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Executives

James C. Foster - Chairman, Chief Executive Officer, President

Thomas F. Ackerman - Executive Vice President, Chief Financial Officer

Susan E. Hardy - Corporate Vice President of Investor Relations

Analysts

Alexander Draper - Raymond James

Robert Jones - Goldman Sachs

John Kreger - William Blair & Co.

Douglas Tsao - Barclays Capital

Greg Bolan - Wells Fargo

David Windley - Jefferies & Co

Todd Van Fleet - First Analysis

Isaac Ro - Leerink Swann

Eric Coldwell - Robert W. Baird

David Windley - Jefferies & Co

Tycho Peterson - J.P. Morgan

Ross Muken - Deutsche Bank

Charles River Laboratories International Inc. (CRL) Q3 2009 Earnings Call November 4, 2009 8:30 AM ET

Operator

Welcome to the Charles River third quarter 2009 earnings conference call. At this time, all lines are in a listen-only mode. Later, there will be an opportunity for your questions and comments, instructions will be given at that time. (Operator Instructions). As a reminder, today’s conference is being recorded.

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

Susan E. Hardy

Good morning and welcome to Charles River Laboratories' 2009 third quarter earnings conference call and webcast. This morning, Jim Foster, Chairman, President and Chief Executive Officer and Tom Ackerman, Executive Vice President and Chief Financial Officer will comment on our third quarter results and review guidance for 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 117470. The replay will be available through November 18th, you may also access an archived version of the webcast on our Investor Relations website.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 23, 2009, as well as other filings we make with the Securities and Exchange Commission.

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

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

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

James C. Foster

Good morning, I’ll begin by reviewing the third quarter results which we reported last night. Sales for the period were $297.5 million, at decline of 13.1% over the third quarter of ’08. Foreign exchange accounted for 1.8% of the decline. Excluding the effect of foreign exchange, the constant dollar sales decline was 11.3% with the RMS segment reporting flat sales year over year and the PCS segment declining 21.4%.

Operating income was $57.9 million and the operating margin was 19.5% compared to $77.6 million and 22.7% reported in the third quarter of ’08. The operating margin declined just 40 basis points from 19.9% reported in the second quarter of ’09 as the benefit of the cost savings actions partially offset the impact of lower capacity utilization in the PCS segment.

Earnings per diluted share was $0.65 in the third quarter of ’09 compared to $0.76 in the third quarter of last year and $0.66 per share in the second quarter of this year. Finally, we have reduced our ’09 guidance to reflect sales of 10% to 11% below last year with EPS in the range between 228 and 232 for 2009.

As we get closer to year end, clients are becoming are even more hesitant to commit to studies, apparently preferring to wait for the new budget year. Therefore, we believe that fourth quarter will be softer than we originally expected. Our results for the quarter and our expectations for the year reflect the continuing soft market demand for the company’s broad portfolio of essential drug development products and services due to pharmaceutical and biotechnology clients delaying spending on therapy in development.

As we have previously noted, pharmaceutical companies are facing significant challenges as they reinvigorate the development pipelines and create more efficient infrastructures. We believe these challenges are being exacerbated by the disruption surrounding this year’s significant large pharma merger activity and availability of excess capacity for outsourced preclinical services.

Excess capacity is enabling our clients to reduce lead times and study placement and to exert pressure on preclinical pricing. It’s important to recognize that our RMS segment continued to perform well despite the uncertainties in the market, delivering net sales of $163.3 million in the third quarter. When excluding the 0.9% negative effect of foreign exchange, sales were essentially flat with the prior year. Through cost savings actions and tight control of expenses, we maintained the operating margins just above the 30% level.

There were a number of positive and negative drivers for this segment sales. Prices increases have been maintained, running at approximately 3% to 4% for the year-to-date. Sales research models held up surprisingly well, especially in view of the fact the that third quarter is usually seasonally weaker than the first quarter and the second quarter of the year. Sales of CD rats continued to be below historical levels due primarily to slow demands in toxicology services.

We were very pleased to see that sales for the academic market increased year-over-year as they have done so each quarter n ’09. We believe the increase is due primarily to market share gains, the result of our more competitive pricing and increased sales coverage. As you know, we have added to our sales coverage of the academic market over the last few years and are further expanding coverage significantly through the new sales organization realignment. Although we are yet to see a meaningful contribution from stimulus funding, we expect those funds to begin to flow soon and want to be well positioned to benefit when they do.

The most significant decline in the quarter was sales of large models. As we’ve noted previously, quarter to quarter sales of these models can vary widely although we tend to have relatively consistent sales from year-to-year. Given the softness in toxicology, we currently expect sales of these models in ’09 to be below ’08 levels. The sales shortfall was also the primary driver of the year-over-year and sequential operating margin decline.

Our acquisitions of MIR, Piedmont and Cerebricon which are performing well collectively contributed approximately 3% to net sales growth, about half of which was offset by lower sales for our AVN vaccine business. As you know we divested our vaccine operations in Mexico in the third quarter of ’08.

The endotoxin microbial detection or EMD business also made a nice contribution to sales in the third quarter with the sales growth in the double digits. Sales of the PTS or portable endotoxin testing device increased despite our clients’ capital spending constraints. We continue to experience adoption across a number of market segments including nuclear pharmacies, dialysis clinics, microbiology, bio-processing, cell therapy, med device and biotech, and are optimistic about the opportunities for the PTS. Already the market leader in endotoxin testing, the PTS has enabled us to solidify our position and we expect it to continue to generate growth for the foreseeable future.

Net sales of services such as consulting and staffing services and GEM declined moderately, the former due to the expiration of a number of government contracts that were not renewed and the latter to general market weakness for outsourced services. That weakness was more pronounced in the PCS segment when net sales declined to $134.2 million, 24% below last year, of which 2.6% was a negative impact of foreign exchange.

Demand for toxicology services remained weak and primarily as a result of lower capacity utilization. The operating margin declined 13.8%, significantly below last year and the second quarter.

We continue to see our clients invest in discovery of new therapies as evidenced by sales of rodent models and by placement of a greater proportion of acute IND-enabling studies. However, we have not yet seen them refocus their attention and moving those compounds through the development pipeline. Pricing has also been a contributor to the sales decline. Competitive pricing pressure has persisted, and while we are no longer seeing prices decline, they are not expected to strength until CRO capacity is better utilized. Furthermore, lower average pricing is also impacting margins as studies initiated at ’08 prices are completed and replaced by studies at ’09 prices.

To weather this period, we have continued to manage the expenses carefully including the implementation of cost savings actions. The most significant actions have been preclinical headcount reduction including a 6% reduction in October. Through reductions and attrition combined, our PCS workforce has been reduced by approximately 18% in ’09 as we align the workforce with demand.

We continue to evaluate the cost structure, but given the high fixed cost nature of our preclinical business and the necessity to maintain our scientific expertise and ability to respond to client demand when it strengthens. We do not expect PCS margins to improve in the near term.

The PCS reorganization which was announced on July 1st has been implemented and we are very pleased with the impact it has had on our operations. With former site heads collectively focused on global operations, we are driving enhanced standardization across our facilities. By doing so, we are facilitating our clients’ ability to have work performed at multiple sites within Charles River. We are further enhancing our ability to service our clients through the recent sales force realignment.

The new sales structure has been finalized and we are in the process of rolling it out. We have a more comprehensive coverage of all market segments and more effective communications with fee accounts. We believe that new sales structure will enhance our goal to build even stronger relationships with our clients.

In addition to cost savings actions, the PCS reorganization and sales realignment, our 6-sigma program has continued to ramp up with more than 100 projects currently underway and more in the pipeline. Our expectations are for modest cost reductions in ’09 with more significant reductions in 2010. We’re looking at our 6-sigma program as a method by which to drive operating efficiencies which we believe will position us to offer our clients services at a lower cost.

In the absence of significant pricing power, we must rely on improved operating efficiency in order to drive profitability. We are also expecting to gain improved access to information through our IT initiatives. The ERP project which is the largest of the initiatives is moving ahead on schedule. Integration testing is nearly complete and we expect to go live for a significant portion of the company at the end of December. Major user groups have been trained and we are now moving on to broader training initiatives.

As we told you at the beginning of this year, we are using this period of softer market demand to restructure and realign our operations for peak efficiency and client access, and our investing and infrastructure to support our growth. We believe these are critical initiatives not only necessary to manage through the current environment but to maintain and enhance our position as a premier provider of the essential drug development products and services that our clients require and to do so as efficiently and cost effectively as possible.

Although we have yet to see tangible indicators that demand for our portfolio is strengthening, we are resolute in our belief that it will rebound. We believe this will occur for a number of reasons; first, the mergers are closing Pfizer Wyeth on October 15th and Merck sharing was in the fourth quarter.

As they navigate the first 100 days, we believe they will quickly implement the consolidation plan with a goal of reinvigorating the drug development efforts as soon as possible. We expect that the closure of these two significant mergers will have a galvanizing effect on the pharmaceutical industry because with visibility into the structures of the two largest drug companies in the world, we believe others will pursue their own strategies more aggressively. The closing of these mergers is coinciding with the beginning of the 2010 budget year which will provide fresh funding for our clients. Last year, it took most of the first quarter for budgets to be finalized and researchers to begin to put the new funds to work. We believe this will be the case again for next year which is another reason that we believe we should not begin to see improvement until the second quarter of 2010.

Biotech funding has also improved. Market research indicates that total funding available in 2008 from all sources including partnering, public markets, and private equity was approximately $30 billion. That number is estimated to increase to $47 billion in ’09, with comparable dollar increases coming from partnering and the public markets.

Healthcare reform may also be a positive for the pharmaceutical industry. The plan passed by the senate finance committee on October 13th included healthcare benefits for an additional 29 million Americans. Although it will take some time for healthcare reform to become law and changes may occur before go is passed by congress, it’s been a major objective of the sponsors that any legislation would include additional healthcare benefits which should be positive for our biopharmaceutical clients.

And finally, our continuing discussions with senior management of our large pharma clients reinforces a consistent message from them as they are increasingly identifying areas of expertise as non-core and want broader and more innovative strategic relationships with contract research organizations like Charles River who can provide support across a larger proportion of the drug development process.

Through these discussions, we are exploring a myriad of partnership arrangements from preferred provider agreements, dedicated resources to asset transfers. We aspire to be on the same side of the table with our clients so that we are helping to enhance their decision making processes with regard to drug development candidate priorities.

The current market environment is challenging and we believe it offers enormous opportunity for our long-term growth. Although visibility into a recovery and preclinical demand is limited for now, we will not lose sight of the necessity to continue to build our business to support our clients’ emerging requirements for more strategic partnerships. Towards that end, we are continuing to expand our portfolio with strategic focus on acquisitions such as Piedmont and Cerebricon and with novel and impactable technologies such as SPC.

Our goal is to maintain and enhance our unique position as a premier contract research organization that can provide scientific expertise from discovery through first-in-human testing from research models to man.

During this complex and challenging times, I particularly want to thank our employees for their exceptional work and our shareholders for their continuing support.

I’ll now turn the call over to Tom Ackerman.

Thomas F. Ackerman

Good morning. I will speak primarily of non-GAAP results which exclude acquisition related amortization, non-cash interest expense related to the new convertible debt accounting rules, and charge related to cost savings actions and other items.

Overall, third quarter sales and operating income declined 3.5% and 5.5% sequentially driven primarily by the PCS segment as a result of continuing soft market demand and the impact of lower pricing working its way through the backlog. The impact on operating income was partially offset by lower unallocated corporate costs and cost savings actions.

Third quarter EPS of $0.65 was favorable to our prior expectations due primarily to a lower effective tax rate. Unallocated corporate cost declined both year-over-year and sequentially primarily driven by further reductions in expected 2009 incentive compensation levels.

We noted on our second quarter call that we had lower than targeted sales levels for bonuses and have subsequently decided to terminate the majority of our incentive compensation programs for this year. Lower healthcare and fringe related costs also contributed to the substantial decline in unallocated corporate costs versus the second quarter as these costs have historically been lower during the second half of the year.

Looking ahead to the fourth quarter, we expected unallocated corporate costs to increase sequentially because we do not expect a similar benefit from the incentive compensation reversals. We will also incur incremental ERP cost ahead of the planned roll-out. We currently expect unallocated corporate cost to total slightly below 5% of sales for the year, consistent with our previous guidance.

The ERP project continues to progress well and on schedule. We are on track to roll out the system at our US locations at the end of December which is the beginning of our 2010 fiscal year. We completed integration testing in September, finalized the appropriate backup plans to ensure a smooth transition to the new system and are currently in the process of training all employees who will have access to the ERP system. We plan to complete the training in data conversion by the end of the fourth quarter. As a result, we expect to incur $2 to $3 million of expense in the fourth quarter.

We are very confident that our considerable planning, testing, and training will lead to a successful implementation of the new ERP system. We’ve had over 70 people, a combination of both consultants and internal personnel dedicated to this project for over 2 years. In 2010, we expect significant expense especially in the first six months and only modest savings from the ERP project, but as the system becomes more integrated into our operations, we believe it will enhance the availability and accessibility to information which are critical attributes to our ability to deliver real-time data and enhance decision making capabilities. The benefits are expected to ramp over time and generate greater internal efficiency going forward, particularly when leveraged by higher sales volume.

Net interest expense of $2.4 million in the third quarter was largely unchanged from prior quarters as a result of relatively stable interest rates and average debt levels. Other income of $1.3 million was slightly below $1.6 million in the second quarter favorable to our expectations since we generally do not forecast an amount for this line item. Other income is typically driven by investments associated with our deferred compensation plan. Gains and losses on these investments are correlated with market returns and thus unpredictable.

The non-GAAP tax rate declined to 25.5% in the third quarter. The 410 basis point sequential decline was primarily driven by a settlement of the US tax audit that resulted in a decrease of our tax reserves and to a lesser extent the geographic mix of earnings. The lower tax rate contributed approximately $0.04 to EPS on a sequential basis. While we expect the fourth quarter tax rate to return to first half levels, we now expect a non-GAAP tax rate of approximately 29% for the year. This is below our previous guidance of 29.5% to 30.5% due to the lower third quarter rates.

There were several other tax items that affected our GAAP results in the third quarter. As a result of the tax settlement, we also reported $3.5 million in income from discontinued operations. This relates to the portion of a settlement that was associated with our Pharma Phase II-IV Clinical Services business which we sold in 2006. Also, upon filing our tax return in September, we recorded an additional tax benefit of $1.1 million related to our cash repatriation activities in the fourth quarter of last year and the first quarter of this year. Both of these items have been excluded from our non-GAAP results in the quarter.

There were some additional items excluded from our third quarter non-GAAP results. We recorded severance cost of $2.5 million principally related to the consolidation of a small European RMS facility for cost savings purposes, and continued actions to wind down our pre-clinical operations in Arkansas. We took a $1.8 million impairment charge related to the planned disposition of our Arkansas pre-clinical facility. We also reported an $800,000 gain on the sale of real estate related to our pharma phase I clinical in Scotland. As Jim mentioned, we implemented additional cost reduction initiatives in the fourth quarter, the most significant of which was a headcount reduction of approximately 6% in the PCS segment in October. As a result we expect to incur a severance cost of approximately $5 million in the fourth quarter. The October action is expected to reduce cost by approximately $15 million on an annualized basis. In total, the 2009 cost savings initiatives are expected to reduce cost by $40 million in 2009 with a $15 million annualized run rate beginning at 2010.

Our cash and marketable securities position of $215 million in the third quarter was down from $225 million at the end of the second quarter. We repaid $18 million on our revolver in the third quarter and had $90 million outstanding at quarter end which is the same as at the end of 2008. Third quarter DSO was less favorable at 45 days versus 41 days at the end of June and 40 days at the end of 2008, primarily driven by a decrease in deferred revenue due to lower pre-clinical sale volume. Deferred revenue offsets accounts receivable in the DSO calculation. However, we have not seen a meaningful deterioration in our receivable aging or collections. Free cash flow increased to $30 million in the third quarter and $92 million year-to-date driven by a significant decline in capital expenditures. For the year, we have reduced free cash flow guidance to a range of $120 million to $130 million to reflect the lower earnings guidance. This includes CapEx of $80 million to $90 million, also below our previous range.

As Jim discussed, we are reducing sales and EPS guidance for 2009. We are lowering our sales guidance to 10% to 11% below last year on a reported basis including a 2.5% negative impact in foreign exchange for the year and a 1% to 1.5% benefit in the net effect of acquisitions and divestitures. Sales guidance reflects our expectation at PCS sales will be lower sequentially in the fourth quarter as clients appear to have become more hesitant to commit to placing studies the closer we get to year end. This is expected to be partially offset by favorable foreign exchange movements as FX becomes a tailwind for the fourth quarter as well as stable RMS sales. We expect fourth quarter RMS sales to be comparable to the third quarter level as seasonally weak small model sales are expected to be offset by the timing of large model shipments.

Moving to earnings, we have also updated our non-GAAP EPS guidance for the range of $2.28 to $2.32 for 2009. This guidance assumes a lower operating margin in the fourth quarter versus the 19.5% third quarter margin. Several factors are expected to drive the fourth quarter margin decline including lower PCS sales and less favorable mix are expected to reduce the PCS operating margin to single digits which will more than offset the cost savings. Normal seasonality in the RMS segment which is expected to push the fourth quarter segment margin slightly below 30% and unallocated corporate costs are expected to increase by $4 million to $5 million in comparison with the third quarter which benefited from a reversal of the incentive compensation accruals. We also expect to incur incremental ERP costs in the fourth quarter.

In addition, we’re not forecasting a similar $0.05 benefit from a lower tax rate and other below the line items that contributed to the third quarter EPS. While we’re disappointed by this outlook for the fourth quarter, we continue to focus on vigilant expense management and our goal of strengthening our internal infrastructure and operating efficiency. As a result we believe we will be better positioned to capitalize on future growth opportunities and improve profitability when pre-clinical demand does rebound.

Susan E. Hardy

That concludes our comments. Operator, would you please take questions now.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Alexander Draper - Raymond James.

Alexander Draper - Raymond James

Just a couple of quick questions. Did you say Tom, on the RMS commentary, is that comparable to the third quarter in terms of being stable or year-over-year?

Thomas F. Ackerman

Third quarter to fourth quarter.

Alexander Draper - Raymond James

Okay, so you don’t expect the normal seasonal decline that you’ve seen historically?

Thomas F. Ackerman

In some aspects of the business such as the models we would expect some decline for seasonality, but as I noted we expect an uptick in our large animal models and an uptick in some of our services so that on a total sales basis, yes, we expect it to be stable versus the third quarter, but because of the profitability of the small models, we expect a decline in margin.

Alexander Draper - Raymond James

The second question and I’ll jump out; I know you’re not making any specific commentary on 2010, but I wanted to think of in terms of the longer-term add-backs, we’ve had a lot of different adjustments; severance, one, can you outline what basic areas I should be thinking about taking costs out in terms of the severance and the restructuring and where that’s going to go longer term, and then also, what are the ongoing add-backs in each of the divisions as I should be thinking about longer-term add-backs and how you think about a pro forma margin versus a lot of the severance and impairments that have made the numbers move around a lot this year.

Thomas F. Ackerman

While of course a lot of the severance actions were excluded from our non-GAAP results; so if you look at our non-GAAP results this year and our margins, they are on a non-GAAP basis untainted by those actions. In my last remarks I mentioned that the cost savings actions contributed about $40 million this year and would contribute about $50 million next year. The reason why the numbers are not a little bit higher next year is because some of the actions that were taken are not necessarily recurring such as some of the incentive action. So, it’s a little difficult to answer your question in terms of margins directionally because as the demand has softened, some of the actions have been actually mitigated by further demand weakness. So, I think as demand returns, that’s really where we would see the benefit of some of those actions, and of course if demand returns more slowly or it takes a little bit longer, then the actions while they’re beneficial, continue to be diminished by the impact of the demand. So, I hope that clarifies it a little bit. Obviously, a lot of it is dependent on demand return and how fast that rebounds.

Operator

Your next question comes from the line of Robert Jones - Goldman Sachs.

Robert Jones - Goldman Sachs

You mentioned clients becoming more hesitant to admit to studies as we near year end; just a couple on this; are these clients involved in ongoing M&A or is this across the board, and then if you could help us understand what exactly needs to change in early 2010 to give these clients greater confidence in initiating these studies.

James C. Foster

It’s definitely across the board. We’re seeing a slowdown internationally, but large pharma clients, not necessarily focused on the clients that are involved and engaged in major mergers; some of the hesitancy has to be with the fact that clients can wait until the last minute to make commitments in the pre-clinical space because of so much capacity available and want to shop for better prices. Some is the desire to wait until the major mergers are finalized and they can see what the structures of those companies are like so that they can compete with them more effectively. We’re definitely seeing a ‘let’s wait till the next fiscal year’ commentary building with some clients; we’ve seen some studies that we thought would be booked in the fourth quarter be booked in the first, and we’ve seen some slippage, normal slippage, we’ve seen some slippage from the fourth quarter to the first as well; so you have a combination of factors, a lot of that is impacted by the insurgency that surrounded the whole healthcare industry, and as we indicated in our remarks, several of those factors have ameliorated; the mergers are over or almost over and the integrations are about to start; biotech funding has improved. They are certainly in the process of doing the 2010 budget, so clearly some things will wait. Health care reforms seem to have at least a broad-brush structure put around it. Actually, most importantly for us, what our sense is relative to next year, is continuing clients, continuing conversations with clients at the most senior levels who are not only optimistic, but are much more focused on strategic outsourcing and much less focused on having to control everything internally. The issue remains to be when that will initiate, and of course, when it does initiate it’s going to be somewhat impacted by the price reduction that has taken place over the last at least two, maybe three years, but certainly the last year with great intensity. So, the build will be slower than originally anticipated, but we still believe we will see it build around the second quarter.

Operator

Our next question comes from the line of John Kreger - William Blair & Co.

John Kreger - William Blair & Co.

Jim, can you just talk a bit more about the demand dynamics you’re seeing within PCS and how that’s changed over the last year; I know back in the spring we were hearing lots of anecdotes that demand levels and pricing had stabilized although it would seem perhaps that your guidance would suggest maybe that’s not the case here on the fourth quarter. From your perspective, are we still in the stable demand environment or do you think we’re seeing further deterioration. And then a related question to that, this roll-off of 2008 pricing into 2009 pricing, is that dynamic done or are we going to continue to feel the effect of that for the next quarter or two?

James C. Foster

What we would say on that is that demand is continuing; we’re seeing very good inquiry levels, and we’re actually seeing that we’re winning historically consistent number of bids or number of proposals that we’re bidding upon. There continues to be enormous amounts of pressure on pricing and that is very much tied to the capacity; this continued downward pressure, and so we don’t think it will be continuing to be available, we don’t think that this pricing is off nor do we think the demand is off, but there is some inherent downward pricing pressure so that we don’t seem to be cut. We’re seeing ’09 pricing now playing through the revenue base. Certainly the price decline has played through the backlog, and as we see long-term studies that were priced at ’08 levels come off line and be completed and new ones initiate, it brings down the whole pricing platform as it was. It gives us a false sense of what demand is actually like. We actually think demand is pretty good, we also think that directionally demand will be lot stronger given what we’re hearing from our clients; the value of that demand, and how that compares to the prior year, definitely going to be impacted by pricing, so yes, I think we’re going to see certainly another quarter of this, at least we certainly have that playing through our guidance. We’re warning for reduced revenues and margins associated with that revenue as the current prices really become the preponderance of what we do. We’re seeing a disproportionate amount of short-term studies because of the hesitancy to commit. On the positive side I would say that specialty work is holding up relatively well and we have a large footprint in specialty work and that continues although I think clients wait until as long as they can to buy more expensive studies.

Operator

Your next question comes from the line of Douglas Tsao - Barclays Capital.

Douglas Tsao - Barclays Capital

Just following up a little bit on that line of questions; Jim, I was just hoping you could perhaps provide a little color in terms of how your current study mix compares to what you’ve seen historically. I understand that given your comment about I&D enabling study picking up as well as your mix in terms of long-term studies that we typically see associated with clinical development, but running parallel to clinical development.

James C. Foster

As I was saying previously, we don’t have an adverse study mix in terms of specialty versus general toxicology. We continue to be the market leader in specialty work and it is continuing proportionately to be strong. We have seen disproportionate amounts of short-term studies, so we have a lot of turnover. The value of those studies tends to be not as high, and so, we don’t have this commitment to longer-term studies running in parallel to the pre-clinical work, and some of the very expensive studies which they often don’t initiate until the late phase II and sometimes phase III studies, they are waiting as long as possible to commit to those two. So, we have an elongated decision making process. We’ve used the term hesitancy to commit, there’s really no better way to say that, we have robust activity, lot of request for proposals, we get back to them immediately with those proposals, we win a significant portion of those and then we wait for contractual commitments and they’re not coming. I am not sure what the difference is in the ultimate effect; last year we had the studies booking immediately, but then slipping from quarter to quarter to quarter to quarter and never really starting; these days they’re just not committing at all. So, you probably have a similar effect although this year it’s exacerbated by the pricing. So, we would expect coming out of the first quarter with budgets done, the mergers done, biotech funding improved; all of the things that we said in our prepared remarks, but most importantly the necessity to start to get drugs through the pipeline. We would expect studies to he initiated. We would expect longer-term studies to be initiated as well. I suppose the mix between specialty and general not to change too much, and we would expect pricing which we’re feeling as a very low point now to begin to lapse that, and we wouldn’t expect it to fall any further, and as capacity fails we certainly are not going to be raising our prices, but I think that the intense competitiveness from a pricing point of view from all of our competitors, with our clients taking advantage of that, I think that will ameliorate certain parts of our infrastructure came online both the Charles River and in other companies, it’s somewhere between unlikely and totally unforeseeable that that will happen again in fiscal 2010. We also have some of that dragging down margins, and we warned about that earlier in the year, but as we begin to have those operations break even and move into profitability, it will strengthen our situation from a profitability point of view as such space fills out. Directionally, we remain optimistic. We don’t have any short term tangible solid indication that our prognosis is rock solid, and there’s no way of knowing that until we finish this year and begin to look very closely at the first quarter. We have obviously been looking at it now, but it’s premature, so as we said on our last quarter call, as we come out of this year, the first quarter looks thoroughly, and the second quarter is beginning to look up, and we’re getting indications from clients that they are indeed getting back to business and have a lot of this historical things that we have seen this year impact them. We should begin to see an improvement in the second quarter.

Douglas Tsao - Barclays Capital

If we exclude the closure of the Arkansas facility, what’s the net decline and PCS headcount? You cited 18%, if you take out Arkansas, what’s the number?

James C. Foster

I’m not sure I understand the question.

Douglas Tsao - Barclays Capital

If we exclude the impact of the Arkansas facility closure, for the other Charles River sites, what’s the reduction in headcount then?

James C. Foster

I don’t remember the exact number Doug, but Arkansas headcount was 100 plus, and of course some of those people have actually while winding down, we haven’t completely reduced all the headcount at Arkansas, so hopefully that helps, and we can probably get you some more specifics later.

Operator

The next question comes from the line of David Windley - Jefferies & Co.

David Windley - Jefferies & Co.

Jim, we’re talking about the margin impact of the lower pricing in 2009 being felt in the third quarter here more fully anyway. Just thinking about how the cycles back up, so if we assume that the Q2 of 2010 is the right timeframe for demand to start to loosen up and flow a little bit better and commitments being honored more closely to start date and things like that, would it then also be appropriate to expect that ’09 pricing would take a couple of quarters, a quarter and a half, or something beyond that increase in demand to fully flow out of the backlog? In other words, you get into fairly late 2010 before you get the 2009 pricing flushed out, and as a tangent to that I suppose if you just got volume improvement and you didn’t see a meaningful improvement in price, what kind of margin could PCS re-achieve and return back to just on a volume improvement?

Thomas F. Ackerman

It’s certainly not an easy question to answer, but we’ll try to give you whatever information we can give you that’s helpful. Obviously the longer term studies have more of a tailwind for sure, so I think you’re question about how does it play for the backlog, it takes a little bit more time to unwind and it has impacted us probably more progressively through this period in terms of feeding into the actual revenue and therefore impacting the margin. As Jim said earlier, I believe we have seen more shorter term activity, so there’s a little bit of a different dynamic there. That activity has tended to placed more closely to the time that the customers wanted to get the study done and obviously because of the shorter term nature of it tends to flow through the P&L more quickly, and then to the extent that there was a change in that activity in terms of pricing, it would flow back into the P&L more positively and our shorter term duration. Beyond those comments, I’m not sure what else I could say about it.

James C. Foster

David, I think we would assume as I said earlier that probably the second or third quarter of next year, we should be anniversarying the full impact of the price, and we don’t feel it’s going to get any worse. This is a very capacity sensitive business and we would expect as capacity fills even without pricing improvement but without any pricing decline that we would be able to improve our margins somewhat, so I think that as we move through the second quarter and into the back half of the year, those dynamics should play out. It’s hard to imagine a repeat of factors occurring again next year. As we said, we’re not seeing a continuing pricing decline even now. We have just seen the impact of what we saw earlier, so that should wash itself out, and directionally we should see some improvement. When we can ultimately get those margins, it’s really too early to say.

Operator

The next question comes from the line of Greg Bolan - Wells Fargo.

Greg Bolan - Wells Fargo

Jim, as we think about the large PCS headcount reductions year to date and then contemplate a potential rebound in demand for tox services, how do you feel about the company’s ability to execute on project timeliness and quality?

James C. Foster

Obviously, we have been very careful about how and where we have reduced our headcount. It’s obviously always a painful and difficult thing to do because our workforce is most valuable resource. In fact, we took headcount out at multiple places, not that there was any huge concentration in any particular location. We strive to retain virtually all, not all, but virtually all of our senior scientific staff and study directors, I would say in situations where we had some inductions in some of our senior staff, it was conscious to get the deficiency benefit of shared services, so we were aggregating activities that were done in multiple places into one or two places. We had staffed up for an anticipated increase in activity in the back half of this year which has not happened, so we simply found ourselves with certainly too much space, but significantly too much headcount in connection with both the current as well as the anticipated demand, and we feel that we’re staffed now to respond to the current demand and even some slight increase as we move into the second quarter. We obviously will have to staff up principally talking into direct labor level. We’ll have to staff up as we get advanced solid indication of the demand coming back, so it’s a very careful equilibrium that we have to achieve in order to be responsible in terms of how we manage our costs but also have the right scientific infrastructure in place. I think we’re still known for our scientific strength and capability, and it’s important for us to continue to retain that sort of prominence.

Operator

The next question comes from the line of Todd Van Fleet - First Analysis.

Todd Van Fleet - First Analysis

Lots have been said here, and I am just trying to reconcile in my own mind what the outlook for the fourth quarter looks like with respect to the margin in the PCS business segment. Let’s say we model it out. Pick a number, for a sequential decline in revenue in PCS, call it $7-8 million or what have you. We’re still looking at probably maybe a 500 basis point or more contraction in the margin for that business segment to come down to a non-GAAP EPS range that’s implied in your annual guidance, so you talked a lot about volume, you talked a lot about price, you talked about some of the investments that are being made. I have a two-pronged question. One is that kind of margin decline in Q4 in the ballpark in terms of that 500 plus basis points type of movement, and then what are the primary contributors to that movement? Is it volume, is it price, is it some of the investments in ERP? Can you help us calibrate our thinking a little bit better in that regard?

Thomas F. Ackerman

I’m not sure that I could answer the question as thoroughly as you would like, but we’ll attempt to do that as best we can. Clearly, we indicated that the sales volume would be down, and to your question, without indicating specifically how much it would be down, margin would be down. Pricing is having an impact; there is no question about that, so volumes may not be down as much for instance as revenue because of the impact of pricing. Volumes are also down to some extent, and as Jim alluded to before, the mix has changed somewhat to the point that that is also affecting the profitability since different components or types of studies have different margin levels. So we’re obviously putting out indications as best as we think we can and as much as we think would be accurate, and beyond that I am not sure that I can add a lot more to help you understand probably as thoroughly as you’d like.

Todd Van Fleet - First Analysis

Tom, if you had to rank them then, it sounds like pricing is number one, volume might be number two, and I thought I heard Jim say that mix really wasn’t a significant issue, but is that number three then?

Thomas F. Ackerman

I would say so. I don’t want to give you the impression that it’s a perfect science in terms of calling one, two, three, because of the vast myriad of customers we have and actually trying to capture the price impact and things like that. It’s not as perfect as we’d like it to be and therefore our answers aren’t as crystal clear as probably you’d like them to be, so as best we can see it, I would say that that’s a pretty good prioritization.

One other thing is that the foreign exchange has moved around a bit. In addition to that, the Canadian dollar has continued to strengthen, and as we’ve said in the past, that creates a drag on margin. Because of the movement in other currencies which have continued to move in parallel versus the dollar, that tends to give us a little bit of a benefit on sales, but the actual Canadian dollar movement tends to be a drag on margin, and that’s probably something that we didn’t point out that maybe would be beneficial to that conversation as well.

Operator

Your next question comes from the line of Isaac Ro - Leerink Swann.

Isaac Ro - Leerink Swann

I am thinking about the number of long-term contracts within pharma that might be available over the next few months for bidding, as you mentioned, as these mergers close. I’m just wondering if it’s fair to say that you’re not really seeing any handful or single competitor out there that might be trying to take a more aggressive approach to pricing that want these businesses for the long run, and as a followup to that, I think you mentioned the general slack capacity out there in the industry. Do you have a rough percentage improvement or relative improvement to the capacity utilization that you think you need to see before the pricing environment stabilizes from that side of things?

James C. Foster

We haven’t specific color on really what the capacity underutilization is either for us or for our competition. Suffice it to say, the capacity utilization has to improve significantly in order to see some improvement in pricing. I would say certainly it will take all of next year to see any sort of dramatic improvement. We don’t have really any indications that our competitors are likely to do anything more dramatic from a price reduction point of view in order to secure business. We have anecdotal information that some of the price points at which some of our competitors are quoting work is below the level at which they’re able to provide good quality work, so clients seem to be okay with that. So I think what we’re going to see besides probably some asset transfer opportunities, whether we or anyone else actually want to close that sort of business, we’ll see what the terms are, but I just think those deals will be on the table. I think the most significant thing is there is a fair amount of preclinical work that has never been outsourced by several of the major drug companies, most of whom we are speaking to and are indicating that they will outsource it. The issue is how fast do these entities move from the time they make that decision to actually placing the work externally and with whom, and that’s a bit of an imponderable, but certainly we would think that well into next year that ought to be happening, and I think that that will be the last one on price because I think the price points are okay now for the clients, and I think more run on corporate relationships on the size and scale of the portfolio that you have with which to support them and what the long-term capabilities for us to support them in multiple geographic locales for instance. So those conversations are well underway, and as I said, it depends a lot on what the time frame is for the companies to make a decision and actually let the work out.

Operator

Your next question comes from the line of Eric Coldwell - Robert W. Baird.

Eric Coldwell - Robert W. Baird

We’ve had a lot of general discussion about early development in the toxicology market, but Charles River actually has a pretty broad suite of offerings with BPS, biopharmaceutical services, bioanalytical, clinical pharmacology, pathology, a number of fairly large businesses. I am curious whether you could rank how those various sub-units are doing relative to your expectations in this environment by demand and profitability.

James C. Foster

That would be a substantial chore here. I would say that as a general proposition demand for most of those activities is less substantial than we would have liked to have seen it. I think a lot of it moves in tandem, certainly bioanalytical chemistry moves somewhat in tandem with tox, so does pathology for sure. Biopharmaceutical testing services runs a little bit countering that, pretty much depending on the strength of the large molecule companies or the biotech companies, so you can infer the state of that business. I think that the whole preclinical outsourcing demand curve moves pretty much in tandem, at least the way we’re structured. We have various parts and pieces that are scaled to support one another and so we’re likely to see the whole sector sort of invigorate slowly, but I think in tandem rather as disparate pieces leading or not. Since we don’t break down the margin by sector within a segment, I am reluctant to do that now.

Eric Coldwell - Robert W. Baird

What I’m trying to get to is we get a lot of these general questions on what is pricing, how much is pricing down, and my assumption has always been that certain of your services would be facing less pricing pressure than others structurally just based on the nature of the work, in that we might massive price concessions on a D&B case study but maybe not quite study on a 6-month inhalation study, etc., and I’m just trying to get a sense of the range of where pricing is and whether certain of your subunits are maybe not seeing as much of a pressure drain as perhaps some of the general toxicology short term work.

James C. Foster

That specific example is a very good one, and so we definitely don’t see this sort of pricing pressure with our specialty tox and things like inhalation versus general toxicology for sure. It tends to hold up more and the competitive scenario is dramatically different. So yes, that’s certainly true, but in some of the sub areas, like pathology testing and some of the biosafety testing, the same general pressure tends to prevail. We are seeing a fair amount of tenacity on the part of our clients to exact the best pricing at the latest possible time, and of course the specialty work we tend to have unique capabilities and unique scale, and we hope that that will always be the case, so yes, that does give us some pricing power in those areas.

Eric Coldwell - Robert W. Baird

If you’d allow me one followup, we didn’t spend a lot of time on this call talking about the facility-specific performance, what’s going on in Shrewsbury or Reno or China, Sherbrooke, etc. Are there any big takeaways from that or is the real takeaway that similar to your comment on your subunit businesses that demand is pretty much down across the board and walking fairly in tandem?

James C. Foster

What we said on our last call and maybe the call before is that in regard to our legacy sections we’re working very hard to scale our entire portfolio. We’re going to stop giving color on specific sites. Suffice it to say that capacity is well underutilized, with a couple of exceptions, pretty much across the board. We did say that we would continue to give color at least for the balance of this year on the two sites we brought online this year, which were China and our second site in Montreal which is called Sherbrooke. I guess all I would say is that they’re filling up much as anticipated given that they got a late start. It’s still a drag to the margin. We anticipate that they’ll become breakeven and profitable in the not too distant future and they should cease to be a drag sometime in 2010.

Operator

Your next question comes from the line of Tycho Peterson - J.P. Morgan.

Tycho Peterson - J.P. Morgan

I have a question on the ERP system. Maybe if you can talk about where you think you may see some of the biggest benefits from that next year. I’m just wondering if there’s an opportunity to get more granular pricing. You’ve obviously talked a lot of end-market dynamics here, but does that provide you an opportunity longer term to extract better pricing and maybe manage projects a little bit more granularly?

James C. Foster

It does Tycho. I guess I want to be careful not to overstate the initial benefits because it will take a little while for people to get used to the information and for us to sort of refine the information, and by the way the rollout in January is for US only. We actually won’t include some of our foreign sites until mid-year, so we’ll have more visibility into certain data, but only for the US footprint which does include RMS and RPCS site. Unfortunately I think in this particular market environment, a lot of our benefits would be on things like capacity utilization and efficiencies like that, and so obviously from a capacity utilization standpoint, that’s not going to be a benefit it’s going to materialize more rapidly because we’re underutilized now and it’s really going to take our ability to start filling up some of our space before we can actually start to get greater efficiencies from a utilization standpoint. Unfortunately, I think the benefits are going to come more slowly and in conjunction with both system familiarity and market demand, I think we’ll probably see less benefits in 2010 than we had hoped for when we initially undertook this project.

Tycho Peterson - J.P. Morgan

On pricing, you obviously gave a lot of color on PCS. Can you talk a little bit about your view on RMS going forward? You talked about some of the pricing traction you’ve had. Is your view that that continues to hold around the 3% to 4% range, or how should we think about that going forward?

Thomas F. Ackerman

We’re not going to give specific color yet on what the magnitude of the price increase would be except to say that we anticipate that we’ll be able to have a price increase next year on RMS as we’ve always have given our strong competitive position and the quality of our products and the importance of them to our clients.

Tycho Peterson - J.P. Morgan

Jim, in a couple of your comments you mentioned embracing asset transfer at least by the industry. Can you comment on how that stacks up in your priorities? Are you actively looking at some of these facilities coming out of pharma, or how should we think about you handicapping that versus M&A or other priorities?

James C. Foster

In terms of the asset transfers, it’s not something that we’re necessarily looking to do. We’re willing to look at those opportunities as our clients present them to us, and they will and have been presenting them to us. They have to really work for us in order for us to take on particularly given the capacity situation right now. There has to be a substantial book of business for a long period of time, and it would have to be in a geographic locale that we currently are not in, and it would have to be very favorable. Having said that, we don’t want to anticipate what the deals will like without seeing them. I think they’ll all be different. Some of the facilities will be too large and too old and too nonproductive for us and others may make some sense. So we’ll rank order it to the extent that if it’s important to our clients, it’s something that we’re willing to talk to them about. I don’t think it’s mutually exclusive with other things that we’re able to do. We continue to look at M&A to fill in our pipeline, but the best scenario for us from an asset transfer point of view is for our clients to either use those assets or something else for us to close them, and for them to use the existing capacity in the system, either from Charles River or others. Actually, that would be the best results for the clients as well because we’re likely to be able to do the work more efficiently and probably at a lower cost for them if they outsource it to our facilities, but that may not be the way they see it.

Operator

Your next question comes from the line of Ross Muken - Deutsche Bank.

Ross Muken - Deutsche Bank

In terms of the models business, if we rewind to the last time we had a series of pharma M&A mergers, whether it was Sanofi-Aventis or Pfizer-Warner Lambert or Pfizer-Pharmacia, what was the reaction in that business both on announcement and then during the quarter of closure? Was the disruption felt more in the initial phases when they were doing the integration planning or was it when actually we saw the facility rationalizations and some of the headcount and there was possibly a freeze at some point post the close?

James C. Foster

Historical ones are not necessarily indicative of what we’re seeing now or what we will see, but I will see that question anyway and then tell you what we actually think is going to happen. Typically, we see some disruption during the post-announcement and pre-close depending on how much overlap there is from a therapeutic area point of view, and we tended in the old days post-merger to have research model businesses pretty constant. Since we have a majority share with most of the clients, one company acquiring another for instance doesn’t typically benefit us. What’s going on right now is that in one of the big mergers where this is occurring, and I won’t tell you whether it’s the one that’s closed or not, we’ve seen a substantial reduction in purchases pretty much in the beginning of the year, so potentially we won’t see a huge dramatic change in the upcoming months. To the extent that we do have an overall reduction in purchases from the four companies that became two, and that’s possible, we think that it’s likely to be offset by increase in our progress sales and toxicology business begins to come back, so it’s likely that that will get washed out in the next.

Ross Muken - Deutsche Bank

Is it possible, Jim, as well that some of the stimulus related sales helped to kind of cushion that as well as that sort of flows through in the same timeframe?

James C. Foster

It could. We’re actually a lit bit surprised that we’re not seeing stimulus sales flow through now, so yes, definitely we could begin to see that by around the first quarter.

Operator

Do you have any closing comments?

Susan E. Hardy

Thank you for joining us this morning, and this concludes the conference call.

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Source: Charles River Laboratories International Inc., Q3 2009 Earnings Call Transcript
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