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Charles River Laboratories, Inc. (NYSE:CRL)

Q3 2007 Earnings Call

November 6, 20078:30 am ET


Jim Foster - Chairman, President and CEO

Tom Ackerman - EVP and CFO

Susan Hardy - VP of IR


David Windley - Jefferies & Company

Douglas Tsao - Lehman Brothers

Eric Coldwell - Robert W. Baird

John Kreger - William Blair

Alex Alvarez - Goldman Sachs

Rob Gilliam - UBS

Hari Sambasivam - Merrill Lynch

Doug Schenkel - Cowen


Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Charles River Laboratories Incorporated, Third Quarter 2007 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. (Operator Instructions) And as a reminder, this conference is being recorded.

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

Susan Hardy

Thank you. Good morning and welcome to Charles River Laboratories' third 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 third quarter results and review guidance for 2007.

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 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 PIN number in either case is 890128. The replay will be available until November 20th. You may also access an archived version of the webcast on our investor relations website.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 the 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 reconciliation's link.

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

Jim Foster

Good morning. I'm very pleased to speak with you today about our outstanding third quarter results. As you know, we believe that the pharmaceutical industry is at an inflection point unparalleled in its history. In an effort to focus their resources on drug discovery, pharma companies are adopting strategic outsourcing as a means to streamline their operations and improve pipeline throughput.

Having spent the last decade expanding our portfolio of essential products and services, enhancing our managerial, scientific, and technical talent, and extending our global reach, we believe we are extremely well positioned to support our clients' drug discovery and development efforts and the strengthening demand from big pharma.

Our third quarter results demonstrate the effectiveness of our organization and validate the investments we made and continue to make, as we correctly anticipated the paradigm shift that is taking place in the global pharmaceutical industry.

For the third quarter, net sales increased 18.6% to $314 million, the results of strong growth in both the RMS and PCS segments. The acquisition of Northwest Kinetics contributed 3.2%, and foreign exchange added 2.6% to the sales growth rate.

Operating income for the quarter was $70.9 million compared to $61.2 million reported in the third quarter of '06. Although operating income was significantly higher, the operating margin decreased to 22.6% compared to 23.1% in the same period last year.

We expected a decline because of the costs associated with the transition of our new preclinical facility in Massachusetts and because of higher corporate costs, as we invest in information technology and scientific and operational staff to support our growing business.

However, we were very pleased with the operating margin, which declined just 50 basis points when compared to last year and improved 120 basis points from the second quarter of this year. At $47.3 million net income from continuing operations was 22.1% higher than the $38.8 million reported in the third quarter of '06.

Earnings per share increased 21.1% to $0.69, even though the number of shares outstanding also increased. We repurchased another 382,000 shares in the third quarter. But the fully diluted shares outstanding increased by an amount of approximately 1 million shares due primarily to dilution from the convert, option exercises, and a higher share price, which affects the inclusion of stock options to the diluted share count.

Based on our strong third quarter results and our expectation that the robust market trends will continue, we are very confident in our outlook for the balance of this year. As a result, we're raising our '07 sales guidance to a range of 14% to 16%, which is a combination of low double-digit growth in RMS and a high-teens growth in PCS.

We're also raising our EPS guidance to a range of $2.56 to $2.59, which would represent an increase of between 16% and 18% of our '06 results. Now, I will tell you more about our third quarter segment results.

Robust pharma and biotech spending continued in the third quarter; and as a result, the RMS segment sales grew 13.8%. Foreign exchange contributed 2.6%. So, on an organic basis the sales growth was over 11%. Sales of research models in the U.S. and Europe were very strong.

Transgenic services continued to rebound, and the in vitro business benefited from sales of the PTS. Primarily as a result of higher sales and improved operating efficiencies, the third quarter operating margin increased 280 basis points to 31.6% from 28.8% in the third quarter of '06.

As was the case in the first half of the year, sales of research models in the U.S. grew at a double-digit rate; and sales in our European operations matched that pace. We continue to see our pharma and biotech customers increase their spending on research models. And sales to U.S. academic institutions and government agencies also increased in the quarter.

Sales were robust across a number of strains, with the strongest growth in immunodeficient mice and outbred rats. We attribute sales of immunodeficient mice to research, focused on oncology drugs, and sales of outbred rats, to safety testing of compounds as they move through the development pipeline.

Our RMS expansion is targeted at supporting the increased demand for our research models. Production in the two new barrier rooms, which we opened in California in June continue to ramp and we expect to meet our target of shipping product by the end of this year.

And given the continued strong demand from the Western region of the U.S., our plan to open a third production room in the California facility in the first quarter and begin shipping by the third quarter of '08 is unchanged.

We're also on track with our new facility in Maryland, from which we will support our dedicated resources agreement with the National Cancer Institute, as well as commercial sales to the mid-Atlantic region.

Sales of worldwide transgenic services increased for the fourth straight quarter. Researchers are continuing to focus on the use of transgenic models as discovery tools. But unlike early efforts when they manipulated only one or two genes, they are focusing on polygenic diseases in which multiple genes are implicated.

Most human diseases have complex mechanisms of action, so a disease model with a similar genetic profile is likely to have better predictive value of drug efficacy in humans. As they develop more complicated models, researchers have increased the need for the scientific expertise in transgenic breeding and the breadth of services that we offer.

Increased need, combined with a desire for more efficient operations is driving pharmaceutical and biotechnology companies to outsource more of these services. Given our extensive expertise and portfolio of services, Charles River is the partner of choice to support the use of these models in research.

As you know, our preconditioning services business has evolved into a broader service offering, which we call discovery services. This business, which includes services required to prepare models to go on study, as well as early pharmacokinetics, pharmacology and in vivo screening, is aimed at providing our clients with an efficient alternative to dedicated in-house operations.

It is early days for our discovery services business, as relatively few of these services are outsourced, compared to Preclinical Services. But we believe that the same incentives that are driving our clients to outsource preclinical drug development services are beginning to impact these services as well.

We're having an increasing number of discussions with large pharma and biotech customers, and given the opportunities we are seeing, we believe that over time discovery services will be a growth driver for our business.

Again, in the third quarter, our in-vitro business delivered strong results. We have continued to make great progress with the PTS both in the U.S. and in Europe. Its portability and ease-of-use are very appealing from an efficiency standpoint and customers are converting from the conventional test kit to the PTF. The FDA's Process Analytic Technology, or PAT initiative is also driving PTS sales.

PAC promotes real-time in-process test measurement, and the PTS is an FDA-approved endotoxin test tailor made for this initiative. We believe that the FDA is beginning to enforce the regulation, because it recently issued the first notice of regulatory deficiency to a biopharmaceutical company.

As the only FDA approved real-time endotoxin testing method, we expect sales of PTS will benefit from the enforcement of the PAT initiative. The PTS also continues to sell extremely well to nuclear pharmacies. The FDA has issued proposed regulations, which require a lot-release testing with an FDA-licensed LAL reagent such as the PTS.

Although the FDA has not established a timeframe for issuance of the final regulations or compliance with them, we're already seeing many of our clients adopt the PTS in anticipation of the regulation. We were very pleased with the outstanding RMS third-quarter results. Our sales growth reflects 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 and our ongoing efforts to effect continuous process improvement. With the new capacity provided by our expansion project and our broader service offerings, we believe we will be extremely well positioned to support our customers' requirements for our high-quality, value-added Research Models and Services and to promote our growth.

The Preclinical Services segment reported very strong sales growth of 23.1% for the third quarter, including 6% from Northwest Kinetics and 2.5% from foreign exchange. Our toxicology facilities delivered very strong performance due to a number of factors, the most important of which was robust demand for our services from both pharmaceutical and biotechnology customers.

We continue to experience favorable mix and stable pricing and improved capacity utilization. The PCS operating margin declined approximately 180 basis points to 21.8% from 23.6% in the third quarter of '06. As you know, the transition to our new Shrewsbury, Massachusetts facility is expected to pressure the margin throughout '07, primarily as a result of the duplicate costs associated with operating two facilities.

However, with Shrewsbury now operating near capacity and progress being made towards our goal to improve the service mix, the Massachusetts margin improved sequentially in the third quarter. The fact that the PCS margin remained essentially flat for the second quarter was the result of the strength of the Canadian dollar, which has significant negative effects on the operating margin of our Montreal facility.

We are quite pleased with the progress we've made in Massachusetts. The final in-life studies, which were being conducted in our Worcester facility, were completed in the third quarter, and as of September 1st, all new studies have been initiated in Shrewsbury. We are continuing to move operations out of our Worcester facility and have just a few of the laboratories to go.

We're on schedule to complete the move by the end of the year and expect further improvement in operating efficiency once we are located in one facility. We are making excellent progress on our capital expansion plans. In Nevada, validation is underway.

We're on schedule to initiate GLP studies in January of '08. We also broke ground in Quebec for our new facility there and have begun renovations on the facility in China. Our expansion plans are critical at this juncture, when so many of our clients are looking to expand their relationships with a high-quality, scientific-focused service provider like Charles River.

Partnering with us allows our clients to reduce their investment in infrastructure and the technical expertise required for highly complicated specialties, such as reproductive or inhalation toxicology and to focus on discovery of new compounds.

The addition of these new facilities to our existing preclinical system will provide us with flexibility, which is unmatched in our industry.

We can accommodate our clients at large, full-service or smaller more-specialized facilities in North America, Europe or China with expert discovery and development services, and no matter where they choose to place their studies, with exacting attention to detail and the level of service with which they have always associated Charles River.

Given these factors, our expertise, operating efficiency and strategic location of our facilities, an increasing number of clients are speaking with us concerning a broad range of working arrangements.

We already have five dedicated arrangements in place, including the three-year $17 million agreement with a top-10 pharma client, which we signed in the second quarter of '07, and a two-year $14 million agreement with a large biotech client which we signed in the third quarter.

In the past, we've referred to these arrangements as dedicated space agreements but we are finding in our current discussions with both big pharma and biotech that we are negotiating and signing more broad-based partnering agreements, which are designed for clients based on their individual needs.

We may accommodate clients within our existing facilities, build out shelf space to their particular specification, or establish a new facility like the one in Sherbrooke, Quebec. We may provide all of the staffing or work side-by-side with client researchers in our facility. Whatever the arrangement, our goal is to maintain flexibility so that we can support what the clients needs.

Because they have different features, we are now referring to all types of dedicated arrangements as Charles River Dedicated Resources, or CRDR, because that terminology catches the fact that clients rely on a broad array of resources we provide rather than just physical space.

Whatever the specifics of the arrangement maybe, all CRDR agreements generally involve a financial commitment for multiple years. As we sign more of them, we expect these agreements to represent a meaningful percentage of our business. When we give guidance in December, we will provide you with an estimate of that percentage.

In summary, we are exceptionally pleased with our outstanding third quarter PCS performance. Our preclinical tox facilities delivered strong net sales growth, and the leverage from higher sales and our continued focus on operating efficiencies provided a significant offset to the higher costs associated with the transition to our new facility in Mass. and the foreign exchange effect in Canada.

As pharmaceutical and biotechnology companies continue to utilize strategic outsources to drive better operating efficiency, we believe we offer an unmatched combination of extensive scientific expertise, a service portfolio which is broad-gauged in terms of the services offered, and geographic locations proximate to our clients.

Our capital expansion projects, which are progressing on schedule, will provide the capacity that we require to accommodate our customer's intensifying demand. And given our expertise in regulatory-compliant preclinical services and our wide-reaching global footprint, including the expansions in Shrewsbury, Reno, Quebec and China, we believe we are positioned as a premier player in this field with significant opportunities for growth.

Year-to-date, '07 has been a very strong year for us, and we believe that we will finish the year on a positive note. In part, our success is being driven by our clients' needs for a more efficient and productive drug development process. But external factors, no matter how positive are only part of the story. A decade ago, we developed a strategy to be the premier provider of potential products and services to the drug development industry and have been intently focused on executing that strategy ever since.

To achieve this goal, we have made strategic acquisitions, expanded our product and service offerings, invested in sophisticated new capacity, and added considerable scientific depth. We have invested internally, building a senior management team that we believe is the best in the industry.

We continue to attract and retain excellent people and have just announced the promotions of three of our key general managers to the position of Corporate Senior Vice President. Dr. Brian Bathgate, Head of our European Preclinical Services; Dr. Jorg Geller, head of Large Model, Avian and Japanese operations; and Chris Perkins Head of Canadian and China Preclinical Services.

We are implementing IT initiatives that will enable us to deliver scientific and business information whenever and in whatever form our clients require. As we grow, we will continue to make these kinds of investments because we believe they are critical to our ability to provide exceptional products and services and to support our clients as they strive to develop better drugs faster and more efficiently.

And regardless of how large we become, we will maintain an intense focus on our customers, anticipating and responding to their needs, and on our core competencies of laboratory animal medicine, regulatory-compliant preclinical services, and Phase I clinical services, because we believe that it is those competencies that define Charles River and the value we bring to our clients.

In closing, I would like to thank our 8,300 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 recap our strong third-quarter financial performance, I would like to remind you that our discussion today focuses on results from continuing operations. Consistent with Jim's comments, I will focus my discussion on non-GAAP results, which exclude all acquisition-related amortization and other items.

Double-digit sales growth and improved capacity utilization in both segments continued to drive operating income, which rose 15.8% to $70.9 million. Driven by this operating leverage, third-quarter diluted EPS increased an impressive 21.1% to $0.69 from $0.57 a year ago, despite an increase in the share count.

As expected, the operating margin declined slightly year-over-year to 22.6% in the third quarter of 2007, reflecting the anticipated decline in PCS margins due to the transition costs in Massachusetts, as well as higher unallocated corporate expense. The 280 basis point improvement in the RMS margin partially offset these factors.

On a sequential basis, the operating margin improved 120 basis points as operating income growth of 7.8% outpaced sales growth by nearly fourfold, primarily due to the sequential decline in unallocated corporate overhead. EPS also increased 7.8% sequentially.

Given the normal seasonality in our RMS business, we do not expect the sequential comparison to be as favorable in the fourth quarter of this year. Foreign exchange had a negligible impact on the bottom line in the third quarter.

As Jim mentioned, foreign exchange did accelerate the sales growth rate by 2.6%; but the operating income effect is muted by the fact that we are naturally hedged at most locations, meaning revenues are primarily derived in the same currency as costs are incurred. However, this is not the case at our PCS facility in Canada.

In Montreal, the majority of sales are denominated in U.S. dollars, while costs are primarily incurred in Canadian dollars. The strengthening Canadian dollar negatively affected operating margins in the third quarter, negating nearly all of the FX benefits generated from other geographic regions.

Unallocated corporate overhead increased by almost $4 million year-over-year to $11.9 million in the third quarter of 2007, driven by the expected increases in stock-based compensation expense and IT costs. However, unallocated corporate cost declined sequentially by nearly $4 million primarily due to a reduction in healthcare-related expenses.

Assuming more normalized healthcare costs, we expect fourth-quarter unallocated corporate overhead to be slightly higher than the third quarter. Total equity compensation expense was $7.3 million in the third quarter. As expected, equity compensation expense increased nearly $2.4 million year-over-year, but only $0.2 million sequentially. We continue to expect these costs to approximate nearly $27 million for the year.

Third-quarter net interest expense of $2.3 million decreased $1.3 million year-over-year and $0.3 million sequentially, reflecting debt repayment. At the end of the third quarter, we prepaid the remaining balance on our Canadian term loan and made payments on other foreign credit lines.

As a result of the Federal Reserve bank rate cuts and the subsequent reduction in the LIBOR rate, as well as our debt repayment activities, we now expect full-year 2007 net interest expense to be approximately $8 million to $10 million lower than our prior guidance of $10 million to $12 million.

The tax rate increased 60 basis points sequentially in the third quarter from 29.3% in the second quarter to 29.9%, as a result of the tax adjustments based on higher-than-expected year-to-date earnings. This was partially offset by a discrete benefit related to tax law changes enacted in the U.K. and Germany. We excluded $0.9 million of this discrete benefit from our non-GAAP results because it was attributable to Inveresk acquisition intangibles amortization.

Last year's third-quarter tax rate of 32% was negatively impacted by several discrete tax items. Our tax rate guidance for 2007 remains at 29% to 29.5%. We had two non-GAAP adjustments in addition to the income tax item, I just mentioned.

We accrued incremental stock compensation taxes in the third quarter, excluding $0.8 million from non-GAAP results as these costs related to pre-acquisition periods of Inveresk. The other item is the $0.02 gain on the sale of real estate in Scotland, which we previously discussed. This transaction was completed and the corresponding gain recorded in the third quarter.

As Jim said, we are on track to exit Worcester by the end of the year. We have recorded approximately $1.7 million or $0.02 per share of impairment charges year-to-date, although nothing in the third quarter, primarily related to accelerated depreciation of the Worcester facility.

While we continue to estimate total charges of $0.03 to $0.05 for the year, the remaining charges are primarily related to the Worcester lease impairment and will not be recorded until we cease use of the facility, which is scheduled for December. Once we exit the Worcester facility and eliminate the duplicate costs, we expect to reduce facility costs by at least $1 million per quarter beginning in the first quarter of 2008.

Now, I'll turn to some balance sheet and cash flow items. At the end of the third quarter, we had cash and cash equivalents of $183.5 million, plus 88 million in short and long-term marketable securities, for a total of $271.5 million compared to $264.3 million as of June 30 and $286.8 million at the end of 2006.

Accounts receivable were $232 million at the end of the third quarter, up from $202.7 million in the fourth quarter of 2006, primarily due to higher sales. Our DSO increased to 43 days in the third quarter versus 39 days at the end of last year, due primarily to lower deferred revenue, which offsets accounts receivable in the DSO calculation.

However, we continue to focus on collections and have not seen a meaningful deterioration in our receivables aging as a result of the higher DSOs. Year-to-date, free cash flow was $27 million in 2007, up from $3 million last year in spite of spending nearly $38 million more on capital expenditures. That equates to a $61 million increase in working operating cash flow.

Our full-year 2007 guidance for free cash flow remains in a range of $25 million to $50 million with CapEx of $200 million to $225 million. Depreciation in the third quarter increased $2.4 million to $13.5 million primarily as a result of the new Shrewsbury facility.

Because we have begun to transition some of our personnel to the new PCS facility in Reno, we will begin to book a small of depreciation in the fourth quarter of 2007. Our full-year depreciation forecast is approximately $53 million.

Total amortization expense declined $1 million to $8.4 million in the third quarter due to a reduction in Inveresk-related amortization expense. Our 2007 forecast for amortization expense is approximately $33 million.

Let me provide a quick update on our share repurchase activities. Last quarter, we announced that our Board had increased the authorization on our share repurchase program to 400 million. In the third quarter, we purchased nearly 400,000 shares at a cost of approximately $20 million.

As of September 29, we have approximately $108 million remaining on this buyback authorization. We continue to anticipate just about 69 million diluted shares outstanding for the fourth quarter. To reaffirm what Jim said, we have raised our 2007 sales guidance to 14% to 16% and 2007 EPS guidance to $2.22 to $2.25 on a GAAP basis and $2.56 to $2.59 on a non-GAAP basis.

With one quarter left in the year, we are well on track to meet our higher sales and earnings forecasts. We continue to expect robust sales growth and operating margins for the remainder of the year, with the fourth quarter pressured by several factors.

Fourth-quarter RMS revenue growth will be affected by normal seasonality and the anniversary of the improvement in the Transgenics business. These factors will be partially offset by favorability in large model sales, due to the comparison to the fourth quarter of 2006 when shipments were delayed due to an extended quarantine. In the PCS business we will anniversary the acquisition of Northwest Kinetics in October.

We also expect some operating margin headwinds in the fourth quarter. Consistent with historical trends, we expect the RMS operating margin to be impacted by reduced operating leverage from the normal seasonality in the fourth quarter.

In PCS, the Canadian dollar will also continue to be a drag on margins; and as I mentioned earlier, we will incur some startup costs at the new Nevada facility as we begin to occupy the facility in advance of the January 2008 opening.

We will also incur duplicate costs in Massachusetts until we exit the Worcester facility, which is expected by year-end. That said, we are extremely pleased with our year-to-date performance and continue to believe that we're well positioned to achieve our higher sales and earnings goals for the year. We look forward to providing our 2008 outlook in mid-December.

That concludes our remarks. We'll now take your questions.

Question-and-Answer Session


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

David Windley - Jefferies & Company

Hi, thanks for taking my questions. Congrats on a nice quarter. First of all, I wanted to ask on RMS margin, but for some of the seasonality, Tom, is the improvement in margin generally sustainable? Are there other underlying trends, be it transgenics, pricing on models, anything in that regard that are -- perhaps even PTS and leverage there -- that are, say, secular movement in margin on the RMS side?

Tom Ackerman

I would say not, Dave. We obviously had a very good quarter. Margins were very good. I think all things were sort of aligned very well. We didn't really have any drags here or there, but in terms of the macro trends, I would say there are not any underlying trends that other than seasonality and things like that bode negative for the margins.

David Windley - Jefferies & Company

That bode negatively for the margins?

Tom Ackerman

Yeah. I would say there were not any of those types of things other than seasonality.

David Windley - Jefferies & Company

Okay. So otherwise, third-quarter margins are a reasonable projection?

Tom Ackerman

Yeah, I would say, the only thing, as I said, all things went very well in the third quarter. Even when we are doing well, generally there is a little bit of a drag here or there. We didn't really experience too much of that.

David Windley - Jefferies & Company


Tom Ackerman

I think it's a very good indicator, but it was a good indicator, in the sense, that things were aligned very well.

David Windley - Jefferies & Company

Right. Okay.

Tom Ackerman

That doesn't always happen.

David Windley - Jefferies & Company

Okay. Moving then on transgenics, obviously the compares to last year have been easier to this point. And I suspect a decent contributor to the overall RMS growth in 3Q. Is transgenics growing sequentially by a meaningful amount?

Jim Foster

Yeah. It is, Dave. We are continuing to see improvement in the demand for transgenic models as more complex models are developed. Continues to be a confirmation of the importance of these models to research.

We obviously saw substantial improvement over the last year, which was a weaker year. But we continue to believe that it will improve going forward. We don't really see any change in the demand quotient, given the level of investment that we are seeing our clients make.

David Windley - Jefferies & Company

Okay. Great. So, just obviously trying to narrow in on -- is the sequential improvement in the business enough to overcome the sequentially tougher comp to the fourth quarter of last year? Relative magnitudes of the two, I guess?

Tom Ackerman

Well, I think just to add a little bit to Jim's comment, we have been growing sequentially, and, of course, we've had nice growth year-over-year in transgenic. What we have seen as the year has progressed, though, as the rate, particularly in the U.S., of increase year-over-year has shrunk gradually.

David Windley - Jefferies & Company

Okay, okay. Super.

Tom Ackerman

It was a trend last year and this year.

David Windley - Jefferies & Company

Okay. And then last question and I'll jump out is, Jim, you defined for us your CRDRs. Talk about for me the pricing on those and, at least in your early experience, how those evolve perhaps from a revenue standpoint and then also from a margin standpoint?

Jim Foster

Yes, so our goal is to have appropriate returns regardless of the specific structure. So we have a certain cost of capital, and we want to recoup that and then some. So, what we're trying to do is maintain a maximum flexibility as we interface with clients who all have a totally different goal and want to operate differently.

So whether it should simply what we used to call the old dedicated space arrangements, where they would sort of rent space for a particular period of years, or literally build out space for clients, or build a new building like we are doing in Sherbrooke for one or two clients who are providing the motivation, or have our folks go in and manage other people's facilities, or work together collectively. And we've even had some conversations, although they haven't come to fruition, with clients who want to sell us their preclinical locations that they have taken out of commission.

So, what we don't want to do is have one-size-fits-all for these clients. We want to be able to listen carefully and respond to their needs and respond to them geographically as well. So it's an evolving way of doing business. We are not going to in any way denigrate our margins in order to respond to the clients' needs. And I think that we should continue to see sort of the demand continue from a revenue contribution going forward.

But the nature of the deals will be perhaps more complex and more diverse going forward.

David Windley - Jefferies & Company

Okay. Thank you.


And the next question comes from the line of Douglas Tsao with Lehman Brothers. Please go ahead.

Douglas Tsao - Lehman Brothers

Thanks and good morning. Congratulations on the quarter. Jim, to start off with, or Tom, I was wondering if you could provide some comment on how you see the transition to the Reno facility; and how that would compare to the transition into Shrewsbury from a cost standpoint, would this be a more or less expensive operation? And how -- what's your thinking going in terms of our expectations for that in the fourth quarter as well as 2008?

Jim Foster

Why don't we both try to answer that? You should anticipate that the Reno transition will be similar in scale and scope to the Massachusetts one. We will be vacating the facility at the end of '08, as we are vacating the Worcester facility at the end of '07.

We have in-life studies that are ongoing that can't be disrupted, so we have to finish them in the old Reno facility at some point in time, as we did in Massachusetts; and then start new ones in the new Reno facility.

So we should see similar pressure on the margin through '08. But remember, we should also see -- we expect to see some sequential improvement in Massachusetts as well in '08, also.

Tom Ackerman

Just a couple of other data points to think about. Both facilities are about the same size. We will be operating probably a little bit more of Reno facility on day one, versus how much we built out in Shrewsbury, both facilities will be run by the same management team that is in that area , both, seven or eight miles from the existing site.

So there are an awful lot of similarities. The work that's done at each site is probably a little bit different on a mix standpoint. But I think when you tally it all up, in advance of our having completed the 2008 plan, it certainly looks and feels an awful lot like the transition at Shrewsbury.

Douglas Tsao - Lehman Brothers

Okay, great. And then, turning to the transgenics business, Jim sort of talked about the technological evolutions there and the increased use of polygenics. From your standpoint, do you get better margins from sort of breeding and maintaining polygenic colonies versus sort of these single gene knockout/knock-in colonies?

Jim Foster

I wouldn't expect that we would get better margins. The margins in the transgenic business have been quite good historically and have been improving as we continue to fill up the capacity. So like most of our businesses, as we utilize the capacity better, fill up the isolators, the margins will stay the same or perhaps get better.

But the specific nature of the animals, it's unlikely that the work product itself will change dramatically.

Douglas Tsao - Lehman Brothers

And how much of a contributor -- you've commented that you are seeing more characterization work, as well as sort of analytical work associated with the transgenics business. Has that been a significant contributor to the rebound in that? Or has it largely been just a question of volume of colonies?

Jim Foster

There has been some benefit obviously from characterization. But I think the primary improvement that we are seeing is the sheer volume of new models that we are setting up almost on a weekly basis; and as I said, filling up the facilities and utilizing our labor wealth.

And again, it is a worldwide phenomenon. We continue to be delighted to see it happening across the world, which gives us the confidence to really believe that this is a fundamental refocused investment in basic technology.

Douglas Tsao - Lehman Brothers

Okay. And then final question. You've spoken a lot about sort of entering into discovery sciences more. You have also continued to emphasize your desire to stay focused on the company's expertise in animal-based medicine.

I was wondering, when you contemplate expanding your discovery services, have you ever thought about getting more into the pure chemistry related services? There is a lot of -- there has been a lot of growth there, especially in the Asian market, servicing large pharma companies. And I was just wondering if that had entered your radar screen?

Jim Foster

Well, we have indeed thought about it, but it really doesn't feel like it takes advantage of our core capabilities. There are lots of people in that business already who have been doing it for a long time. While it's certainly in the development chain for new compounds, it's probably one that we will continue to leave to others.

So our discovery services business is very much a utilization of our core capabilities, premised on our veterinary medicine expertise.

It's the same drivers that we're seeing in the regulated pre-clinical studies that are going to drive this. And we think this is a substantial business opportunity for us, albeit a small one at the current time. So we're going to stay focused on the animal-related and veterinary-related aspects of it.

Douglas Tsao - Lehman Brothers

Okay. Great. Thanks a lot. Congratulations on the quarter.

Jim Foster



And the next question comes from the line of Eric Coldwell with Robert W. Baird. Please go ahead.

Eric Coldwell - Robert W. Baird

Thank you and good morning. The first question is just a simple one on Nevada. It appears to me at least that, perhaps, your GLP work is starting faster than past implications. Is that an accurate assessment?

Jim Foster

Well, we've commented on it before. We have booked studies and have been booking studies in that for '08. Those are new studies, obviously. So it's pretty much what we anticipated. This is a facility that has a long and distinguished reputation in large animal toxicology work, similar client base and the same staff.

So the new facility just makes it, frankly, more advantageous for these clients. But we're seeing repeat work with them and expect to continue to see that but not surprised by it.

Eric Coldwell - Robert W. Baird

Okay. In Shrewsbury, the commentary in the prepared remarks was that it's near capacity on the space that's currently being utilized. I guess the question is -- what percent of that facility is currently staffed and equipped, and what would be the timing of additional shelf rollouts in Shrewsbury?

Jim Foster

We've finished, we've renovated 60% of about 450,000 feet. There is some administrative space in there. And remember, lots of this is replacement space. We've renovated that and that, we would say, is nearing capacity.

Where a lot of that is sort of earlier non-GLP work, we're beginning to see a gradual shift in mix, which we're delighted with. I think that's going to be really important to this operation, and that should continue. We're seeing an increase in the backlog in basic toxicology services at that site as well. So while we are nearing capacity now, we will see a shift in how that capacity is utilized.

We retain another 150,000 feet of space, which is shelf space. That gives us great flexibility to finish that in a myriad of fashions and phases at once, depending on what the demand is for our clients. While we are looking at the design, we'll pull the trigger when the demand intensifies and when we see a more discernible need.

Eric Coldwell - Robert W. Baird

Great. And then, finally, regarding the new facility in Quebec, I guess, there has been some talk about that facility in a press release earlier. But I'm trying to get a sense of what will be unique about that facility in terms of maybe your mix of CRDR work there being higher, perhaps, than in other facilities or what is the exact plans for that facility in terms of mix and structure and how you work with clients there versus your other existing footprint?

Jim Foster

So let's just go back to the driver. The driver for that new space was the fact that we're out of capacity. We're out of physical space. We plan to build at our current Montreal site, which has grown quite large.

We have some very large top-tier pharmaceutical clients, who prefer utilizing that location, because they have a long relationship with the study directors and they're happy with the quality of the work, who, while we may have capacity elsewhere, really prefer to stay in Montreal. And that's the fungibility of the space, is definitely a goal of ours. But at the current time you can't always direct a client to where you want them to.

So there were a couple of clients, in particular, driving this space. This is sort of a satellite facility, a kind of the mother-ship location that we've had for years. This is clearly a dedicated resources arrangement, we have one or two of those clients who will take the first space of this site, which we anticipate will be about 300,000 feet.

We'll build out 75,000 feet immediately. And by the time that's operational, at the beginning of '09, it should be full. So it's more of the same sort of work, but as we said on a satellite basis and we also continue to grow it on a dedicated resources basis as well.

Eric Coldwell - Robert W. Baird

That's great. Let me add my congrats on a really strong quarter. Thanks, guys.

Jim Foster

Thank you.

Tom Ackerman

Thanks, Eric.


And the next question is from the line of John Kreger with William Blair. Please go ahead.

John Kreger - William Blair

Thanks very much. You mentioned your results out at Montreal being affected by the strengthening Canadian dollar. If you adjust for that, how did Montreal do on kind of a constant dollar basis in the quarter relative to your expectations?

Tom Ackerman

Montreal continues to do exceptional both in terms of revenue and operating margins. And actually, notwithstanding the margins, the impact from the Canadian dollar, the margins are still extremely strong and, if not for that, it would have just been better.

So it does take a little bit off of our overall margin for the PCS and the corporation. But overall, from a foreign currency standpoint, because of the pickups we have elsewhere, where it's sort of muted on the operating income level, but we are seeing pickups in sales, as we translate.

John Kreger - William Blair

Great. Thanks. Then, a general question about the profitability in your pre-clinical services business. As you look across your various toxicology facilities, how would you characterize the performance? Are they all kind of meeting your expectations or is there a potential to sort of apply a best-practices approach to drive further margin leverage in the business over the next couple of years?

Jim Foster

We're really pleased with the performance of most of our facilities. We've had topline growth everywhere, except for Nevada, which had capacity-constraints we've had sequential improvement in operating margins everywhere, except Massachusetts, which obviously had duplicate space.

We have -- our goal is to get to 25% operating margins in this sector. And we have most of our operations performing at or better than that level. So we continue to be pleased with the performance. We still have some opportunities to maximize and implement best practices across all of our sites.

We're continuing to work hard and drive efficiencies. We certainly hope to get increasing efficiencies in Montreal and Massachusetts and Nevada, which are newly built, obviously, and quite flexible in terms of how the space is utilized.

John Kreger - William Blair

Great. And then, one last question. Jim, could you just expand a bit on your dedicated resource comments? As those relationships evolve, are they starting to include kind of a dedicated staffing role as well?

Jim Foster

They may. Our goal is to expand our consulting and staffing business, which is predominantly a primarily research model related at the current time. We have clients that have space that they want to utilize but don't necessarily want to do the work and who may not necessarily have the expertise to do the work. While it's very early in those types of discussions, we're certainly having them.

Of course, people are utilizing our facilities, we have another arrangement that we're talking about where some of the clients will be permanently or at least partially located in our facility at the same time. So, again, the goal here is maximum flexibility for the clients, utilizing the facilities that are proximate to them, whether they are currently built out or could be built out in the future.

John Kreger - William Blair

Great. Thanks very much.


And your next question comes from the line of Alex Alvarez of Goldman Sachs. Please go ahead.

Alex Alvarez - Goldman Sachs

Good morning and congrats on the quarter, guys. Just wanted to continue with some of the earlier questions on RMS. This year, there have been a lot of moving parts that have impacted revenue growth. And I was just hoping if we could get some color from you in terms of what you would kind of view as a long-term growth rate for the division?

I just want to make sure we don't get carried away with expectations, because I think the last time that the Street was looking for a long-term double-digit growth rate, it did create some challenges for the company.

Jim Foster

It's okay, if you get carried away. I think that it's reasonable to expect, even though we're talking about low double digits for this year, there is some FX in there. So our realistic aspiration is that we believe we can grow this business at high-single-digit rate. That's obviously a combination of multiple businesses with different growth rates commensurate with them.

But we see a very significant demand both in the early discovery side and the later-stage development side of our business, and on the products and services side as well. We're thrilled with the way that PTS is growing. We're thrilled to see our U.S. rodent sales and European rodent sales are growing at double-digit rates this year.

And we are very -- and continue to be delighted with the transgenic service improvement over the prior year. And we don't really see any indications that that demand quotient should change. So we're looking at sort of high-single-digit growth, where operating margins are continuing to remain in the low 30s.

Alex Alvarez - Goldman Sachs

All right. Thanks. That was great color. And then in terms of the improved growth in research models right now that you're seeing, would you attribute that primarily to higher spending by customers or is there a sense internally that you're making some market share gains as well?

Jim Foster

I think both. We're seeing higher spending in basic discovery, as I said, and in development work, because pipelines have to be invigorated. And that's really the only way to do it. We certainly believe that we're taking share from at least one of our primary competitors, particularly in the United States, particularly in the academic and government sector, and a little bit in the pharmaceutical sector as well.

We continue to get pricing, but we're seeing some nice unit growth and increasing mix benefits and believe that those, sort of, metrics should continue.

Alex Alvarez - Goldman Sachs

And just one last one, in terms of PTS, how many salespeople do you have out in the marketplace, right now, selling the product? And then, could you just remind us of the sales cycle? How long is it taking potential customers to move from the validation stage of the product to actually making a purchase decision?

Jim Foster

I don't know the exact number of salespeople on a worldwide basis. So we'll have to get back to you on that. But it's primarily direct salespeople. It's a highly technical sale that usually requires some sort of wet lab training. The sales cycle can take a while, sort of, three to nine months, kind of, thing.

Even when they're transitioning from our own older technologies, just to understand it, obviously, it's a little tougher when they are transitioning from a competitor's technology to ours. But once we have captured the clients, we feel that we will be able to hold them. And we are definitely making those transitions now.

Alex Alvarez - Goldman Sachs

Great. Thank you for the details.


And your next question is from the line of Rob Gilliam with UBS. Please go ahead.

Rob Gilliam - UBS

Hi. Thank you. Most of my questions have been answered at this point. I guess just one and I don't think that you have addressed it earlier. But just given the robust demand for RMS and as well as the positive mix shift towards transgenics that you spoke about earlier, just curious about pricing.

I understand that this is the time of year when you pass through the new pricing for 2008. And is the 3% still the right number for RMS as a whole or given the positive mix shift could we maybe see that number drift up a little bit higher?

Jim Foster

So we're not going to give details on '08, until our guidance call, which is in mid-December. So I'm not going to answer that specifically, except to say that we've always been able to improve our prices, appropriate levels, in our research model business. And I would anticipate that we'll be able to continue to do so next year. And when we do that, we can give you more specific color on that.

Rob Gilliam - UBS

Okay. Thanks a lot. That's all I have. Appreciate it.


And your next question comes from the line of Hari Sambasivam. Please go ahead.

Hari Sambasivam - Merrill Lynch

Yes, thank you. A quick question for Tom Ackerman. Just given the decline of the U.S. dollar and I'm just wondering in terms of your capital expansion plans ex-U.S., how does that -- how do you sort of think about it over the next, say, three to five years with the dollar going where it is?

Secondly, in terms of the U.S. dollar declining as well, how do you sort of adjust pricing for that? Is it something that you can recoup from ex-U.S. clients? Or is it something that you have to eat, like in the Canadian facility?

Tom Ackerman

Yes, the -- well, it's relevant in a couple of ways, Hari. And most specifically in our Canadian operations, where many of our customers are based in the U.S. and the predominant mode of invoicing or method of invoicing is in the U.S. dollar.

So a couple things that we have looked at and continue to look at is we're having discussions with some of our larger clients about potentially billing those in Canadian dollars, which would obviously alleviate some of that risk.

We are also doing hedging practices and looking at extending those, although given the weakness of the dollar today it would obviously be difficult to make a long-term hedging decision. But nonetheless we want to at least put in policies and practices that would allow us to probably go out and hedge longer than we have historically.

We do look at, as we expand, the locations where we are expanding and the benefits of that. And while the exchange rates are somewhat unfavorable between the Canadian dollar and the U.S. dollar at this particular point in time, labor rates historically have been lower in Canada than they have been in the U.S. So it still continues to be a good source of appropriately priced labor supply. And of course, that's one of the factors we look at as well.

Hari Sambasivam - Merrill Lynch

What about longer-term ex-U.S. expansion with the U.S. dollar going where it is, Tom?

Tom Ackerman

Longer-term, where we would expand, you mean?

Hari Sambasivam - Merrill Lynch

Right. I mean in terms of capital expansion ex-U.S. with the U.S. dollar going down, I'm just wondering that makes it much more expensive to sort do capital expansions elsewhere. So does that sort of figure into your plans as to how you can recoup this investment if the dollar keeps sort of declining over a period of time?

Tom Ackerman

Well, it does. I mean if you think about Canada as an example, we are cash flow positive in Canada. So the CapEx that we would spend in Canada would be mostly driven by operating cash flows within Canada itself. So it's not like we have to send money from the U.S. up there at an unfavorable rate, or if we needed to we could obviously borrow locally.

So, I think all those things factor into it, but from where we sit today, as an example, the expansion in Sherbrooke, we believe, is still a good transaction to undertake.

Hari Sambasivam - Merrill Lynch

Thank you.


And the final question is from the line of Doug Schenkel with Cowen. Please go ahead.

Doug Schenkel - Cowen

Hi. Good morning and congrats on a great quarter. Relative to Street expectations, as I just referred to it was a very good quarter. I think Q3, I think it's fair to say that Q3 is usually a bit of a tougher quarter seasonally while Q4, while it's tough seasonally, it usually rebounds a bit sequentially.

It doesn't look like that's going to be the case this year given that you have implicitly guided the Street to expect a sequential slowdown in sales heading into Q4. So just so we can better understand how strong a quarter Q3 was, can you talk about whether or not you pulled some sales into Q3 that were expected in Q4? And if so, on which side of the business? How should we think about the margin impact both from a Q3 upside and Q4 outlook perspective?

Tom Ackerman

Yes, this is Tom, Doug. There is no -- I would say no -- we would not pull any sales forward. We wouldn't do that, and it's generally not that available to us anyway. We can't ship out animals a little early with some sort of a [SPF program].

I think one of the things that I said earlier is that it was a very good quarter almost everywhere we looked. We always have businesses that outperform, we have businesses that are sort of where you expect them, and sometimes of course we have businesses that are under-performing and the portfolio sort of manages that.

This quarter, being Q3, I would not say that we had any disappointments anywhere. So the stars were sort of aligned all over the place. Corporate expenses were favorable as we talked about, up versus last year but sequentially down versus Q3.

We wouldn't expect to see that same thing in Q4, although we would still expect to see it on a favorable trend basis. So I think it was a very, very good quarter and I think we are sort of seeing the same similar things and guiding that way that we would expect in Q4 in terms of seasonality, opening of the new facilities, things like that.

A couple of things that we probably didn't mention in our prepared remarks is, we did have a bump up in the tax rate in Q3 of last year, which we didn't experience this year. We also expect a higher share count in Q4. Last year we actually had some favorable foreign exchange activities in Q4, and I wouldn't expect that again this year.

Doug Schenkel - Cowen

Yes, okay and now that makes sense. And again it was a strong quarter and I understand it's hard to accelerate sales from one quarter into another.

Just given how positive you and others have been about biopharma demands on the outsourcing side, it just looks like your PCS sales growth is a big conservative, given that if I just punch in the numbers for Q4 to get to your full-year guidance, it doesn't look like you're expecting a material increase sequentially.

So I don't know. Is that conservatism? Or is there something going on there from a capacity standpoint? Or is it a transition into new facilities? Could you provide a little bit more color there?

Tom Ackerman

Yes, well, we certainly wouldn't comment on the type of question and I know you don't mean it that way that is it conservative? I mean, we wouldn't comment on that. RMS is typically down sequentially in the fourth quarter. We don't expect to see anything different this quarter. That's sort of what we talked about in our prepared remarks.

And I do think, we will continue to see some sequential growth in PCS. But I think given the higher profitability of RMS, it sort of weighs on that more heavily. And then I think if you go into a couple of the other things that we talked about, like the continuing transition in Shrewsbury, we now are beginning to occupy Reno, where we will start to have some duplicate costs that will overlap in the fourth quarter, which is really the first time we've seen that.

So while we are not occupying Reno en masse, we do already have people that show up there everyday for work. So we are seeing operating expenses in the fourth quarter. So we kind of have that at both facilities. So I think it will be a good quarter, but I think it will be a different quarter from the third quarter, obviously.

Doug Schenkel - Cowen

Okay. And just one last one, kind of an updated picture question. Clearly, you guys have the nice problem of being at full capacity in some of your older and newer facilities. Clearly, there is going to be upside driven by mix on the topline as well as at the margin line.

Is there any ability to use, I guess what we're referring to now as CRDRs as a way to shift projects amongst facilities, so that you could free up capacity at some of your facilities where it is tight right now?

Jim Foster

Directionally, that's certainly our goal and particularly amongst the four big locations that we have, that have a whole range of products and services. We are hoping that over time clients will pretty much look at them similarly, so we can sell space that's not fully utilized at a particular period of time.

And we are quite confident that we will get there. It will take some time. As I said earlier, clients have long-standing relationships with particular locations and particularly the study directors in those locations; and there is some reluctance to make changes even within a system as sophisticated as ours.

But as we build particularly these two new facilities and are able to validate the depth of expertise we have, we are comfortable that over time that will change.

Doug Schenkel - Cowen

Great. Thanks for taking my questions.


There are no additional questions at this time. Please continue.

Susan Hardy

Thank you for joining us today. We look forward to seeing you at the Credit Suisse Healthcare Conference next week and speaking with you on December 13, when we hold our 2008 guidance call. This concludes today's call. Thank you.


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

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