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

March 13, 2013 9:30 am ET

Executives

James C. Foster - Chairman, Chief Executive Officer, President and Member of Strategic Planning & Capital Allocation Committee

Analysts

Douglas D. Tsao - Barclays Capital, Research Division

Douglas D. Tsao - Barclays Capital, Research Division

Okay. So I think the appointed hour is here. I'm Doug Tsao. I think I know most people in the room. I cover specialty pharmaceuticals, as well as the pharmaceutical outsourcing companies at Barclays. We are pleased to have Jim Foster, the Chairman and President and CEO -- a lot of titles for you, Jim, of Charles River Labs, which is a very unique company, I think, in the sort of life sciences space of the world. And so, I think, before I sort of start the formal interrogation, Jim can perhaps provide a little bit of some perspective and opening remarks on the company, as well as, more broadly, the industry.

James C. Foster

Thanks, Doug. Nice to be here. We were pleased with our performance in 2012. We had some -- we hit some of our stronger financial metrics like proven free cash, EPS and return on invested capital. We had sales increase for the first time for 3 or 4 years. And the preclinical business actually increased 4% on a non-GAAP basis in the fourth quarter, which was a nice uptick. We're finding that we have a very interesting moment in time here, and we've hit this inflection point in the markets.

Life cycle clients -- or life cycle, where the drugs were in the midst of the patent cliff, and as these drugs rollout patent, the clients absolutely have too much capacity. And we're seeing lots of capacity being taken out quickly, and workforce is reduced, and a significant increment of additional work being outsourced. We had a couple of big deals last year, one of which we were able to announce -- or we announced them both, one which we were able to name, that was with AZ, and we did a larger one about 6 months before. And we're finding ourselves involved with multiple conversations with multiple clients right now about potential deals. And of course, when I say a moment in time, you have a dozen drug companies and you have them all sort of thinking about this as a fixed cost of just way too significant right now.

We have been taking share pretty much in all of our businesses across the board for the last 12 months or so, both in the research model side and on the preclinical side. A lot of that has to do how much we leaned out our cost structure. And of course we've got SAP in there now, and our knowledge of our cost basis is really pretty exquisite. And I think it allowed us to be more effective in not just pricing but how we interface with clients. So we've guided to 4% to 6% up this year, which is -- would be significantly up over the prior year and certainly up over the last 2 or 3 years. We did a couple of small acquisitions at the end of last year, which gives us about 2 percentage points on the top line, and they're both neutral to slightly accretive. M&A is very robust, at least the activity is very robust for us right now. We continue to be out there looking for opportunities upstream so we can be a more substantial collaborator for our clients who are, as I said, continuing to look at additional things to outsource, including discovery or in vivo pharmacology increasingly so. And we've got a couple of important franchises in oncology and CNS in that field. So I think I'll stop there, Doug.

Question-and-Answer Session

Douglas D. Tsao - Barclays Capital, Research Division

Jim, I know prior to being here, I'm pretty sure you were at SOT.

James C. Foster

Yes.

Douglas D. Tsao - Barclays Capital, Research Division

The Society of Toxicology meeting. Just curious in terms of what the flavor was for the meeting. And sort of in the context of the start for 2013, some sort of any directional insight that you might have gained?

James C. Foster

Yes. It's a meeting that I think everybody overreads. I can say that we had a lot of activity at that meeting, both in booth basis and on meetings that we all have. We have -- I forgot how many meetings. 150 client meetings. I would say that the interest is high from clients, mostly large but also second to the third tier biotechs as well. There seems to be a sincere interest in increasing outsourcing. I think that has a lot to do with the fact that there's still a meaningful amount of space left and the value proposition is good given the price points and nobody's going to build additional vivarium space going forward. And of course, the biotech companies never did that. So it's a dangerous meeting to call because one really knows what will come of it. But I would say, the nature and the focus and the specificity of our conversations probably will bode well.

Douglas D. Tsao - Barclays Capital, Research Division

And in terms of the sort of interest level, perhaps a little bit more sort of color in terms of -- is it in terms of -- is it just focused largely on the strategic deals or is this pricing studies and work that they have ready in the queue to start executing upon this year?

James C. Foster

Most of the big drug companies, there is an interest in doing larger -- having larger relationships. Those won't all be multiyear but I think some will, some of those will be bid. And there'll be a fair amount of aggressive players trying to get that work, that's okay. Some of them are on annual basis. A couple of conversations we had with big pharma about additional work, the work isn't going to be bid. So I think there's more of that, particularly once you have a foreign-based asset partner. Some of that work will be more transactional, which we're okay with, particularly when we have this preferred relationship with clients. So there's a very interesting sorting out period that's been going on, I'd say, for the last couple of years in the tox business. Continues to happen with some severity and speed. I think there's a lot of players who are going to get left behind, particularly with regard to their ability to [ph] service larger clients. And this is all a supply and demand issue, isn't it? And we have a couple of our sites that are full and several that are filling. I think our ability to be a little more selective with who we choose work from is beginning to happen. I think our ability to test pricing and get a little bit of a spot basis is also beginning to happen. And you can't push the clients to make that fundamental final determination to outsource. But once they decide to do that, they tend to move quite quickly. And the nature and the tone and the content of conversations is just -- it's speeding up, and you have a little bit of a lemmings effect in the industry, which I do think the drug companies will follow one another. Some get nervous by the fact that the competition has taken fixed cost out and they're behind the curve in doing that or not. So we've got very strong senior relationships with all of the major drug companies and all the major biotech companies. And a significant amount of work tends to beget additional work.

Douglas D. Tsao - Barclays Capital, Research Division

And how broadly -- you made the comment that you're able to perhaps selectively test price a little bit in the context of some of your competitors perhaps being left behind in how they respond to their own need to fill capacity and to meet their own financial goals.

James C. Foster

Yes, it's a sort of multiplicity of issues that the clients are looking for. So they're looking for science first, always. We do hear that from everyone. They're looking for quality of IT interface. They're looking for flexibility of structure. So we would never say, we only work on multiyear deals. They're looking for a fair price. We just won a bunch of work from one of the big drug companies where we were not the lowest bidder, which was interesting. So that's happening a little bit more regularly. So the extent to which a smaller competitor would want to severely reduce prices, there may be some clients with whom that will work. I think that it makes a lot of clients nervous. And so we won some of that work back, and it's nice to hear that we're not always the lowest priced. So I think it's going to be challenging for a lot of these companies to participate, often the science isn't great. And if you have companies submitting bids at or below their cost, they are only going to be able to do that for a short period of time.

Douglas D. Tsao - Barclays Capital, Research Division

And you've referenced some -- your capacity filling up now. At what point do you think about potentially revisiting the idea of opening up the space in Massachusetts again?

James C. Foster

So opening up space is always a terrifying notion for us, given how much space we've built and how bad the timing was of that. The good news is we have 3 relatively small buildings in 3 different sites that we built and didn't open, those will open first. I would guess that probably next summer, we will be getting pretty full in approaching that optimal capacity utilization, which is about 85%. So let's say we're at 80% at that point, we're likely to open some or all of those sites in some combination. The Shrewsbury facility, the big one outside of Boston. I was talking to a bunch of clients about this, this week, several of them were Boston biotechs so, of course, they have a keen interest in it. That's a spectacular facility, 45 minutes away from Cambridge. The notion of building it was a smart one. We just -- the timing was terrible, and the issue there is that the running costs are so high that we'll need several large clients to commit substantially before we open it. But I think directionally, that's a facility that we certainly want to open, and I hope that we will. It has huge competitive advantages because of proximity. Smaller players absolutely want to go, and be present during the studies as often as possible. So I think as things strengthen and space kind of fills generally that there will hopefully be a better opportunity. I don't see it, Doug, though probably in the next couple of years.

Douglas D. Tsao - Barclays Capital, Research Division

And then how do you manage that process of trying to bring in several large clients in a facility because you sort of bring in the complexity of managing multiple companies to commit to something like that? And would you take risk if you had just a couple and you're one short, that you would move ahead at the risk of needing to fill it?

James C. Foster

Hard to say. We certainly wouldn't want to open that unless we were well ahead of breakeven. We've managed it the way we manage all of our large deals, almost like a consulting company where there's a separate team on each deal, both science and business managing it. We would give them separate space in the facility, and I think we could readily do that. The availability of people, most of whom are coming from big pharma, is pretty substantial these days. So access to staff is not a -- senior staff is not a problem. We don't actually need senior staff at the moment. Most of what we'll be looking for is just to add technical labor.

Douglas D. Tsao - Barclays Capital, Research Division

And then in terms of -- just sort of focusing on -- because a lot of your comments over the last year have been focused on strategic relationships and partnerships. Just for some perspective, because this has been a theme for the industry for a long time now, certainly the entire time I've been following it, it sort of evolved from the dedicated capacity model to the one today. Just curious in terms of additional color on how this has changed in the dynamics of the conversations for better, and perhaps in some cases, a little worse, if you don't get the commitments in the same level that you did, people were potentially looking for in 2007.

James C. Foster

Those were different times. By the same token, it's all related to capacity. And the very large deals that are multiyear, those are really powerful in the potential to sort of freeze out your competition. So you get those deals. You'll become pretty much instantly a research partner for these big drug companies, and we find several things. We find that we actually immediately get additional work outside of the confines of the deal that we just negotiated because there's a value benefit to them because the more they buy, the better the pricing is. They need to buy a host of things from us, and so we're tending to be able to improve the margins over time by more complex studies, additional research and laboratory services beyond the confines of that deal, and just a preference by the client to give us work. And I think a lot of that has to do with the fact that they're all looking to work with a smaller number of players. So I think we're ways away from dedicated space agreements, although I don't think that's impossible as spaces starts to get tight. Clients used to wait 6 to 9 months, used to wait in line to start a study, and they had to plan a lot better. And they've been waiting less than a month to start studies now, and they're kind of used to that. And as space gets tighter, they'll have to plan better, we'll have better backlogs, we'll have a better understanding of what business is in the queue and certainly, we should have some pricing power. And whether it moves as far as to -- we used to have take or pay agreements, as you'll remember, even when the space wasn't utilized, it was -- they were paying for it. And of course, in those days, we used to build the space and it would fill before it was finished. So I mean, it's hard to predict how robust that will be. But of course, you have a lot of work being outsourced at a time when nobody's building new space and at a time where the clients are taking space offline. So we do think that the sort of basic business fundamentals of supply and demand are moving positively in our direction.

Douglas D. Tsao - Barclays Capital, Research Division

And I know there's been a lot of focus on the PCS business. The RMS business has sort of continued to plug away. What are some of the dynamics now affecting that business? There have been a lot of changes at some of your key competitors in terms of the demand, and sort of how you're looking to sort of grow that business moving forward?

James C. Foster

Our Research Models and Services sector is now comprised of 5 or 6 different lines of business. We've guided 4% to 6% guidance, as both segments of our business growing at essentially the same rate. So you pick whatever number you want in that 4% to 6% range. But the same growth trajectory is preclinical. In the core research model business, we're going to get sort of low single-digit growth, price mix, a little bit of share in the academic marketplaces and in U.K. and Japan, buttressed by the service business portion of research models with higher growth rates, still with very good margins. I'm still quite confident we can keep the operating margins north of 30%. We have a growing Discovery Services business, which is a huge market opportunity that historically has been done only by the drug companies. So that's the first time the drug is going to sort of a living system to determine whether they are effective and safe. So we're really helping our clients with these critical go and no-go decisions. So that should buttress the growth as well. And of course, our EMD business, which is growing north of 10% and has operating margins way higher than low 30s, so it rounds out that package. So on a composite basis, we're really pleased with that segment. And we think we can keep this growth rate up for several years.

Douglas D. Tsao - Barclays Capital, Research Division

And another question in perspective on the China market. You obviously -- the last few years, you talked about trying to get very big very quickly with the WuXi acquisition. Just your current thinking in terms of what you're seeing and hearing about activity levels there, the interest level in terms of doing work, there's a lot of investment taking place there, and the refined thinking about how to address this market opportunity.

James C. Foster

So the deal didn't happen, it's not one not worth revisiting and draw your own conclusions about how well or not that company has done and what the importance of chemistry might or not have been for Charles River. But we just did an acquisition in China of a Research Models business, happens to be a licensee of ours. We actually bought a company that was already breeding our animals and with a very high quality facility. And the issue in China is that you've got second-rate research tools and research models that are produced by the government and they're just not -- they won't be effective research tools going forward. So we have a really interesting opportunity to educate the marketplace about the benefits of having highly defined pristine research models for research as we did in Japan, Europe and North America over the last 50 years, actually. The company that we bought is growing nicely, has really good margins. Obviously, the cost structure is much lower, but as the cost structure increases, I'm quite confident we'll be able to walk up the pricing there and educate the market. I mean, there's a lot of risk in China obviously about IP. We don't have that specific risk as Charles River because we don't have IP. We may be having someone else's drug, but we don't necessarily know what it is. So we're in sort of an interesting place there. So our strategy will be to slowly and decidedly and strategically add the additional products and services that we do in other parts of the world there when it makes sense to do so. We think there's significant demand now both in local Chinese companies and obviously, international ones to be using research models there. So it feels like a good -- it feels like a sound way to enter the Chinese market.

Douglas D. Tsao - Barclays Capital, Research Division

And so do you see real -- in the U.S. market, the demand for the sort of production models has been probably sort of a little bit more stable. You've gained some on mix in terms of inbred models versus sort of the outbred sort of the old reliable outbred rat. Do you see some sort of that being a new source of demand for -- in the models businesses as R&D levels increase in that region?

James C. Foster

Are you talking about specifically China?

Douglas D. Tsao - Barclays Capital, Research Division

Specifically China.

James C. Foster

Yes, yes. I think that, as I said, the opportunity to use really important quality models, both standard models and more sophisticated ones, I think, is huge. So things like immunocompromised animals for infectious disease work, I think, will be useful as well. So starting from scratch is really sort of interesting. And we know how that movie is going to play out, because we've done it elsewhere. There's a huge amount of money being invested in the life sciences in China and in local biotech companies, which I think will actually drive the growth there more than the big pharma companies. They'll end up amalgamating, but we don't see any other commercial competitors in China. It would be tough for them to do that financially.

Douglas D. Tsao - Barclays Capital, Research Division

And do you see in your early efforts sort of an appreciation of using the high-quality animals versus sort of a lower standard in terms of the sourcing and the sort of genetic staff of the research model?

James C. Foster

We do, we do. And a lot of that has to do with the educational process we've been putting people through. So we've always run these big seminars for sort of lab animals that are in areas that want to get boarded, in the U.S. and Europe and Japan. And so now we're trying to do the same thing in China. And at some point, it will be inappropriate from a research point of view not to use quality animals.

Douglas D. Tsao - Barclays Capital, Research Division

And you referenced sort of a robust environment for M&A in terms of the things you're looking at. Just curious in terms of your process, are there clear needs you see in the portfolio that you're directing business development, do you seek out, or is it more that sort of opportunistic in terms of niche service providers or product providers that as they come into the door, look appealing and you're sort of more than not [ph] ?

James C. Foster

No, it's not very haphazard at all. We've sort of blueprinted the upstream opportunities. A lot of the areas that we're focusing on and the specific targets that we're focusing on are coming from our clients who say, "We've got some company that does work for us in Singapore. They have great science, but we're worried about the sustainability of the company. Would love if you can make that part of the Charles River portfolio." So a lot of the M&A ideas come from there. We're looking to expand our current footprint as we deal with the Accugenix deal, expand it geographically as appropriate as we did with the Vital River deal, and just -- we want to try to get as early in the drug discovery process as possible to help with the candidate selection and go and no-go decisions, whether it's an in-vivo or in-vitro system. Deal flow is actually exquisite right now. A lot of the targets are venture owned. So I have some concern that the price points won't be attractive. The flip side of that is that a lot of these venture firms have been in these deals for 5, 6, 7, 10 years. I do think they have a need to monetize them so we're looking at some very high quality technologies that would enhance the portfolio, I think is the best way to put it. We're not looking downstream. We're not looking at particularly large deals, I would say small to slightly medium-sized, all of which we could afford without taking on much, if any, additional leverage. So we don't have an arbitrary goal or anything, and if the price isn't right we won't do any. But we love the deals that we did last year, and we're working on several right now.

Douglas D. Tsao - Barclays Capital, Research Division

And would you anticipate that we should look at a similar number, sort of the same cadence, in terms of 2013 and 2014 in terms of the types of deals or the pace of deals that you'll be doing?

James C. Foster

It's hard to say. It takes a while to get them done. It's hard to say. We could do more or we could do fewer. But we have several that we're looking at right now that we would like to do.

Douglas D. Tsao - Barclays Capital, Research Division

Okay. Well, I think we're out of time, and we'll go across the hall to the breakout session.

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