based on current trends we expect the market to be stronger in the second half of the year.

Based on our view of the market, we are estimating '09 earnings per share in the range of $2.30 to $2.60 which is based on sales growth in a range between negative 2% and negative 7%. This range includes the 5% impact from foreign exchange. So it would represent the range from negative 2% to positive 3% in constant dollars. Tom, will give you more detail about our exposure to various currencies shortly.

Excluding foreign exchange, we expect RMS sales to be flat to an increase of 5%. And PCS sales growth to range between negative 3% and plus 2%. We expect lower sales growth for the RMS business in '09 due primarily to weak demand for out bred rats used in toxicology and also due to softer demand and services. Like PCS, the first quarter had started slowly, price increases and research models implemented at the beginning of the year that provided some offset and consistent with our view of preclinical demand we expect unit growth for out bred rats to improve later in the year.

Because the operating margins are very sensitive to volume they will be impacted by lower sales growth in '09. We expect the total company margin to be in the high teen with the RMS margin slightly and the PCS margin meaningfully below '08 level. In addition, to the volume effect the PCS margin is also being pressured by our China operation.

We have had to postpone GLP validation by one quarter in China due to local permitting and construction delays. So, it will not generate the sales we had initially planned. By the time of our November conference call we had already assessed our available capacity and decided to limit further expansion. As you know, we evaluate all of our in-process projects to determine when and how much capacity should be brought on line.

To review, our decision led to complete Sherbrooke and to delay Ohio until 2010. We have not changed that plan although we are experiencing a one quarter construction delay in Sherbrooke. Between maintenance spending and our limited expansion requirement we estimate that capital spending in '09 will be in the range of $100 million to $120 million. This will boost our free cash flow in '09 to a range of $130 million to $160 million compared to approximately $80 million in '08. We are using this period of market uncertainty to streamline our operations and improve our operating efficiency.

We implemented a few actions in the fourth quarter including a hire increase, tight control of discretionary spending, a limited management restructuring and the closure of the small RMS site in Hungary. In the first quarter of '09, we have initiated a salary freeze for a substantial percentage of our workforce including all incentive eligible employees. We will also implement a headcount reduction which will affect approximately 3% of our total workforce. These reductions will occur predominantly in the PCS business with the largest number coming from the Arkansas facility which we intend to close by the end of the year. We expect this decision will enhance our operating infrastructure because it will enable us to focus on improving utilization of our larger and particularly our newer facilities, as a result of these actions we expect to reduce our operating cost by approximately $20 million in '09 with an annual run rate of $25 million beginning in 2010.

We have also decided to pursue strategic alternatives for our Phase I operation in Edinburgh. Currently, we have identified a perspective buyer and are engaged in preliminary discussions to divest the business. To further enhance our operating efficiency, we are continuing to implement a Lean Six Sigma initiative which we refer to as APEX or Accelerating Performance Excellence.

The Charles River culture has always encouraged continuous improvement and we are embracing Six Sigma, because it provides us with a set of tools to enhance that process. We have chosen a number of our high potential employees to be trained as black belts and green belts and are dedicating them to the APEX project. They will be mentored through the first year by SSA and Company, a leading Six Sigma Consultant Group.

Our expectations for efficiency gains in the first year of APEX are moderate, but we believe that the gains will increase significantly going forward. Our guidance for 2009 reflects our expectations that software markets demand particularly for Preclinical Services will persist at least until mid-year. It takes into consideration the potential consolidations of our pharmaceutical client, although experience has shown that acquisitions ultimately result in more outsourcing as companies seek to reduce their fixed overheads.

We fully expect this to continue to be the case although it may well be short-term disruption. It's worth noting that our assertion that no single client represents more than 5% of our total sales will still be true under all of the current publicly disclosed acquisition scenarios.

Our pharmaceutical and biotechnology clients are undergoing a period of unprecedented challenge and change as they strive to bring new therapies to market faster and more effectively than in the past. This has led to the current challenges in our business but it is now also our belief that this environment is temporary and that our clients will continue to outsource drug development services in order to improve the efficiency of their drug pipelines.

We have a unique portfolio of products and services. In fact, we are the only provider in the industry positioned to offer a solution to expand the entire spectrum from lead compound selection through IND.

I have had a number of meetings with senior management of our largest clients to discuss opportunities to meaningfully broaden our partnerships with them and we are encouraged by this opportunity. Our value proposition is aimed at exactly what our clients need to achieve their goal, scientific expertise, flexible staffing and facilities and lower operating cost.

Charles River remains a strong company, focused on its core competencies of laboratory animal medicine and science in regulatory compliance with medical services. We are a market leader in all major business areas, all of which have high barrier to entry. We are continuously evolving our unique portfolio to enhance our ability to meet client needs and have expanded our geographic footprints to support them wherever they are. As Tom will expand upon, our balance sheet is strong, we are highly liquid and our capital structure is conservative, giving us the power to weather this period of softer demand.

We intend to emerge from this period as a leaner, more efficient operation, and combined with our gene scientific expertise to enhance our position as an ideal partner for pharmaceutical and biotechnology companies. During this complex and challenging economic times I particularly want to thank our 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. First, let me remind you that I will speak primarily to non-GAAP results which exclude the goodwill impairment, acquisition related amortization and charges related to asset impairment; cost savings actions, repatriation and other items. This morning my remarks primarily focus on two important elements, our 2009 financial guidance and our balance sheet. For 2009, we have opted to provide wider ranges for both sales and EPS guidance from prior years, in order to encompass the uncertainty in our markets from the reduced visibility into preclinical demand, pending potential merger activity among our pharmaceutical clients.

Reported sales are expected to decrease between 2% to 7%, which includes negative foreign exchange impact of 5% based on current exchange rates. The net effect of acquisitions and divestitures including the planed divestitures of our Phase I clinic in Edinburgh added less than 1% growth for the year. The organic sales growth is expected to be in a range from growth of 2% to a decline of 3%. Based on these sales assumptions, we expect 2009 non-GAAP EPS to be in a range of $2.30 to $2.60. And the components of this range include the impact of lower sales and operating income, a negative $0.12 per share impact from foreign exchange and below the line item such as increased net interest expense and a higher tax rate. These are expected to be partially offset by the cost savings and a lower share count. I will now outline each of these factors in more detail.

Foreign exchange has a significant impact on our guidance in 2009. Our guidance is based on current foreign exchange rates and does not include the impact of future movements that these rates will have on our results.

You can get a sense of the magnitude of our sales exposure from the geographic distribution of our 2008 sales. Approximately 60% of our total sales were generated in US dollars, 16% are invoiced in euros and 10% are derived in British pounds. Sales in Canadian dollars represented another 6% and the only other currency we really have notable exposure is the Japanese Yen which represents approximately 5% of sales.

For budget purposes, we have used current rates as of last week which are as follows; the euro at 130, the British pound at 1.42, the Canadian dollar at 0.825 and the Yen at 91 yen per dollar. The British pound and Canadian dollar exposures are primarily related to our preclinical facilities in Edinburgh and Montreal, so the foreign exchange impact is expected to have a greater impact on PCS in 2009 representing an FX reduction of nearly 7% compared to a 3% reduction to RMS sales.

Foreign exchange typically has a more muted impact in operating income EPS as the FX impact on sales generally drops down at less than the margin range. This is because we are naturally hedged at all our facilities with the exception of PCS Montreal and the Canadian dollar impact tends to have an offsetting effect with all currencies moving tandem. We expect this to hold through in 2009 and at the rates I just mentioned, foreign exchange will reduce 2009 sales by approximately $70 million and operating income by approximately $11 million or $0.12 per share.

Foreign exchange is expected to have a far greater negative dollar impact on us than in other period in memory as a result of the extreme currency volatility we have been experiencing. With this information, you can model your own FX assumptions based upon your view of how the dollar will fare against other major global currencies this year. In light of the challenging market environment in 2009, we believe we are taking the appropriate and necessary actions internally to make our operations leaner and more efficient without sacrificing the ability to fully accommodate our clients' outsourcing needs in the future.

As Jim discussed, cost saving actions are expected to reduce our operating cost by $20 million in 2009 and annual run rate of $25 million beginning in 2010. To complete these actions, we expect to incur charges of approximately $9 million or $0.08 per share of which approximately 60% will be cash charges. These charges which will be excluded from non-GAAP reserves will primarily be incurred in the first quarter of 2009. Unallocated corporate cost totaled $53.7 million or 4% of sales in 2008.

Fourth quarter unallocated corporate expense of $11.4 million was slightly lower than expected. The anticipated increase in global IT cost was more than offset by a sequential decline in healthcare and things related costs. Looking ahead to 2009 we expect unallocated corporate cost to be approximately 4.5% of sales with a range of plus or minus 25 basis points. This represents a modest increase year-over-year due primarily to our investment and global IT initiatives, outpacing normal inflationary cost increases.

In recent years, our corporate unallocated costs have been weighted towards the first half of the year as healthcare improved related expenses have been lower in the second half. Net interest expense of $5.3 million in 2008 was inline with expectations. In 2009, non-GAAP net interest expense is estimated in a range of $9 million to $11 million. This has roughly doubled the 2008 level primarily driven by lower interest income and cash balances as well as lower capitalized interest on projects. Interest income is expected to decline due primarily to lower interest rates. For the first quarter we are adopting the economy change required by FSP APB 14-1 related to convertible debts and we will exclude the incremental GAAP interest expense of $10 million or $0.10 per share from our non-GAAP results in 2009.

We will also be required to reclassify a portion of $350 million of convertible debt on our balance sheet as shareholders equity, related to the bifurcation of debt and equities that APB 14-1 requires. This accounting change has no cash or economic impact, and we expect to remain in compliance with our debt covenants.

The convertible debt was not diluted to our share count in fourth quarter, as our average share price was below 48.9 [into a threshold].

Because the convertible was diluted for the first three quarters of 2008, the average share count for the year was 2 million shares higher than the fourth quarter. In addition, all those in line have the right to convert their notes of their shares during the first quarter as the stock price triggered for these rights was not met at the end of the fourth quarter.

Other expense rose to $5.9 million in 2008, including $3.4 million in the fourth quarter, primarily driven by the loss and investments associated with our deferred compensation plan which we discussed in our third quarter call. We generally do not budget for other expense since gains and losses and the investments associated with our deferred compensation plan are correlated with market returns and are unpredictable.

The non-GAAP tax rate was 27.3% in 2008 and 26.7% in the fourth quarter. In 2009 we expect the tax rate will increase by approximately 200 to 300 basis points to 29.5% to 30.5%. Increased rate is primarily due to loss of R&D tax credits in Canada, result of both of our efforts to reduce our currency mix by getting more sales in Canadian dollars and increasing request from PCS Montreal clients to claim RMB benefits.

General tax items were excluded from our non-GAAP results during the fourth quarter, the first item was $1.9 million charge associated with a recently enacted Massachusetts tax law change. The second item was a $4 million benefit related to our anticipated repatriation of approximately $90 million in accumulated foreign earnings in the first quarter of 2009. A portion of these foreign earnings will be repatriated via a dividend and distribution resulting in a US excess foreign tax credit benefit. As you know, the majority of our cash is held abroad, so bringing this amount of cash back will enhance our liquidity in the U.S.

As we disclosed in the press release, we recorded a goodwill impairment in the fourth quarter based on management's annual assessment of goodwill. As a result of this assessment, we will require to revalue the fixed assets, goodwill and intangible assets on our balance sheet at fair value.

Based on our analysis, we have recorded a non-cash charge of $700 million which has been excluded from non-GAAP results. There was no impact to cash flow, all of our debt covenants and only a small tax benefit of $2.9 million related to the impairment.

In the fourth quarter, we repurchased approximately 800,000 shares of common stock at an average price of $31 per share representing a total cost of approximately $25 million. As of December 27, we had approximately $187 million remaining under our current buyback authorization and expect to continue to repurchase shares under the 10B5-1 programs that we have in place. We expect these purchases to further reduce our share count from the 67 million shares outstanding at the end of the fourth quarter, but the exact share count for 2008-09 remains dependant on our stock price and corresponding level of repurchases under the 10B5-1.

There were two changes to our capital structure during the fourth quarter. First, the goodwill impairment translated into a corresponding reduction to retained earnings, which lower shareholders' equity. As a result, our total capitalization stood approximately $1.8 billion at the end of the year.

We also improved on an additional $42 million in our revolver in the fourth quarter and at the end of 2008, had an outstanding balance of $90 million. With total debt of $576 million or 1.7 times 2008 non-GAAP EBITDA, we believe our conservative capital structure, existing credit facility, and ability to generate cash flow will be more than sufficient to meet our near-term funding requirements.

Cash and equivalents including short and long-term marketable securities were $263 million at the end of 2008 versus $289 million at the end of 2007. However, our cash position improved sequentially compared to $233 million at the end of the third quarter.

Fourth quarter accounts receivable declined to $210 million. DSO remained relatively stable and within our target range at 40 days compared to 41 days at the end of the third quarter, but below 35 days at the end of 2007.

Credit risk has become an increased area of focus in light of the global financial crisis and particularly its effect in our small biotech lines. We continue to actively manage our receivables, continuously monitor our clients’ credit risk profiles and require stringent approvals before extending credit to our client. As a result of these activities, we believe that we have significantly reduced our risk related to client as evidenced by the fact that we increased our bad debt reserve by less than $1 million in 2008.

We continue to generate approximately 20% of our sales from small biotech classified with a market cap of less than $1 billion to smaller private companies. However, we believe this number greatly overestimates our exposure to at-risk clients. Further analysis indicates that the actual exposure is less than 5% of our sales. We ended 2008 with free cash flow of $82 million slightly above our expectations and ahead of $61 million in 2007.

In 2009, we expect a meaningful increase in free cash flow to a range of $130 million to $160 million driven by a significant decline in capital expenditures. CapEx is expected to decline from $197 million in 2008 to an estimated range of $100 million to $120 million in 2009. Nearly two-thirds of 2009 CapEx will be related to maintenance projects as we have completed our major expansion projects.

We expect depreciation expense in 2009 of approximately $56 million, an increase of approximately $5 million from 2008 primarily reflecting a full year of depreciation at the new Nevada facility and smaller facilities that opened in 2008.

We expect 2009 amortization expense to decline to $26 million or $0.26 per share based on current exchange rates. Foreign exchange rates will be the primary driver behind the $4 million decline in 2008. As we look at our expected performance in 2009, we expect the first quarter to be the low point for the year, and non-GAAP EPS in the first quarter to be approximately 10% below the fourth quarter of 2008.

We expect both the RMS and PCS segments to report lower sales in the first quarter of 2008 partially due to the significant FX headwinds. Preclinical sales are expected to decline sequentially as well as study delays and constrained client spending continue to impede results. In the RMS segment, we expect sales to show sequential improvement from the seasonally weak fourth quarter despite a slower start this year.

Our business plans for 2009 factors in a challenging year for global economy and uncertainty for many of our pharmaceutical and biotech clients. We view 2009 as a year to transition our business to a more cost efficient and leaner organization while continuing to build upon the strength of our balance sheet and cash generation capability. This will undoubtedly leave us in a stronger position to compete when the economy and client demand improves.

Our focus on improving operating efficiency and delivering value to our clients, further aligns Charles River as a key partner to accelerate their drug development goals.

That concludes our remarks. We will now take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we will go to line of John Kreger with William Blair. Please go ahead.

John Kreger - William Blair

Thanks very much. Jim, you mentioned in your remarks that of your outbred rat business was down giving it's tied off the toxicology business. Could you just expand upon that a bit and give us a sense of your model business? What percentage is generally tied to a toxicology work versus other uses?

Jim Foster

It's probably close to half, John, it could be a little bit less than that. That isn’t consistent necessarily from year-to-year, but I think over the long-term we are seeing about half the animals used for discovery and half used to serve development purposes. Obviously, it has an impact, it correlates pretty closely. You should get some relative early indicator, confirmatory indicator that tox is firming up as we see research model purchases strengthen, perhaps a quarter in advance or so. And we will get a sense of that for the whole industry. So, it’s a very good guideline for us.

John Kreger - William Blair

Great. And I think, you also said that you were seeing some signs recently in the last few weeks firming up in your business. Can you just elaborate a bit, is that coming in, in the form of better orders, fewer delays or perhaps commentary from those client meetings you mentioned?

Jim Foster

Combination of all, inquiry levels have been extremely low in the past, at least two quarters maybe three quarters. And they became increasingly slow. And so, it started the quarter slow as well as several of our preclinical locations. We are beginning to see inquiry levels increase substantially or meaningfully at many of our locations. The second quarter as we said in the prepared remarks certainly looks stronger. That's a very good sign. What we don’t know of course, is will that continue to be steady slippage as we saw very much through much of '08, where now that we have inquiry levels so we had booked orders and they continue to slide sometimes from month-to-month and sometimes quarter-to-quarter.

So inquiries were up substantially as we were able to close that business and hold on to it. That will serve the combining metric for us. And again given the fact that there are large number of preclinical molecules awaiting development given the fact that the drug industry does for a living and given the fact that they didn’t do it much of that in '08 as perhaps they would have liked to or should have, it's not yet. They are going to get back to developing them, it's when we believe we are seeing some really strengthening signs that they will do that.

That’s definitely buttressed by our conversations with very senior people as we also said, we've had a large number of those conversations already. We have several more scheduled to this month and we will continue to do so, and I am talking about the top two or three persons in the drug company. So we are talking about long-term strategy, we are talking about the utilization of outsourced services, how much work they will do inside, what types of work they consider core versus the type of work that they are comfortable finding the strategic outsourcing partner, what they are building or not, how they are going to utilize their internal resources in terms of asset shutdowns or other things.

So, I would say a combination of those conversations, the firming up of work, the necessity to get back to work and a sort of leveling of the competitive playing field in terms of capacity build-out and the price point definitely points to a strengthening second quarter, slightly strengthened second quarter and a stronger back-half of the year.

John Kreger - William Blair

Thanks very much.

Operator

And next we will go to the line of Douglas Tsao with Barclays Capital. Please go ahead.

Douglas Tsao - Barclays Capital

Hi. Good morning. Jim, I was just hoping you could provide some context regarding the hold-back that you spoke about having seen in the GEMS business this quarter. Are we seeing something of similar magnitude to what occurred in the 2005-2006 period or is the pull back more modest and if could you also sort of elaborate in terms of similarities to what occurred then and the differences to what occurred then?

Jim Foster

The prior slowdown that we saw was much more dramatic, with major rationalization of models across the whole range of clients. It also demonstrates some dissatisfaction with the quality of the models and their predictable translational value. So, what we are seeing now is something pretty much entirely different. We are seeing definitely cost sensitivity across all of our clients. So, I think they are going to evaluate what they outsource, what they don’t and the utilization of these models. But we are seeing a greater acceptance and clients are definitely more pleased with the quality of the models. The models are much more refined, much more sophisticated and tend to apparently have better predicted value. So, the commentary which was around genetically altered models was more questionable I would say a few years ago. Now there is a great focus on them, there is actually some resurgence in the creation of the model by our clients, they tend to be multi-genetic so the are much more complex.

And I think we are seeing now just slight rationalization of the portfolios and we are seeing strength in different geographic locales which also gives us the confidence to recognize the fact that these models are deemed to be important discovery tools for our clients.

Douglas Tsao - Barclays Capital

Okay, great. And Tom, you commented that you saw less than 5% of your customer base as being at risk. I was just hoping if you could provide a little more detail in terms of what you are defining as an at-risk client.

Tom Ackerman

Doug, we took a look at approximately 250 of our clients that we felt fell into that category of smaller companies, biotechs, etcetera. And actually in conjunction with our own available data, as well as Standard & Poor's, basically we looked at those that we thought had capitalization with appropriate cash on hand and things like that to essentially winnow down the large number into companies that we felt would probably be more at risk in terms of continuing relationship for sales.

Companies that may cut back on sales because they are looking to stretch out cash flow from 12 months to 2 years or possibly companies based on their size that may not exist in business for that much longer.

Douglas Tsao - Barclays Capital

Okay. Yes, that’s helpful. I will hop out for now. Thank you very much for taking question.

Tom Ackerman

Thanks Doug.

Operator

And next we go to line of Eric Coldwell with Robert W. Baird. Please go ahead.

Eric Coldwell - Robert W. Baird

Thank you. First question relates to the company's plans with clinical pharmacology moving ahead. Clearly, Edinburgh has been a challenge for sometime, but we understood Northwest Kinetics was actually doing quite well. Should we read into this that you plan to keep the Northwest Kinetics business and would you have future plans to expand Phase I, if you find a site that you are more comfortable with?

Jim Foster

Yeah Eric, this is a very disparate operation. At one point, they were both performing extremely well and the regulatory environment in the UK was challenging and remained challenging for us. In the early days we also had some currency arbitrage pressures. And I would say, looking at not just our location but the competitive locations, I think everybody has the same situation. So, it's just not a viable business strategy for us continue the Scottish facility going forward.

Northwest Kinetics, we have been very pleased with the progression and development of that site. It was a new facility when we bought it, reasonably large facility amongst the Phase I players. We filled it up nicely with very high value studies and a loyal and repetitive customer base; some in the West Coast, but not entirely, it's a worldwide base as well.

We still believe in the strategic benefit of having Phase 1. We are experiencing some pull through effect from preclinical to Phase I. In fact, some of that is with some of our larger clients. So, yes, if and as we find Phase I facilities that are of extremely high quality and high signs and are in the right geographic locale. And we think that they yet or they can complement our current preclinical portfolio, then we would be likely to do add something in. We certainly wouldn’t be reluctant also to add something off shore along the same line.

Eric Coldwell - Robert W. Baird

Thanks. Shifting gears, research models, you had a fairly noticeable price increase in your US catalog for models this year. I suspect that Europe was less and Japan was flattish in terms of pricing. Could we get a weighted global average for your expectations of research model pricing contribution in 2009?

Jim Foster

That's probably 3% to 4% and as you say U.S. was always historically and this year stronger, Europe less so and Japan price increases have historically been on more of a periodic basis although not necessarily as a case this year. So, across the worldwide RMS global business we are probably seeing 3% to 4%.

Eric Coldwell - Robert W. Baird

Great. Last question relates to in vitro, continues to put up a great growth rate and be a driver for performance in the RMS segment. We felt we understood from a recent conference or presentation that you made though that the growth rate has flowed to the high-teens down from the low to mid-20s. Could you just update us on what the growth rate was in the fourth quarter and what the outlook is for 2009?

Tom Ackerman

Well it was in the high teens, we don’t consider that any sort of meaningful slowdown, it’s increasingly off of a higher base. It’s a very strong franchise, we are clearly the market leader. We continue to take share and continue to convert clients from our historical technology over to the PTS technology, and also the up tick in the disposables or the cartridges is increasing nicely. So, we continue to be very optimistic about that product line and going forward both in terms of making a meaningful contribution to sales growth as well as margin contribution.

Eric Coldwell - Robert W. Baird

So, we would be looking for a mid teens to high teens growth in 2009 is that still in the target?

Tom Ackerman

Yes, I think we anticipate similar growth rates to what we saw in the back-half of this year.

Eric Coldwell - Robert W. Baird

Great, thanks very much.

Operator

And next we will go to line of Dave Windley with Jefferies & Company. Please go ahead.

Dave Windley - Jefferies & Company

Hi, thanks for taking the questions. Jim, are you seeing a noticeable difference in demand levels for specially toxicology services versus general toxicology, either you answer it that way or in terms of your ability to maintain utilization levels in the respective pieces?

Jim Foster

Yes we have seen a slowdown pretty much across the Board for the last few quarters. I would say that we are seeing strengthening now in terms of inquiry levels and demand again across the portfolio. So, we have a strong and unique portfolio for which clients seek us out both because of the geography or the specialty nature or indeed a fill-in for general toxin. I don’t think that trend has continued. I think the new facilities will be very beneficial to us. Places like Montreal which has significantly high compilation of specialty services continue to be in strong demand going forward. So, I think as the market invigorates, we will continue to see increased demand across all of what we do.

Dave Windley - Jefferies & Company

Okay, and Eric touched on Edinburgh Phase I a little bit, was there I think the longer term thought process there and dating back to the prior owner was the opportunity to pull clients through talks in the Edinburgh area and into Phase I close by. What factors I guess caused that not to pan out?

Jim Foster

I mean that was certainly the case early on, I think it was in large measure the nature of the client base that impacted that, the fact that clients that we had previously were doing business with us and perhaps other people in the states and elsewhere. Even at a lighter volume, we still did see some pull through but not as much as we had seen in previous years. So, it's really a function of demand, client mix, availability of business from the US that really impacted kind of the basis of the bargain at that location and our ability to be able to use it as strategically as we have been in our Northwest Kinetics site.

Dave Windley - Jefferies & Company

Okay. And Tom, on tax rate, I think you mentioned that, the lack of an R&D tax credit in Canada is a factor there and I also understand something about your FX impact as it relates to Montreal having an impact on the tax rate. I didn’t quite understand that.

Tom Ackerman

No, the primary impact, Dave, is the not lack but slightly reduced R&D credit in Canada versus last year, the same to a smaller extent in Edinburgh as well. And in Canada, it's because we are seeing more clients profess a desire to be billed in Canada and capture some of those credits themselves. The other thing that’s a little bit at play is just our earnings mix will change a little bit more favorable to the US which of course we have a higher tax rate in the U.S.

Dave Windley - Jefferies & Company

Okay, thank you. I will drop out, thanks.

Operator

Next we will go to the line of Ricky Goldwasser with UBS, please go ahead.

Ricky Goldwasser - UBS

Hi, good morning. I know you said that the guidance assumes potential consolidation. Can you just be more specific if you are factoring in what’s already was announced or also potential additional deals. And then assuming that Pfizer Wyeth closes in the third quarter, would the impact be greater than 2010? And then lastly what would be the EPS impact if there is no pick up in the second half of the year and is that factored to low end of guidance range, and if not what is the sensitivity on the EPS?

Jim Foster

Our guidance does really anticipate the consolidation through mergers that have at least been announced and identifies and maybe more of course, but the ones that are publicly teed out. We typically always in our RMS operating plan assume because it's been the case over the last few years that there will be some merger and we have an operating margin contingency to protect us against that. And of course, we started the year with that as well this year.

So guidance does anticipate that there will be the consolidations at least that we know of. We studied our current volume of business with those clients carefully and tried to prognosticate what the impact would be from the consolidation.

It's always a little bit difficult to call it, because every single one of them historically has been different, but we would expect by and large some short-term slowdown in purchases across all of our products; research models as well as pre-clinical, by one or both of the combined entities, usually one, and a significant pickup in service demand into next year. So certainly, we anticipate both of these deals will be done sometime in '09, last half of the question?

Tom Ackerman

Last half of the question, I think was about sensitivity to the second half of the year Ricky?

Ricky Goldwasser - UBS

Yeah.

Jim Foster

And I wouldn't want to be too specific on the answer, but let me try to answer it this way. We set a wider range of EPS in part, because of some of the uncertainty that exists out there. So I think our range itself suggests some level of uncertainty in terms of the recovery, the timing, the liquidity and things like that.

Clearly, if we don’t see a recovery as we progress through the year, we will have to continue to reassess the structure of the company and how we are organized and our particular infrastructure and take appropriate actions.

But at this time as we said, we are anticipating a stronger second half of the year and will have to, as the year plays out, obviously get more visibility and decide if we are taking the appropriate steps in the company. Anything else?

Ricky Goldwasser - UBS

So just to clarify, the 230 still assumed to pickup in the second half, or assumes a partial pick up?

Tom Ackerman

Well, it's like I said really, we have a wide EPS range anticipating the volatility in the marketplace and the visibility that we have, it’s not as easy to predict exactly what will happen as we have had historically.

So I think, we have talked about pharmaceutical mergers, which was the first part of your question. Obviously that could play into our numbers, the timing, the pace of the recovery could play into our numbers. That's primarily the reason for the wider range, we could experience some disruptions in our costs, while I don't expect commodity prices to trend upward dramatically in the near-term. They are always unpredictable, so the range doesn’t necessarily cover or encompass every single outcome nor is it intended to be necessarily. If nothing better happens or nothing worse happens, it's sort of our best range for where we think things will be at this time giving a little bit more wider breadth to that.

Ricky Goldwasser - UBS

Okay, thank you.

Tom Ackerman

Thank you, Ricky.

Operator

And next we’ll go to the line of Randall Stanicky with Goldman Sachs. Please go ahead.

Randall Stanicky - Goldman Sachs

Hi, great. Thanks, just a couple of questions. Tom, in terms of the PCS margin, I think you had talked and you gave a lot of detail in the disclosure. Where do you see that margin hitting from a low perspective?

You talked about it being down from the 18.2%, I think meaningfully lower, but I guess where does that go to and then how do we think about when that starts to ramp back up?

Tom Ackerman

Well, we didn't say exactly what we thought it would be in Q1, so by default I won't be too specific on that other than to say, we will come down from Q4, and as Jim said, we will come down meaningfully.

Some of the reasons for that are obviously the headwinds in terms of sales; we mentioned that sales would be down sequentially that puts some pressure on the number. While we are taking costs actions, we are taking those literally as we speak, so this is almost the middle of February, so it will have some impact on Q1, but obviously is going to play back with our price reductions.

And we are opening up our Sherbrooke facility a little bit later, but still we are opening that up during the first quarter; we brought on our Shanghai facility during the fourth quarter. So we are seeing some increased in costs as well because of those.

So Q1 should be the low point for the year, and as Jim said, demand seems to firming up a little bit. Hopefully we will start to see a slight sequential pickup as we move through the year, and then a large recovery in the back half of the year.

The cost benefits will have a larger impact obviously in Q2, Q3 and Q4, so I think Q1 will be the low point and then we should pick up from there, Randall.

Randall Stanicky - Goldman Sachs

Okay, how much of the cost benefit, the $20 million I think you talked about this year, how much of that falls in PCS versus RMS?

Tom Ackerman

Yeah we didn't say, but certainly based on the headcount reductions, which Jim mentioned primarily with PCS, the vast majority of that would be PCS.

Randall Stanicky - Goldman Sachs

Okay

Tom Ackerman

Over 75% just as a watermark.

Randall Stanicky - Goldman Sachs

Okay, and then my last question. I want to go back to the utilization theme. As you think about, I guess first what is the utilization? And then the other part of that is, as you think about ramping that utilization back up, how much of that is pulling forward business that you currently have booked. In other words, moving ahead with projects and avoiding some of the slippage versus the need to go out and bring new business into PCS.

Tom Ackerman

Well, of course the closure of Arkansas should help our utilization, and we are obviously working with those clients, there will be a ramp down of the facility itself as we complete studies and things like that.

Our utilization is not at our ideal level right now; obviously it's not at 50% or however either. So it's really somewhat less than what we would like it to be, but not horrific. And one of the things that we didn’t express is, while we are taking a number of actions, we are still trying to preserve a lot of the key talent that we have and infrastructure that we have, so that we don't put ourselves in a position where recovery starts to occur in the second and third quarter, and was actually cut deep.

So I think we have taken appropriate actions, but we are still maintaining quite a resident level of expertise, so that we can continue to do that work in a meaningful way as it comes back.

So, I think it’s a combination of those factors Randall, managing our capacity aggressively and that's really one of the keys in terms of driving the margin backup.

Randall Stanicky - Goldman Sachs

Yeah. I guess the question is, is there a way to place, how much importance does that bringing in new business, in other words, new contracts in PCS versus the slippage issue, which I assume a lot better visibility around mid-to-late March?

Jim Foster

We are continuously bringing new business, Randall, all the time. So it is indeed important not just to meliorate the slippage, but just to fill capacity and have a better, have larger role of satisfying our client, so we have a lot of repeat business and lot of loyal clients of large pharma and biotech in multiple locales.

We certainly are hopeful that the slippage is going to continue to dissipate as they really have to get back to developing new compounds by the same token, should be given in geographic locale of our two larger sort of rebuild facilities in the East and West coast that the huge number of clients out there that are locals that we are actively talking to and working with the service.

We just got a new dedicated resource agreement with one of them in our Massachusetts facility for long-term arrangement and we think there more of those. So certainly it's a combination of servicing our current clients consistently and brining on new ones as well.

Randall Stanicky - Goldman Sachs

That's great. Thanks, guys.

Operator

Next we go to the line of Tycho Peterson with JP Morgan. Please go ahead.

Tycho Peterson - JP Morgan

Hey, good morning. I wanted to ask on, you didn't talk a lot about the academic business, but Jim we are in an environment here where things are potentially getting better on the academic front. Can you just comment a little bit as to whether you are seeing any pick up in demand there from your academic collaborators?

Jim Foster

Yeah. I mean it's a little early to see any flow through from the anticipated increase in the NIH, so at this point, we have I'd say, for the last three years focused aggressively in terms of how we structure our sales force, have greater coverage to the academic marketplace. I am talking principally in the U.S. of course.

Our sales have been up, were up in '08 in a meaningful fashion. We would anticipate certainly that that will continue A, because we are focusing on it, B, because our price premium is less dramatic versus the competition than it was historically and a lot of the academics didn't buy from us, because it was a perception that we were too expensive, which is no longer the case.

There is no question, I was talking to one of our directors who is a senior policy person on some of these issues in Washington, who was saying that we are beginning to see in the back half of this year sort of more meaningful flow through from the government directly into the academic and university based marketplaces.

So we got to see some pickup there. Also, we do a fair amount of government work as you know. Obviously a lot of that is contractually committed over the long-term, but we would expect to see more RMPs coming out as well and given our strong reputation in that genre, I think we will be able to increase sales there. So, I would imagine overtime as our academic sales as a percentage of total sales will continue to increase.

Tycho Peterson - JP Morgan

Okay that’s helpful. On RMS, I appreciate the color you provided on price, can you give us a sense as to what you are seeing in terms of share? I felt like coming out of your RMS stake last year that you are still talking about kind of 3% or so from competitive share wins. Can you just kind of the competitive dynamic right now?

Jim Foster

That sounds a bit high to me. We certainly have been taking some share from our primary competitor over the last, basically four years now and I would say maybe a percentish a year. Again that has to do with a compression of our price points and I think the fact that we are providing a higher service level combined with our geographic reach. So those structural strengths that we have not changed at all and notwithstanding the overall economic environment, I think we would anticipate that we will be able to continue to take share from that competitor and perhaps others. Again our price points versus all of our competitors now is not nearly as dramatic as it used to be and as you see there are some product lines where our prices are the same and few where they are actually less.

So we are in a very strong competitive position also because of the range of services that we provide. If you go to the RMS side, our service component is probably one-third of total RMS sales and the clients who buy research models from us increasingly want us to provide services for them or to them in some cases without some even shipping to the client, but as maintaining them and providing the services to them. So whether it's GEMS or our laboratory services or our growing discovery services business, we think we got to be able to not only pick up share but be able get more of the outsourced business from our clients than our competitors will be able to.

Tycho Peterson - JP Morgan

Okay, that’s helpful And just a last one on China, and I understand the timelines have slipped a little bit. But can you give us a sense of to what you are assuming there for this coming year in terms of that business?

Jim Foster

We think we still have a strong competitive position in being the fourth large international player who is going to have GLP quality space.Our location is very fortuitous being in close proximity to major clients. Because of the delay, we are just sort of finishing the validation of that site and while we have a large number of clients who have been interested in utilizing this site, they are not going to make major commitments. We are doing non-GLP work. We are not going to make major commitments until this space is fully validated.

So we anticipate we should be getting some commitments from them in the back half of this quarter, maybe the beginning of next quarter. So it continues to be online in terms of fulfilling customers' needs and demands, we are just a quarter behind.

Tycho Peterson - JP Morgan

Okay thank you very much.

Operator

(Operator Instructions) And we will go to line of Isaac Ro from Leerink Swann. Please go ahead

Isaac Ro - Leerink Swann

Hi guys thanks for taking my question. I was just wondering if you guys have had conversations with your major pharma customer and potentially seeing cases where you are actually getting maybe materially higher levels of outsourcing levels for fiscal '09 relative to what you would have previously expected but maybe at the same time actually seeing the dollar levels lower than you might have expected. Just trying to wonder how you are comparing the low level of outsourcing versus the dollars that are flowing through to you?

Jim Foster

That’s an interesting question. I think that, I don’t think the levels are dramatically higher I mean the levels, if anything would have solved somewhat and beginning to reinvigorate. Yes, when they do invigorate, there is probably some impact across the whole spectrum that price affected because as long as there is more than sufficient capacity, price will be of a greater issue. I will tell you that in a lot of our conversations where price is still important, that science and service are more important. And so we are really focusing on execution and we are really focusing on providing value, as opposed to pricing benefits. So, we are trying to sell our clients a larger range of product services which cut across both of our businesses. We are having some success in doing that and while that may end up with more beneficial price plan, it ends up with greater volume to us. So I think the volumes will increase as we said in the back half of the year. The pricing issue or pressures will continue to persist, but we should get more leverage with the increased volume.

Isaac Ro - Leerink Swann

Well thank very much.

Operator

And we will go to our last question with Greg Bolan with Wachovia Capital, please go ahead.

Greg Bolan - Wachovia Capital

Good morning and thanks for taking the question and just one from me here. Jim when you think about your pharma clients' willingness to strategically outsource preclinical work. How much do you think is core to pharma and how much do you believe is non-core. I guess I am just trying to get a sense as to how much these sponsors are willing to outsource? I know this will kind of require a very anecdotal answer. But is it everything or is it capped at some level?

Jim Foster

We ask that question to every client. The answers range as you would imagine, to nothing core to a great deal of it is core. But I would say on balance, the clients have a previous position to keep some of the very short term studies in house to gain greater knowledge about the molecule and see the very early results. And they have the scale and the scientific stats will accommodate that.

When we get into longer-term studies, specifically more of the complex studies and lot of specialty work, there is very little interest in doing it. So we have to say that much of it is available to be outsourced over time. And that very little is essentially core and I would also say that every quarter and certainly every year that we have the conversations with clients, less than last year's quarter, and I think that’s from operational financial necessity on their part, but they really have to make some decisions on what they must do internally and since they have greater confidence in our ability and others ability to do the work with that, they are letting go of those things. So as we've said historically, we certainly believe that 50% of this work will be outsourced, probably 75% will be outsourced or greater. And that provides this very large market opportunity for us when the demand begins to invigorate again.

Greg Bolan - Wachovia Capital

That’s helpful thank you.

Operator

And I am showing no questions in queue. I will turn this call back over to you for any closing remarks.

Susan Hardy

Thank you for joining us this morning. We look forward to speaking with you in the next week and seeing you at various conferences in March. This concludes the conference call. Thank you.

Operator

And ladies and gentlemen that does conclude our conference call. Thank you for your participation and for using the AT&T Executive Teleconference service. You may now disconnect.

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