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

Q2 2007 Earnings Call

August 8, 2007 8:30 ET

Executives

Susan Hardy - VP of IR

Jim Foster - President and CEO

Tom Ackerman - EVP and CFO

Analysts

David Windley - Jefferies & Company

Douglas Tsao - Lehman Brothers

Eric Coldwell - Robert W. Baird

Kerry Nelson - Skystone Capital Management

Jonathan Palmer - Thomas Weisel Partners

Derik De Bruin - UBS

Tycho Peterson - J.P. Morgan

John Sullivan - Leerink Swann

Doug Schenkel - Cowen & Company

Presentation

Operator

Welcome to the Charles River Laboratories Second Quarter 2007 Earnings 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'd now like to turn the conference over to Vice President of Investor Relations, Ms. Susan Hardy. Please go ahead.

Susan Hardy

Thank you. Good morning and welcome to Charles River Laboratories' second quarter 2007 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 second quarter results and review guidance for 2007. Following the presentation, we will respond to questions.

There's 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 3203653844. The pin number in either case is 880215. The replay will be available until August 22nd. You may also access an archived version of the webcast on our Investor Relations website.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 27, 2007, 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.

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Jim Foster

Good morning. I am very pleased to talk with you today about our second quarter results, which demonstrate robust demand on the products of pharmaceutical and biotech customers with the essential products and services we provide, and they are confident in Charles River Laboratories.

For the second quarter, net sales increased 14.8% to $307 million as a result of strong growth in both the RMS and Preclinical segments. The acquisition of Northwest Kinetics contributed 2.9 percentage point and foreign exchange added 2.1% to the growth rate.

Operating income for the quarter was $65.7 million compared to $62.5 million reported in the second quarter of '06. The operating margin decreased to 21.4% compared to 23.3% in the same period last year.

The primary drivers of the decline were higher corporate costs resulting from the investments we are making in order to support our growing business, and the costs associated with the preclinical facility transition in Massachusetts. Although we reported improved capacity utilization across many of our facilities, both RMS and PCS, the benefit as expected, was offset by the start-up and transition costs associated with operating the two facilities in Massachusetts.

I will discuss the transition in more detail shortly. But you should note that although we recorded a full quarter’s costs for the two Massachusetts facilities in the second quarter, the overall margin declined only 40 basis points in the first quarter of '07, when we reported only partial costs. At $43.8 million, net income from continuing operations was 5.3% higher than the $41.6 million reported in the second quarter of '06. However, earnings per share increased 10.3% to $0.64, due primarily to the lower number of shares outstanding.

Through August 1st, we have repurchased a total of $6.7 million shares under our stock repurchase authorization, and just increase the authorization by a $100 million. The strong second quarter results combined with our expectation as the market trends will continue to support our growth the basis for our confidence in the outlook for the year. In recognition of that confidence, I am pleased to tell you we are raising our 2007 sales guidance to a range of 12% to 14%, which is a combination of high single-digit growth in RMS, and high-teens growth in PCS. We are also raising the lower as of the EPS range to 247 from 243.

Now I will tell you more about our second quarter segment results. The RMS segment results sales grew 9.9% in the second quarter, the foreign exchange contributing 1.8% as was the case in the first quarter, the growth was quite broad-based with significant contributions from the US and European research model transgenic services and in vitro products.

A wide spectrum of pharma and biotech customers including many of our largest customers increased their spending.

Second quarter operating margin increased 80 basis points to 31.7% from 30.9% in the second quarter of '06, due primarily higher sales and improved operating efficiencies. This was especially the case in transgenic as we continue to benefit from the cost savings initiatives we implemented last year. The sequential decline is due primarily to the contribution from the additional sales of large models in the first quarter following a quarantine delay in the fourth quarter of last year.

We were extremely pleased to see sales of research models in the United States for the industry ride faster than the 10% we recorded in the first quarter. Sales of immunodeficient mice were quite strong, which we attributed at least in part to increased focus on discovery and oncology drugs; sales of outbred rats and inbred rats were robust due to an increased drug developing effort. The US sales trends were echoed in our European business.

Worldwide transgenic services sales increased for the third consecutive quarter and again were better than anticipated. There was a continuing focus on the use of transgenic models as discovery tools, and the strength of our discovery services offering which, in addition to housing and breeding include genotyping, phenotyping and other services, which support development of these models, make us the first choice for researchers in this field.

The creation and development of transgenic models are driving the current growth. However, cost pressures of pharmaceutical companies have offset the growth in the past, and may do so again. We have conducted extensive discussions with customers to try and determine whether the growth will continue, but have not been able to identify a discernible trend.

Based on current customer indications, we do expect sales in the second half of this year to be higher than in the same period last year, although the fourth quarter will not be an anniversary of improving transgenic sales. Our guys will be optimistic for now, and hope to have a better perspective on '08 by the time we provide guidance in December.

Our in vitro business performed extremely well in the quarter primarily as a result of sales of the PTS. Sales are continuing to ramp, with increasing sales not only to pharmaceutical manufacturers, but also to nuclear pharmacies; we expect to be subject to endotoxin testing regulation as early as '08. The PTS is tailor made for nuclear pharmacy since the compound they produce has a very short-shelf life, and those test results are critical.

We have also just launched a multi-cartridge system or MCS. The MCS will read multiple cartridges, and the ability that our larger customers require. I would like to update you on the status of our California and Maryland RMS expansions, as you know two of the new barrier rooms in the California addition were put into service in early June. We are currently building production in these rooms and expect to begin shipping product by the end of the year. Given the strong demand in the western region of the country we expect to open a third production room in the first quarter of '08.

I am pleased to tell you that we broke ground two weeks ago for the new Maryland facility from which we will support our dedicated states agreement with the National Cancer Institute. We are eager to begin operations in that facility, which is now scheduled to open in the third quarter of '08.

We are very pleased with the RMS second quarter results. Our sales reflect the strong demand from many customers for our high quality products and the expert services we provide. Our operating margin reflects the leverage from higher sales, improved efficiency from last year’s cost saving initiatives, and our ongoing efforts to affect continuous process improvement. With the new capacity provided by our expansion project, we believe we will be extremely well positioned to support our customers' requirement for a high quality value added Research Model and Services and to promote our growth.

The Preclinical Services segment reported sales growth of 19.4% for the second quarter, benefiting from robust sales, favorable mix, improved capacity utilization, and stable pricing. Foreign exchange contributed 2.3% and Northwest Kinetics added approximately 5.5%. We were pleased that Northwest Kinetics growth was considerably better than our expectation, as the new capacity is growing quickly.

As expected the PCS operating margin at 22% was lower than the 25.4% we reported in the second quarter of '06. Second quarter of this year was significantly affected by the transition and start-up costs associated with the new facility in Shrewsbury, Massachusetts.

Second quarter was the first full quarter of Shrewsbury and as expected its operating margin decline significantly. However, robust sales growth and the resulting improvement in capacity utilization at all of our other preclinical toxicology facility helped to offset the decline in the Massachusetts operating margin.

Before I discuss Massachusetts in more detail, I would like to spend another moment on the performance of our other task facility. To say that the results improved doesn't do justice to the excellent performance they delivered.

All of these facilities delivered double-digit sales growth in the second quarter as clients continue to outsource services like Charles River as their provider of choice. Each of these facilities also reported a higher operating margin the result of the combination of greater capacity utilization, benefits to arrive from the cost saving initiative we implemented last year, our fourth generation six-signal process and sales mix. In fact the margin improvement was so significant that on a sequential basis the PCS operating margin improved 60 basis points from the first quarter.

Historically the Worcester facility has been known for its expertise and earlier stage discovery and services, and we are continuing to focus on those services at Shrewsbury. Clients are very pleased to place studies with a significantly enhanced and experienced scientific staff in our state-of-the-art facility and I am pleased to tell you the Shrewsbury has been feeling rapidly.

Much of the early discovery work is short-term, so to improve the sales mix our plan for Shrewsbury involved expansion of our services to include a greater proportion of long-term development work. By doing so, we will better support our clients drug discovery and development effort as well as increase the revenue generation capability and profitability of the facility.

Based on the growing backlog the toxicology studies, we believe we are making good progress on this plant. The transition from our Worcester facility is also proceeding on schedule. We continue to move functions regularly and expect to finish our lab in life study in the third quarter. We estimate that by early September all new in life studies will be placed exclusively in Shrewsbury. The remaining laboratory service will move during the fourth quarter and we expect to exit Worcester on schedule no later than the end of December.

Our Nevada expansion continues to progress well and most of the product phase is nearly completed. We are on schedule to begin validation in September, complete construction in October and initiate studies in the new facility in January of '08. Customers are regularly touring the facility and we already have studies committed to next year.

As this is the case in Massachusetts, we are also discussing dedicated phase arrangement for the Nevada facility and we believe that such arrangements are likely in both locations.

Overall, we are extremely pleased with our preclinical performance in the second quarter. As I said before, all of our preclinical-type facilities delivered strong net sales growth and operating efficiency, which give us confidence that as we get the cost associated with transitioning to our new facilities in Massachusetts and Nevada, we will make strides towards our longer term goal of the 25% operating margin. We see no diminution in the demand for high quality preclinical services, and in fact find the customers are increasingly choosing to outsource entire drug development programs.

We are currently providing management to nearly 300 programs for approximately 90 customers, who were chosen to use Charles River Scientific and technical expertise rather than to incur the costs to maintain in-house capabilities, and that number has risen significantly from the '06 level.

With intensifying demand given our expertise, and regulatory compliant preclinical services and our global footprint, including the expansions in Shrewsbury, Reno, and China, we believe we are positioned as a premier player in this field with significant opportunities of growth. Execution of our strategy to be the premier provider of the essential products and services to the drug development industry is dependent on investment on a number of funds, and we are committed to making those investments.

Our current capital expansion program is the building block of the capacity; we need to support our customers' requirement and our own growth into the next decade. Many other investments are equally important. Internal development and strategic bolt-on acquisitions will augment our portfolio.

Our IT initiatives will enable us to build the infrastructure that will provide scientific and business information, when and whatever form we needed. Our larger executive team and other personnel addition give us the bench strength to execute our initiatives, and I will tell you that we are the strongest and most experienced senior staff in the history of the company.

We also believe that success requires intense focus on core competencies in being the best of what you do, and doing it flawlessly; while we strive for continuous improvement, we believe that we excel in our core areas of laboratories, animal medicine and science and regulatory compliant preclinical services.

Our confidences are our greatest asset. And we invest continuously to leverage them to our own and our customers' advantage. We believe that the pharmaceutical industry is at an inflection point unprecedented in the history. With many drugs coming of patent and new drugs increasingly complex and more possibly to develop pharma companies are recognizing the need for a new drug development model. Strategic outsourcing is the key component of this model, evidenced by the number of pharma facility closures and staff reductions, and by the intensifying demand for outsourced services.

In this environment, our goal is not only to be the supplier of choice, but to be a partner. By partnering with outside customers, we can focus on the early discovery that they do best, and rely on us to support their late discovery and development effort rather than incurring the costs of replicating our expertise in-house.

Customers can operate more efficiently and cost effectively when they partner with Charles River, to achieve the ultimate objective of bringing drugs to the market faster. In closing, I would like 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 and good morning. Before I discuss our second quarter financial performance, I would like to remind you that our discussion today focuses on results from continuing operations. As Jim did, I will also focus my comments on non-GAAP results, which exclude all acquisition-related amortization, and other items such as charges associated with the accelerated exit from our Worcester preclinical facility and those related to our cost-saving actions in the second quarter of last year.

Now, I will comment on making the GAAP results, to say that the GAAP operating margin increased 70 basis points year-over-year primarily due to the fact that the nonrecurring charges related to the cost savings initiatives plus last year's second quarter GAAP results. In addition, acquisition related amortization expense declined this year.

As anticipated, the overall non-GAAP operating margin declined to 21.4% in the second quarter of 2007 from 23.3% last year reflecting the expected decline in PCS margins due to the startup and transition cost in Massachusetts as well as hire and allocated corporate cost. An increase in the RMS margin partially offset the overall operating margin decline. However, operating income did increased by 5.2% to 65.7 million driven by higher sales and improved capacity utilization in both segments, as a result of higher operating income, lower net interest expense and lower share count to do the repurchases, second quarter EPS increased 10.3% to $0.64 from $0.58 a year ago.

On a sequential basis, growth in sales and operating income was robust at 5.6% and 3.6% respectively. The contribution from the shipment of large research models in the first quarter of this year and the second quarter startup and transition cost in Massachusetts, cause the operating margin to decline by 40 basis points sequentially. EPS remain flat at $0.64 with the higher operating income offset by increases and other expenses and the diluted share count.

Unallocated corporate overhead increased by $3.2 million year-over-year to $16 million in the second quarter of 2007 driven by the expected increases in IT costs, stock-based compensation expense and corporate spending on our Greater China initiative.

On our first quarter conference call, we had stated that we expected unallocated corporate costs to decline from the $16 million we reported. That did happen for higher than anticipated healthcare expenses offset the reduction. Assuming healthcare expenses return to normal levels, we expect the quarterly run rate in the second half of 2007 to be slightly below the first half.

Total equity compensation expense was $7.1 million in the second quarter; as expected equity compensation expense increased nearly $1.7 million both year-over-year and sequentially driven by the timing of our first quarter equity compensation awards. We continue to expect these costs to be approximately $27 million for the year.

Second quarter net interest expense of $2.6 million decreased $1.1 million year-over-year reflecting increased interest income on higher cash balances. However, net interest expense increased by approximately 500k sequentially versus the first quarter due to reduction and the amount of capitalize interest expense.

We expect full-year 2007 net interest expense to be approximately $10 to $12 million. Other expense increased sequentially by $1.2 million related to foreign exchange losses partially offset by gains on investments related to our deferred compensation plan.

The tax rate remained stable in the second quarter decreasing slightly to 29.3% from 29.4% in the first quarter of this year. We expect the rate to remain stable in the second half of the year and as a result our maintaining our tax rate guidance of 29% to %29.5 for 2007.

Year-over-year the tax rate increased approximately 200 basis points from 27.3% in the second quarter of 2006. Last year second quarter benefits from a one-time evaluation of our Canadian deferred tax assets and liabilities following a reduction in the Canadian federal income tax rate.

Now let's move to balance sheet and cash flow items. At the end of the second quarter, we had cash and cash equivalents of $162.5 million, plus $102.3 million in short and long-term marketable securities for a total of $264.4 million compared to $255.5 million as of March 31st and $286.8 million at the end of 2006.

The decrease versus the end of last year was due to the investments in our capital expansion program, payments made on term loans, purchase of the remaining interest in our Japanese business from minority partner, completion of our Chinese joint venture, and share repurchases.

Accounts receivable were $228.6 million at the end of the second quarter up from $202.7 million in the fourth quarter of 2006 primarily due to higher sales. Our DSO increased slightly to 40 days in the second quarter, when compared to 39 days of the fourth quarter of 2006. We continue to work on improving DSOs in a few targeted areas, and have not seen deterioration in our receivable aging as a result of the higher DSOs.

For the first half of 2007, free cash flow was $6 million up from $4 million last year. However capital expenditures were $87 million in the first half of this year versus $57 million in the prior year period, so that's a net increase of $33 million in operating cash flow. Our full year 2007 guidance for free cash flow remains in the range of $25 to $50 million with CapEx of $200 to $225 million.

Depreciation in the second quarter increased $1.9 million to $15.1 million primarily as a result of the new Shrewsbury facility. Our full year depreciation forecast remains at $54 million. Total amortization expense declined $1.2 million to $8.1 million in the second quarter due to reduction in the Inveresk-related amortization expense. Our 2007 forecast for amortization expense increased slightly to $32 million, as a result of foreign exchange rates.

As noted in our press release last night, our board has authorized a 100 million increase to our account share repurchase program, bringing the program to 400 million, with approximately 122 million remaining for repurchase as of August 1st. We planned to buy the active shares over the next couple of years to help offset dilution.

As Jim mentioned, we remain on track to exit Worcester and fully transition to our Shrewsbury facility no later than the end of the year. We are incurring impairment and other charges of roughly $0.03 to $0.05 per share in 2007 to complete the accelerated exit. But as we have stated previously, we are expecting an early exit to reduce duplicative cost in Massachusetts by at least 1 million per quarter beginning in the first quarter of 2008.

We booked another 0.9 million of Worcester impairment charges in the second quarter for a total of 1.7 million year-to-date of approximately $0.02 per share. The $0.03 to $0.05 charges should be partially offset by gain of approximately $0.02 on the anticipated sale of real estate in Scotland. The result would be a net charge of approximately $0.01 to $0.03 per share in 2007.

Looking ahead, I would now like to discuss some factors regarding our second half performance. We expect robust sales growth to continue in the second half of the year, but at a level slightly below the first half due primarily to normal seasonality in the Research Model business, a smaller anticipated benefit from foreign exchange, and the anniversary of Northwest Kinetics acquisition in the fourth quarter of 2006. We also expect slightly lower operating margins, and EPS in the second half of the year due to normal seasonality in our RMS business particularly in the fourth quarter, and increased cost in Montreal due to the stronger Canadian dollar.

Finally, we expect our diluted share count will average slightly more than 69 million shares for the second half of the year, which is higher than the first half due to dilutive effect of option exercises of 2.25% convertible debt and increase in our share price. This dilution will be partially offset by repurchases under our 10b5-1 plan that covers the remaining 22 million under the buyback program prior to the new $100 million authorization. In the second quarter we included 0.2 million shares of dilution from the convert, which occurred on a share price rose above 48.94.

You should also note that the fourth quarter of 2006 included $1.6 million of other income from gains on investment related to our deferred compensation plan and foreign exchange gains, which we do expect to recur in the fourth quarter of this year.

Based on our exceptional performance in the first half of the year and expectation of robust sales growth in the second half, we are raising our 2007 sales guidance to 12% to 14% growth. We have also narrowed our EPS guidance to 215 to 221 on a GAAP basis and 247 to 253 on non-GAAP basis. We are extremely pleased to be well positioned after the first half to deliver 2007 results at the high end of the ranges that we originally provided in December.

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

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from the line of David Windley with Jefferies & Company. Please go ahead.

David Windley - Jefferies & Company

Hi, good morning. Thanks for taking the questions. Jim, in your prepared remarks you commented on program management or full programs in toxicology and so could you describe a little bit more of the package of services that you are providing in full programs?

Jim Foster

Hi, Dave. It’s that range of services, which is always comprised of multiple studies to clients depending on the size of client and the type of arrangement, how to take a client how we go through the whole of the development preclinical process and some has as we just to a portion that in our cases if we are given unusually robust expertise in specialty study we do a wide range for all 300 of those programs.

David Windley - Jefferies & Company

Okay. Are you seeing any of that pull-through to Phase I?

Jim Foster

Yeah, we still see some of that pull-through in [Sky] facility and all we have since we have been, as we did at the end of '04. Obviously in Northwest Kinetics operation is relatively new and should work very nicely in terms with expanded Reno operation. We expect to get some to West Coast pull-through there, but where really we have to wait for the facility is more operational.

David Windley - Jefferies & Company

Okay. And more specifically do those full programs include Phase I or is that something that comes along for you after the program management is complete?

Jim Foster

Really, at the end of the program management.

David Windley - Jefferies & Company

Okay. Moving on to Tom, your comments on corporate overhead, I want to make sure I understood that. So it is about flat, sequentially you thought it would be down a couple of million dollars, healthcare costs are accounting for that full difference?

Tom Ackerman

I won't say the full difference Dave. That was the primary driver. So we also saw in the second quarter expenses in corporate areas as a result of our initiatives into China for example.

David Windley - Jefferies & Company

Okay.

Tom Ackerman

The healthcare would have accounted for most of it and I wouldn't say that those are increases either. We actually expected to see healthcare costs lighten up a little bit as occurred last year and that didn't happen.

David Windley - Jefferies & Company

Didn't happen?

Jim Foster

Yeah. Although at this point, it does look like they will moderate out a little bit. And I think we're still a little bit optimistic for the rest of the year. But essentially, what we saw last year too, where we've had a little bit of heavy alone in the first half and for whatever reason things improved in the second half.

David Windley - Jefferies & Company

So, you guys are working too hard.

Jim Foster

Exactly that, but…

David Windley - Jefferies & Company

In California and Worcester two rooms opened now, and you mentioned the third room is to open. I wanted to make sure I understood the timing of that third barrier room opening?

Tom Ackerman

We've got two rooms opened now Dave, which we've production coming up, and we will be shipping before the end of year. We anticipate a third room coming online in the beginning of '08.

David Windley - Jefferies & Company

Beginning of '08. And then how many rooms would Worcester be able to support, how many does it have in total by the time you are fully fitted out?

Tom Ackerman

We built an incremental five.

David Windley - Jefferies & Company

Five, okay. Thank you very much. Congratulations.

Jim Foster

Thanks.

Operator

Thank you. We have a question from the line of Douglas Tsao with Lehman Brothers. Please go ahead.

Douglas Tsao - Lehman Brothers

Hi, good morning. I was just wondering if you could provide some kind of detail as far as the utilization of capacity outside of Montreal and Edinburgh, income of your other satellite facility, just to get a feel for how much growth we might see beyond just the additions of Shrewsbury and Reno?

Jim Foster

So, we've sufficient capacity collectively in operation Doug to accommodate the demands of the market. And I think we've been bringing on multiple locations in relatively rational increments each year. And the two new locations were obviously replacement state and eventually some incremental state. So, we've been adding, and we'll continue to add to all of our operations in order to keep abreast of and ahead of the market.

Douglas Tsao - Lehman Brothers

And then have you been utilizing additional -- I know that there is a government-run facility in Montreal that you cap into frequently. Did you expand your user rooms at that Montreal facility this past quarter?

Jim Foster

No, we did on last year, and we have a sizeable number of rooms that we utilize consistently, and have contracted for those exclusively, and we pretty much matched out that operation.

Douglas Tsao - Lehman Brothers

Okay. And then final question, it seems the Reno facility will be a multi-species facility versus being primate only in the past. Have you had to significantly -- I guess the question is how are you handling the recruitment of new study directors, who have the appropriate experience for doing that the studies that will being used for that region?

Jim Foster

Well, it's a combination of utilizing our current staff from other locations to do some training of current study directors, and at the same time recruiting people expressly with background in species besides large animals. The general manager of that operation has extensive experience of multiple species, and has extensive contacts in the industry. And through his offices and also sort of a very focused recruitment effort, we are broadening our expertise and will be training up employees prior to the launch.

Douglas Tsao - Lehman Brothers

So that recruiting effort is already begun, recruiting/training effort is already begun?

Jim Foster

Yeah.

Douglas Tsao - Lehman Brothers

Okay, great. Thank you very much.

Operator

Thank you. We have a question from the line of Eric Coldwell with Baird. Please go ahead.

Eric Coldwell - Robert W. Baird

Thanks, good morning. I think Dave basically captured my big questions. Quickly I was hoping you could go into a little more detail in Shrewsbury in terms of its sense where the study mix is today, what kind of activity levels you are seeing, an update on staffing in Shrewsbury just any additional color on that facility build out?

Jim Foster

Yeah, so Shrewsbury is validated consolidated open at staff. So we are fully staffed with a ramp at this time, and obviously we continue to staff up as we continue to fill the facility. It has been filling up rapidly, we've got lots of clients come through potentially new clients and clients that are repeat clients we been utilizing in Worcester.

The mix to business tends to be predominantly sort of early discovery studies or acute studies, which would be primary expertise of our Worcester operation and sort of reputation base. We now have the capability from a facility point of view and a static point of view to go well beyond that and we've more long-term, more sophisticated studies.

And we are beginning to move in that direction. Backlog is building nicely to support this notion and as customers become more familiar with the various customers do want short-term studies and then we progress the longer term study, we believe we will be able to modify that mix in a more favorable fashion.

Eric Coldwell - Robert W. Baird

Jim, are you seeing any market mix shift in the type of toxicology studies being done today, or Pfizer is talking about a threefold increase in Phase III programs obviously long-term oncogenicity and other studies are in concurrent with Phase III, a lot of manufacturers are making the same comments. Is there a big shift here towards chronic studies or long-term work, and also what kind of mix shift are you seeing with specialty versus general?

Jim Foster

We are seeing a continued mix, continued shift towards longer term studies, but feel a combination of both, which allows to be more response to the clients need. I think there is a continuing build in demand for specialty studies, given their complexity and cost facility drop in a necessity to training employees to be able to do that in a consistent fashion. So we've always come from a background of specialty work, but I would say that increasing our scope and focus commensurate with the type of work that client performing and commensurate with the increase demand to do that externally and not make the investment in order to develop the expertise themselves.

Eric Coldwell - Robert W. Baird

My final question and then I will seed the floor here is preconditioning -- I didn't hear a lot of commentary about the preconditioning initiative in the prepared remarks. So I was hoping we can get an update on your status with that initiative?

Jim Foster

Our discovery services, part of our business which is really a broader umbrella, which includes preconditioning and things like genotyping and pharmacokinetics and surgery et cetera, the whole range of studies to our clients is progressing to offer very small base portions of it like [Shrewsbury], capabilities continue to be quite strong and we see a very rapid outsourcing.

Move on to clients part and we are beginning to make some inroads, and some strides with clients in understanding that the other services are available to them on a large scale basis, multiple geographical location. We are confident that we will see that business continue to build, but it is still at a relatively small base at the moment.

Eric Coldwell - Robert W. Baird

Okay. Thanks very much. Good results in the quarter.

Jim Foster

Thank you.

Operator

Thank you. We have a question from the line of Kerry Nelson with Skystone Capital Management. Please go ahead.

Kerry Nelson - Skystone Capital Management

Hi, great quarter. A couple of follow-ups, can you just comment on, I think you mentioned, if you feel like the industry is at an unprecedented tipping point? Can you just talk about what that means in terms of pricing and backlog?

Tom Ackerman

It means that price is not the first item on the agenda with that client. There the tax historically was a more important issue for them. I think there is recognition that we are making significant investments in facility and staff, and little of the clients are doing it themselves. The pricing is part of our rational business practices in order to effectuate appropriate returns, in order to pay our folks well, and the clients were able to offload that business to itself.

Price is always prior to every discussion, but instead of rank where at the top four or five things it tends to be in most cases very much near the bottom. As long as we continue to make investments remotely at these levels, we are going to ask for and expect to get additional price from clients.

We've seen the backlog is building nicely. We commented that we are very pleased with the backlog building in Massachusetts, which is obviously important given that it's a new account for us. Some margin of capacity is left, that capacity is filling up well in other places, so backlogs are building there also. Again, there is only a certain amount of time that clients will wait. So, it's important for us.

We would like to have three, four months of backlog over time; incremental facilities slightly has the demand for the backlog it doesn't hold much longer than that or frustrate clients, and they will be forced to look elsewhere. So, we are pleased with the levels of backlog, and we are pleased with the reaction of our clients about pricing initiatives.

Kerry Nelson - Skystone Capital Management

That's great. And then, just one other follow-up, on the dedicated space, as you work towards that in both Reno and the Shrewsbury facility, can you just help us understand how you are thinking about the return on capital as you price out that space relative to the visibility that dedicated space would provide? Are you going to require the same sort of return on capital that undedicated space would be?

Tom Ackerman

That would be our goal. That was the important to their clients, who is not building new space with some clients, who is not building new space to have the sleep factor associated with knowing that they have the space dedicated and a complete studies in at any time. I don't think it necessarily follows that a different margin contribution for that sort of business versus normal business. And so, we are going to try to effectuate both having long-term partnership relationships with clients, where we'll sit on the same side of the table and they pay us well for our work.

Kerry Nelson - Skystone Capital Management

Okay. Thanks very much.

Operator

Thank you. We have a question from the line of Jonathan Palmer with Thomas Weisel Partners. Please go ahead.

Jonathan Palmer - Thomas Weisel Partners

Good morning. Thank you for taking my questions. Jim in your prepared remarks, you spoke about the strong performance in Toxicology. I was wondering if you could just break that out a little further for us on the drivers behind that. Is it stronger outsourcing from pharma or winning more contracts in business?

Jim Foster

Not sure there is a distinction between the two. There is no question that one can feel the increasing intensity of strategic outsourcing being used as a labor by our clients, by large pharma, large biotech and emerging biotech as well. There is no question that there is a reluctance on the part of clients to make the capital drop to build their own space. If you look at our portfolio on our preclinical location a quite close geographically, which is help from a proximity point of view and our clients getting comfortable and getting notice that.

We have different capabilities to our facilities from [class of gel] very sophisticated specialty type. And so we are able to quite respond to the needs of various types of clients, clients who have no background sophistication during the regulated phase and clients quite aggressive and sophisticated. So I think it fair to say that we are experiencing a steady build in demand and still in demand we don't see any indications that's going to back off as long as we and other companies like us build the space, hire the people and most importantly execute extremely well, preferably follow through; as long as we do that we should see the demands remain consistent or perhaps even increase.

Jonathan Palmer - Thomas Weisel Partners

Thank you and just switching gears here. At the analyst day you guys highlighted some of the your IT initiatives, I was wondering if you just give an update of where you stand with those and when you think it will be complete.

Jim Foster

The multiyear process with various stages, all that as everything from HR to finance to how we attract customer information, how we schedule our capacity, a different portions of that initiative will come online at different times, but it’s a couple of years initiative anyway.

Jonathan Palmer - Thomas Weisel Partners

Great, thank you for taking my questions.

Operator

Thank you. We have a question from Derik De Bruin with UBS. Please go ahead.

Derik De Bruin - UBS

Hi, good morning.

Jim Foster

Good morning, Derik.

Tom Ackerman

Good morning, Derik

Derik De Bruin - UBS

So could you just talk a little bit more about the pharma spending environment, I saw your comments, there is the comment that the you are still having a difficult time, but you are still trying to feel out what they’re booking for in terms of the spending, are you getting any sense that as pharma faces tougher comps in the second half of the year because R&D issues that they’re looking at how big into the R&D spend?

Tom Ackerman

Provide the average if you would compare the demand an increase in revenue from major pharma clients this year versus last. All of us without exceptions and take exceptions that will be clients were closing facilities, also that exception we are seeing them up in a meaningful way across the Board. I think that the combination of two things, the combination of pure increase spending in both R&D. Our activities are at the tail end of our…

And much of the D combined with intensified efforts to move the work out externally. So, we need the client that certainly feels very positive. There seems to be a real intensified focus by the clients and really obviously relating to their pipelines, and in almost all cases that's manifesting itself, that increase in research spending.

Derik De Bruin - UBS

Okay. Most of my other questions have been answered. Thank you.

Operator

Thank you. We have a question from the line of Tycho Peterson with J.P. Morgan. Please go ahead.

Tycho Peterson - J.P. Morgan

Good morning. Jim I’m trying to get -- I guess some of the things you talked about there earlier in the Q&A around on backlog. It's been a couple of quarters here since you have seen some pretty growth in Transgenic. Can you give us a sense of how much visibility you have in that business, and to what extent we can think about trends there going forward?

Jim Foster

I will do the best I can. It's a complicated story, and I would say it's a service that we have with somewhat inconsistent visibility. But at the current time, this is where we are. We had three consecutive quarters of pretty substantial increase, I would say exceeded our expectations and continue to. We of course came off of a very rough kind of 18 months to the two year period.

We are also seeing an increase from transgenic work on a worldwide basis, which resulted in something we didn't expect, when I'd say worldwide that predominately, but also substantially in Europe and in our operations in Japan. So, I would say from an underlying scientific point of view two things happened, one is that there has been a significant reduction or rationalization of the numbers of colonies by all of our clients large and small, but mostly large over the last couple of years.

And they have got next to a level where they think the models are important to retain. Coupled with an increased investment in creating new models is where we are continuously setting up isolated a new holding environment for new models that are being created.

So, and of course we are in touch with all of our clients all the time. So, all we can say is the current tiredness -- that we are quite confident that the back half of this year will be at higher levels than back half of '06. Budget to the county asset we begin to sort of anniversary at times, where we began to increase fourth quarter of last year. And it's a business that's quite sensitive to major swing by major pharma companies, who decide to cut costs something we have no control over. Sometimes there are overriding cost cut initiatives that are put in place that effect transgenic.

So, in the prepared remarks we try to be very careful in saying that we are enjoying the increase. We expected to continue; too early to call '08. We're talking about clients constantly, there are some good signals in terms of basic investment in these models that look positive at least for the foreseeable future. But we are reluctant to say we expect this to continue indefinitely until we have more critical information and more data points from our clients.

Tycho Peterson - J.P. Morgan

Okay. That's helpful. Switching gears a little bit, it sounds like the ramp in the Endosafe has been pretty good out of the gate. And you've always talked about some of that being driven by the FDA process and local initiatives. Can you give us a sense as to maybe how aggressive the FDA has been and pushing these initiatives, whether you are seeing any fall from customers at this point? And then to what extent are you thinking about pipeline in terms of environmental testing or diagnostics or some of the other opportunities you have talked about roughly in the past?

Jim Foster

So our short-term focus is on maximizing the potential of PTS for endotoxin and we are doing that in large measuring in the pharmaceutical companies and increasingly with the new pharmacies, we need information rapidly because of the self like of the drug was being created.

In terms of the FDA initiative, the PTS initiative to really testing as quickly as possible, it’s sort of working on the background, it’s an issue that a lot of clients are recognizing and we are out of ahead of the tax in terms of being able to offer a solution when those drugs really take hold. As I also said in environment to major focus on our part about having a multi-cartridge system, which accelerate the throughput for our clients who want to do this on a more comprehensive basis.

Simultaneously, we are working diligently on R&D basis in developing these systems for other uses, particularly in areas like environmental testing. And that will naturally follow, but we don't want to do that veteran as a focusing and most of our time and attention in maximizing our returns in endotoxin markets.

Tycho Peterson - J.P. Morgan

Okay fair enough. And then finally just on the dedicated base I know you made some comments earlier about, potentially some of the economics around those agreements. But did you quantify the level to which you signed any new dedicated base agreements, and now you talked about I think a $17 million agreement on your analyst day, back in May?

Jim Foster

So that's the last one that we commented on, as we said we have several unusual discussions as soon as we have something definite to comment on we certainly -- we will achieve both.

Tycho Peterson - J.P. Morgan

Okay. Thank you very much and congratulations.

Jim Foster

Thank you.

Operator

Thank you. We have a question from the line of John Sullivan with Leerink Swann. Please go ahead.

John Sullivan - Leerink Swann

Hi guys, good morning. Quick question on Endosafe, was Endosafe a significant contributor to RMS in the quarter and more to the point I guess are you seeing any traction in the additive applications for Endosafe that you've talked about in the past things associated with process analytical technology initiatives of your clients?

Jim Foster

Endosafe is always a significant contributor. We have to define what we mean by significant John, but it has an extremely high growth rate and margins that have already exceeded total charge of our margin. So as the growth it’s a meaningful contributor and as I said earlier, our focus on the technology side is primarily to continue to refine the device for endotoxin testing into branch of into multi-cartridge system and continuing to work on the environmental testing and some of the other application simultaneously with that, but not in line with it.

John Sullivan - Leerink Swann

Thanks very much.

Operator

Thank you. We have a question from line of Doug Schenkel with Cowen & Company. Please go ahead.

Doug Schenkel - Cowen & Company

Hi, good morning and thanks for taking my questions. First I want to start off with a free cash flow question, given that for the first half free cash flows were just about $6 million. What are the second half drivers that are going to change and allow you to hit your full year target of I believe $25 to $50 million in free cash flows?

Tom Ackerman

Good morning, Doug. Generally we see the first quarter as our weakest quarter, that's primarily attributable to a couple of factors, one of them is bonus payments as a result of the prior year that of course we pay in the first quarter of the following year. We also attend to see capital spending a little bit here towards the later part of the year, and carrying over to the following year in terms of commitments being paid in the following year. Beyond that we think the business continues to be strong. We've improved our guidance as we said and the outlook continues to be good for the second half of year.

Doug Schenkel - Cowen & Company

Okay. Thanks for that. That's helpful. In terms of dedicated space agreements at competitors, if a competitor would have announced an acceleration of the number of BSAs they are entering into would that in any way affect your thinking regarding the space of BSAs that you would want to enter into?

Jim Foster

Not sure about the question, but just taking out the space value not really. As long as our capacity continues to be substantially fully utilized and margins continue to improve their locations, I don't know if you are agnostic to it. But I mean dedicated space agreements will be something our clients want to or not. And we're happy to do them, if the basis of the [bargainers rational] given the amounts of investment they're making and if it's in the best interest of the company and responsive to their need.

We are not really pursuing them just to pursue them for additional notches in our call. I mean, it's about keeping the capacity full and satisfying as many customers as possible. So, we're happy with the conversions. We're having them with the types of clients and the geographical we would expect perhaps with the nature of those arrangements. And we do expect that we'll get some of these and they will generate interest by others who may be concerned about the availability of the space. But it's really a difficult thing to titrate on its own, so it is important to us from a strategic point of view.

Doug Schenkel - Cowen & Company

Okay. That's great. And then just one more thing, I just wanted to quickly touch base on the China facility. I just want to make sure and you may have mentioned this in your prepared remarks so if you did, I apologize. But I just want to make sure that an initial opening of the 50,000 square foot facility is on track for I believe the second half of 2008, and I didn't know if you were in a position at this point to comment on any of the CapEx needs for that facility?

Tom Ackerman

So, we did mention it. So, thank you for asking. We closed on our deal in June. We've got a great general manager for that facility. We hired a controller and are continuing to put together staff, some of whom may come from another location. We are undertaking plans to renovate a four-story 50,000 square foot building that's leased. That work will be initiated before the end of this year, and should be completed by the third quarter of next year.

We are already in discussions with several major international pharmaceutical companies, who are in the look out, that are quite close by from a proximity point of view to our facilities about doing work for them. And we are quite optimistic that we will be able to out in the facility with that business enhance. So, it will schedule out in the third quarter of '08.

Doug Schenkel - Cowen & Company

Okay. And then…

Tom Ackerman

You could say, but I am surprised to say that capital expenditures of this year would not be substantial obviously just given the time of the -- as it we are right now and start of the construction. I don't believe we said exactly what would be in the total, but as Jim said it's a 50,000 square foot facility in most of the cost would be in next year from a capital stand point.

Doug Schenkel - Cowen & Company

Next year. Okay. Alright Jim, Tom thanks. I appreciate you guys taking the questions. Great quarter.

Tom Ackerman

Thank you, Doug.

Operator

Thank you. And speakers I'll turn it back to you for closing comments.

Susan Hardy

Thank you for joining us today. We look forward to speaking with you soon and to seeing you at (inaudible) conferences, which we will be presenting in September. This concludes the conference call. Thank you.

Operator

Thank you ladies and gentlemen. That does conclude your conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.

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