Buy One, Get One Free At Charles River Laboratories

| About: Charles River (CRL)

By Lauren Migliore

Contract research organizations dramatically cut costs and development time for drugmakers. As cutbacks continue in response to patent losses, we expect the cost advantages of outsourcing to persuade Big Pharma firms to hand over an increasing portion of their drug development work to CROs. We estimate that 35% of research and development is currently outsourced, but our valuations imply an increase to 40% during the next five years. Charles River Laboratories (NYSE:CRL) is one of the few top-tier contract research providers with the necessary expertise, infrastructure, and reputation to provide research models and conduct preclinical testing for the world's largest drugmakers. We think the market is undervaluing the cash flow power of Charles River's research models and services business, and the firm's early-stage franchise should provide substantial upside for investors as demand comes back on line.

Charles River's operations are divided into two segments: research models and services, which is a highly profitable and stable business, and preclinical services, a much more volatile segment with potential for considerable growth, in our opinion. Preclinical services have fared poorly in recent years as clients try to eliminate molecules earlier in the drug-development cycle and focus R&D spending on late-stage candidates closer to approval. Drugmakers are postponing or canceling planned trials to focus on near-term revenue opportunities; this especially has hurt early-stage providers like Charles River. We think the firm's PCS franchise could provide substantial upside as demand improves. In the meantime, Charles River has been able to lean on its RMS business to stabilize earnings and provide a floor for the firm's depressed valuation.

RMS Business Provides Floor for Valuation
The research models and services business provides stable cash flow generation and the foundation for Charles River's narrow economic moat. With a 50% market share worldwide, RMS is an extremely profitable and stable component of Charles River's operations. We expect Charles River to maintain RMS operating margins around 30% and see mid-single-digit growth on a normalized basis.

In calculating our expectations for RMS' profitability in 2012, we begin with our projection for the segment's operating income, subtract the segment's share of unallocated corporate expense, and factor in our estimates for interest and tax expense. We arrive at an adjusted earnings per share estimate of $2.36 for the segment.

Although Charles River has traded as high as 25.0 times earnings during the heyday of preclinical spending, we think a more appropriate multiple for valuing the RMS business is the average trading multiple over the past four years, which spanned the pullback in drug-development spending. During this period, Charles River saw declines in its preclinical services operating income each year and had to rely on RMS to buoy earnings. The average trading multiple during this period was 15.5 times, so we use 15.0 times as our baseline multiple for this rough valuation assessment (although we think the firm could also see multiple expansion as preclinical services demand recovers and operating leverage once again drives strong profitability in the segment). Using this calculation, we estimate that the RMS segment is worth around $35 per share. With the shares trading around this number, we believe investors essentially can acquire the cash flow generation power of the RMS business and Charles River's preclinical services business--which is still profitable and carries a substantial amount of upside potential, in our opinion--for free.

Research Model Production Provides Stable Base for Segment
Through research models and services, Charles River is the uncontested market leader in all things concerning laboratory mice and rats for scientific research, and we expect its competitive advantages to sustain strong cash flow generation. With a 50% market share worldwide, the RMS business is an extremely profitable and stable component of Charles River's operations. We expect Charles River to maintain RMS operating margins around 30% and see mid-single-digit growth on a normalized basis (although still-depressed preclinical activities will cause revenue growth to fall slightly below our long-run expectations in 2012).

Since it first supplied research models to the drug-development industry in 1947, Charles River has grown to become the largest provider of laboratory testing mice and rats in the world (it also sells large models, such as nonhuman primates, though this subset makes up less than 2% of total RMS sales). Half of all models sold come from Charles River's research models business, and the global market for model production is estimated at $1.2 billion.

Production constitutes roughly half of RMS segment revenue; although this portion has come down in recent years as the downturn in drug-development spending resulted in lower demand for models. Specifically, Charles River saw a decline in volume sold of outbred rats, which are the model of choice for toxicology testing (an area which has been hit the hardest during the preclinical spending pullback). Volume declines for outbred rats have been offset by small price increases globally, as well as growth in models used for discovery (including immunodeficient mice used for cancer studies or inbred mice used to make genetically modified knockout models). These specialty products command higher prices than outbred rats (price is based on age and weight, but outbreds typically cost $12-$47 per model while immunodeficients can run into the $100 range). However, margins are roughly the same because of specialty models' smaller litters and higher costs of production (including the need for isolators).

Charles River's models are regarded as the gold standard for laboratory testing and continue to claim a premium to the competition (primarily Jackson Laboratory, Harlan, and Taconic, which hold roughly 25%-30% of the market combined). Charles River's competitive advantages lie in the quality of its products, breadth of coverage, and extent of client support. The firm has 20 production facilities in seven countries in close proximity to its clients. Charles River's wide geographic footprint allows multinational pharmaceutical firms to use the same model colonies across different countries and ensures distribution with a minimal amount of travel-induced stress, all of which reduces the variability introduced into the research. To illustrate, in 2011, Charles River performed 18 rescue studies for clients after competitors incorrectly performed the original studies. We expect Charles River's research production segment to continue seeing roughly 2%-3% gains from price increases annually, as well as low- to mid-single-digit volume growth once demand normalizes.

Model Services Add Switching Costs for Customers
Charles River's expertise in biosecurity, breeding, and distribution outfits the firm with sustainable competitive advantages, enhanced by its service wing, which establishes switching costs for clients once they transfer care of their models to the firm. Constituting roughly 30% of RMS revenue, model services include four subsegments: genetically engineered models and services, insourcing solutions (largely composed of consulting and staffing functions), discovery services, and research animal diagnostic services. We think GEMS and drug discovery hold the greatest growth potential for Charles River. Within GEMS, Charles River is hired to assist with the breeding and maintenance of its clients' genetically engineered models. Given the advent of personalized medicine, genetically altered research models are playing an increasingly critical role in drug discovery, and we expect GEMS to contribute a substantially larger portion of Charles River's revenue over time.

Turning to drug discovery, Charles River provides in vivo pharmacology and non-GLP (unregulated) testing assistance to clients investigating new therapeutic agents. Two recent acquisitions--Piedmont Research Center (which specializes in oncology) and Cerebricon (central nervous system)--have expanded Charles River's discovery capabilities. Large biopharmaceutical companies are increasingly emphasizing shorter-term efficacy studies aimed at eliminating nonviable molecules earlier in the drug-development cycle. Although this dynamic has taken a toll on Charles River's preclinical services revenue, it bodes well for demand for drug-discovery services, which are nonregulated--and thus cheaper--than GLP testing. Given its scale, Charles River can support a broader portion of the drug-development pipelines at large pharma firms and was recently awarded an expanded five-year preferred provider agreement with a major drugmaker for discovery services (sales to client are expected to double to more than 5% of total revenue in 2013). Drug discovery is relatively underpenetrated compared with other markets usually targeted by contract research providers--Charles River estimates than only 15%-25% of discovery is outsourced compared with as much as 40% of toxicology services. Drug discovery could be a key area of growth for Charles River, although we expect it will take time for companies to become comfortable with outsourcing an activity that historically has been conducted in house.

The research animal diagnostic services subsegment is Charles River's diagnostic lab function that tests model colonies for known contaminants throughout the research process. Clients using Charles River's insourcing solutions allow the firm to manage their research model care operations (including recruitment and training of employees). In this subsegment, Charles River helps staff and run clients' in-house vivarium at a lower cost than researchers could achieve themselves, thanks to its decades of animal husbandry experience and purchase discount conferred by RMS' scale advantage.

Other Products Buoy RMS Growth
Other products--the last 20% of RMS revenue--make up a small but fast-growing portion of the business. They include in vitro testing and avian vaccine services. The former represents nonanimal (or in vitro) methods of testing medical devices and injectable drugs for contamination. This business has seen robust growth following the Food and Drug Administration approval of its next-generation products, which allow for rapid and portable testing in central labs or manufacturing centers and are poised to continue to see low-double-digit growth for at least the near term, thanks to continued innovations.

Charles River's avian business, which produces clean eggs for the development of vaccines, is included in other products. Roughly 85% of clean eggs sold are used for the manufacture of poultry vaccines, while the remaining eggs are sold to produce human flu mist and for research purposes. This is a very mature business, although supply issues in prior years helped boost 2011's performance. Over the long run, we do not expect higher than flat to low-single-digit growth from it.

Preclinical Services Segment Offers Investors Significant Upside Potential
Charles River's current stock price assigns almost no value to the preclinical services segment. We estimate that RMS is worth about $35 per share. With the stock trading around this number, investors can acquire Charles River's PCS business--which is still profitable and carries a substantial amount of upside potential, in our opinion--for free.

Charles River is a leading provider of early-stage testing services through its PCS business. Pharmaceutical, biotechnology, and device companies outsource their R&D activities to contract research organizations to improve the efficiency and speed of testing, lower staffing and operating costs, and benefit from CROs' specialization and expertise. Charles River estimates that it saves clients as much as 30% of costs and three to six months of development time compared with in-house activities. PCS continues to be affected by soft demand from large pharmaceutical clients, as well as the impact of sales mix, which remains more heavily weighted toward short-term studies. However, sales and pricing have begun to stabilize in recent quarters, and we expect this segment to soon return to growth as drugmakers unfreeze their early-stage development plans because of the fundamental need to drive new therapies through development. We expect the market for outsourced drug-development services to rapidly expand over the next few years, driven by growth in R&D spending and increased outsourcing penetration. We think top-tier players like Charles River will gain share at the expense of smaller competitors, as larger drugmakers increasingly employ long-term strategic partnerships with a select group of preferred providers.

We hesitate to use a similar relative value analysis for PCS, as we do not believe current segment earnings reflect normalized long-term conditions. However, the implied valuation of $15 per share for the segment makes intuitive sense to us. This valuation constitutes about 30% of our total fair value estimate of $50 per share for Charles River. Although PCS represents about 40% of revenue, the segment is half as profitable as RMS, which contributes a disproportionate amount to the company's overall value. To further verify, we took a look at the historical price/sales trading multiples for other CROs in the industry, which have averaged around 1.8-1.9 times during the past three years. We expect PCS to generate more than $8 in sales per share in 2012, allowing us to come up with a value between $13 and $15 per share through the use of 1.5 and 1.7 times sales, respectively (we handicap the multiple slightly given rivals' higher reliance on late-stage testing, which carries higher margins than earlier phases). We are comfortable with this back check, especially considering our use of still-depressed PCS revenue as its basis.

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