Charles River Laboratories International's CEO Discusses Q2 2012 Results - Earnings Call Transcript

| About: Charles River (CRL)

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

Q2 2012 Earnings Results Conference

August 8, 2012 08:30 AM ET

Executives

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

Thomas F. Ackerman - CFO and Corporate EVP

Susan E. Hardy - Corporate Vice President of Investor Relations

Analysts

Ross Muken - ISI Group Inc., Research Division

David Windley - Jefferies & Company, Inc., Research Division

Garen Sarafian - Citigroup Inc, Research Division

Timothy Evans - Wells Fargo Securities, LLC, Research Division

Douglas Schenkel - Cowen and Company, LLC, Research Division

Tycho Peterson - JP Morgan Chase & Co, Research Division

Gregory Bolan - Sterne Agee & Leach Inc., Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

John Kreger - William Blair & Company L.L.C., Research Division

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Charles River Laboratories Second Quarter 2012 Earnings Call and Meeting with Management. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session. Instructions will be given to you at that time. (Operator Instructions) And as a reminder, today’s conference call is being recorded.

I’d now like to turn the conference over to Susan Hardy, Corporate Vice President of Investor Relations. Please go ahead.

Susan E. Hardy

Thank you. Good morning and welcome to Charles River Laboratories’ Second Quarter 2012 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 2012. Following their presentations, we will respond to questions.

At approximately 9:30 when the earnings portion of the conference call has concluded, we will continue with presentations by other senior managers. The webcast will continue through the end of these presentations, which should be at approximately 12 noon. There are two slide decks associated with today’s presentation, which are posted on the Investor Relations section of our website at ir.criver.com. A taped replay of today’s presentations will be available beginning at 2 PM today and can be accessed by calling 800-475-6701. The international access number is 320-365-3844. The access code in either case is 253408. The replay will be available through August 22nd. You may also access an archived version of the webcast on our Investor Relations website.

I'd 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 on our annual report on Form 10-K, which was filed on February 27, 2012, as well as other filings we make with the Securities and Exchange Commission.

During this call, we will be primarily discussing results from continuing operations and 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 Financial Relations section of our website through the Financial Reconciliations link.

Now I'll turn this over to Jim Foster.

James C. Foster

Good morning. I’d like to begin by providing a summary of our second quarter results before providing commentary on our business prospects.

We reported sales of $285 million in the second quarter of 2012, due primarily to the negative effect of foreign exchange. Reported sales were approximately 1% lower than the second quarter of ’11. Strong dollar impacted sales by 3%, so on a constant currency basis, the sales increase was approximately 2%.

PCS business delivered a very good performance in the second quarter with sales increasing 3% over the prior-year on a constant currency basis. We were particularly pleased to see a sequential improvement in PCS sales, up $8.3 million or 8% over the first quarter. The increase was driven primarily by the improvement in In-Life sales, both non-GLP and GLP services and also by the BPS business, which you may recall had a weak first quarter.

The strategic partnership which was initiated last November with the global pharma company was a contributor to the In-Life sales growth. RMS segment sales increased 1.2% year-over-year on a constant currency basis, but as expected was sequentially lower than in the first quarter. This was due to a number of factors including the expected seasonal softness in Research Model sales in Europe and Japan, which we noted when we reported our first quarter results.

The operating margin increased 20 basis points from the second quarter of 2011 and improved 170 basis points sequentially to 19.4%. The improvement was driven by the PCS business. Although declining 90 basis points year-over-year sequentially, the PCS margin increased by 420 basis points to 13.1% primarily due to higher sales. The RMS margin benefited from an insurance payment we received related to the 2011 earth quake in Japan and offset a decline due primarily to lower sales of large models.

As a result, the RMS margin was 32.8%, 20 basis points over the prior-year and just 50 basis points below the outstanding first quarter performance. Earnings per diluted share increased by 7.1% in the second quarter of 2012 to $0.75 per share from $0.70 in the second quarter of ’11. The EPS increase was driven primarily by the lower number of shares outstanding.

We continue to return value to shareholders in the second quarter through our share repurchase plan with a purchase of approximately 458,000 shares of $15.3 million. We are on track to purchase between 1 million and 2 million shares this year, which we noted when we gave our 2012 guidance last December. We are reaffirming our constant currency sales guidance of 1% to 3% and raising our non-GAAP EPS guidance for 2012 to a range of $2.53 to $2.73.

We’re confident that our targeted sales efforts are enabling us to strengthen relationships with all of our clients and to gain market share. Although the volatility of demand impedes stronger sales growth in the near-term, we continue to believe that we’ve positioned ourselves for higher growth as a large pharma client base increasingly turns to outsourcing for the expertise that they no longer need to retain in-house.

In anticipation we’re continuously striving to improve our internal efficiency and to implement systems and capabilities which give us a competitive edge. The benefits of these actions as well as our stock repurchases are evident in our EPS and give us the confidence to increase our non-GAAP EPS guidance.

I’d like to provide some details on the segment performance. The RMS segment delivered a very good performance with sales of a $173.6 million. The year-over-year decline was due primarily to foreign exchange, which reduced sales by 3.8% and constant dollars RMS sales increased 1.2%. The growth rate was lower than the first quarter for a number of reasons. First, as we discussed on our first quarter call, we’ve historically seen seasonality in Europe with second quarter sales growth lagging the first quarter.

We also commented that in Japan the fiscal year ends in March leading to higher spending in the first quarter and the usual delays in spending and to start of the new budget year in April. Global pharma was the third factor. As earlier elimination of molecules and industry consolidation both through acquisition and capacity reductions resulted in lower volumes. And finally sales of large models declined again as sponsors continued to shift to less expensive agent models.

All these factors were evident in sales of Research Models, which decreased 3.4% in the second quarter of ’12 compared to the second quarter of 2011. However, excluding the negative effect of foreign exchange Research Model sales were effectively unchanged. Europe still delivered sales growth excluding foreign exchange, although at a lower rate in the first quarter. Japan also had higher sales in the second quarter of last year, which was impacted after the aftermath of the earth quake.

Looking at the balance of the year, we expect sales of Research Models to continue to decline primarily due to normal seasonality. However, we expect the RMS segment as a whole to remain stable from the second quarter levels as services and In Vitro offset the decline in models. As was the case in the first quarter, the largest RMS sales contributions came from our In Vitro business followed by our Discovery Research Services or DRS business. Excluding foreign exchange these two businesses continue to drive growth at a double-digit rate.

In Vitro business delivered an outstanding performance in the second quarter with sales growth exceeding 10%. As we’ve continuously reported the PTS franchise including the newer Multi-Cartridge System or MCS performed extremely well. Instrument sales was strong and the number of cartridges used per reader per-day, a key performance indicator increased in the quarter. The PTS products appeal to a wide variety of clients because of the ease of use and fast accurate results.

The smaller businesses, such as nuclear pharmacies and small manufacturers, the benefits are immediate. They can test in-house without the delays associated with outside lab services. For our larger clients the conversion process is more complex requiring high throughput capabilities and in some cases revalidation for regulatory agencies. The benefits however are just as compelling.

The advent of the automated MCS scheduled to launch in the second half of 2012 addresses the throughput issue for our large biopharmaceutical clients. And we’re offering training and consulting services to assist with the implementation and validation process. We already have clients committed to the automated MCS based on the significant opportunity represented by these larger clients, we’re very optimistic that this business will continue to grow, at a constant currency rate of 10%. Foster Jordan will tell you more about the PTS business later this morning.

Discovery Research Services or DRS, was another growth driver in the second quarter for both RMS and PCS. As you know our North Carolina and Finland businesses are reported in RMS and all other non-GLP discovery services are reported in PCS. Regardless of which segment you look at, this business is benefiting on three fronts. First, from the decision by many of our large client to outsource these services as evidenced by our strategic partnership with a major global pharma company. Second, from the shift in R&D to eliminate more molecules earlier in the process and third, from the focus on oncology.

Our DRS business provides the non-GLP services, which are clients need to make earlier go and no go decisions on which molecules should advance through the pipeline. In our largest therapeutic area of expertise is oncology to which the greatest percentage of research dollars is directed. Elise Martin manages the strategic partnership with Charles River will give you more insight into our Discovery Services shortly, so I wont comment further here. I will simply say that we believe we’re very well positioned to gain market share in outsource Discovery Services and particularly with our large biopharmaceutical clients.

Table on slide 13 summarizes the second quarter sales performance for the RMS segment compared to the second quarter of 2011. On a constant currency basis, Research Model sales were essentially flat at $87 million, services increased to 0.5% to $54 million and other products increased 5.3% to $32.5 million. Service sales increased primarily due to the DRS business.

For the first half of 2012, DRS represented approximately 10% of total Charles River sales. About 1/3 of this amount is reflected in RMS and the other 2/3s in PCS. Both of these businesses – both of the businesses in other products contributed to the significantly lower growth rate compared to the first quarter. for the first quarter of 2012 we noted that In Vitro’s growth rate far exceeded the expected 10% and now we anticipated growth for the remainder of 2012 to approximately 10%. In addition, comparisons for the Avian business became more challenging in second quarter of ’12 as we anniversaried some supply issues, which had depressed prior period results.

As I mentioned, the RMS operating margin was 32.8% in the second quarter compared to 32.6% in the second quarter of 2011. And on a sequential basis, just 50 basis points below the outstanding first quarter results. The insurance payment offsets a decline from lower sales of large models and our continued efficiency initiatives also helped to maintain the operating margin well above the 30% level.

At a $111.1 million, PCS sales in the second quarter increased approximately 1% from the second quarter of 2011 and 3% in constant currency. The sequential increase was outstanding. At $8.3 million or 8.1% this was the best sequential performance since 2008. As I mentioned, the BPS business, which was a drag on first quarter results improved in the second quarter as expected. However, the primary driver of the improvement was the In-Life business both non-GLP services and GLP safety assessment.

I’ve already discussed the increase in non-GLP Discovery Services, which is being driven by our clients intensified focus on earlier elimination of molecules from the pipeline and moving forward only with those molecules which have the greatest likelihood of commercial success. This focus is evidenced by the strategic partnership with a major global pharma client as well as the increasing proportion of discovery studies in our sales mix, and our continuing discussions we’re having with other large pharma clients.

Discussions concerning additional strategic partnerships are ongoing as our clients grapple with the logistics of how and what to outsource. In our opinion it’s no longer a question of if, but rather when. As a result of the organizational changes and process improvements we’ve made, as well as the IT infrastructure we put in place, we believe we’re extremely well positioned to be the partner of choice for our clients. Nancy Gillett will discuss this concept with you shortly.

We were very pleased to see a small increase in GLP safety assessment studies. I mentioned in the first quarter that reproductive toxicology studies had improved and we’ve continued to see some increased activity in other areas. Even the volatility of the large pharma market in the limited visibility of demand in general, it’s still too early to say that we’re seeing a sustained improvement in the safety assessment market. I will say that we’re currently seeing better proposal quality and an increase in longer term studies and this supports our belief that this is a stable to slightly improving market.

With market stabilization and our success of winning new business, our facilities are filling. Although we haven’t reached the optimal utilization level overall, we do have some of our facilities running at or near capacity. The actions we’ve taken over the last four years to harmonize and standardize our preclinical sites have been instrumental in giving our clients the confidence to place work at multiple sites. They can choose a site based on proximity or study-start timing with the knowledge that they have full access to Charles River’s expertise wherever they reside and that the data can be easily obtained on a consistent format regardless of site.

Higher sales, improved capacity utilization, and DPS recovery resulted in the 420 basis point sequential improvement in the PCS operating margin to 13.1% in the second quarter. The year-over-year decline of 90 basis points is attributable to a greater proportion of shorter term studies in the sales mix as well as the initial transfer of protocols under the strategic partnership.

We’re making excellent progress on the transition and the partnership is working extremely well, in addition to the direct comments they’ve made, we believe our partners willingness to act as a reference to Charles River indicates their satisfaction with the relationship.

We’ve been working collaboratively with the client at every step to ensure smooth transition of the work. And both we and they’re very pleased with our progress to date. As the relationship solidifies, we truly believe that the client is viewing its colleagues at Charles River as critical partners on the same side of the table. Not us and them, but one seamless discovery and development team.

We’re very pleased to report another strong quarter for non-GAAP earnings per share and to increase both our GAAP and non-GAAP earnings per share guidance for 2012. We believe the biopharmaceutical companies continue to move forward with outsourcing as a cornerstone of their goal to improve efficiency and enhance the productivity of drug development pipeline.

Our continuing discussions with multiple large clients concerning strategic relationships indicate to us that they value Charles River’s broad portfolio of early stage products and services, our scientific expertise and our flexible solutions to the drug development challenges. We continue to believe that the breadth of our integrated portfolio, our deep scientific expertise in In Vivo biology, rigorous management of our business and intensive focus on our four key initiatives are the foundation for the successful execution of our business strategy today and in the future.

In conclusion, I’d like to thank our employees for their exceptional work, commitment and resilience and our shareholders for their support. And I’d now like Tom Ackerman to give you the second quarter financial details.

Thomas F. Ackerman

Thank you, Jim, and good morning. Before I recap our financial performance, let me remind you that I'll be speaking primarily to non-GAAP results from continuing operations. A reconciliation of non-GAAP items can be found in our press release and on our website.

Second quarter results were quite favorable, highlighted by a 19.4% operating margin and EPS of $0.75 as well as the rebound in PCS sales to $111 million. This was particularly impressive in light of the increasingly negative impact from foreign exchange, which reduced reported sales by approximately $9 million or 3.1% and EPS by nearly $0.03 when compared to the second quarter of last year. Sequentially, reported sales declined by slightly over $1 million or 0.4%, but would have been unchanged excluding the impact of foreign exchange.

We are pleased with the meaningful improvement in the consolidated operating margin, which increased 170 basis points sequentially and the $0.05 increase in EPS. Higher operating income versus the first quarter contributed $0.07 to EPS driven by the improvement in PCS sales and operating margin as well as lower unallocated corporate costs. In aggregate, items below the operating line reduced EPS by approximately $0.02, driven primarily by a $2 million unfavorable shift in other income.

I will now walk you through these drivers in more detail. PCS contributed nearly $0.08 to the sequential EPS improvement as the segment sales and operating margin increased significantly as a result of improved demand across all areas, non-GLP Discovery Services, GLP safety assessment, and biopharmaceutical services. The decline in RMS sales and operating income offset the majority of the PCS improvement due primarily to lower sales volume for Research Models, particularly in Europe and Japan coupled with a negative impact of foreign exchange.

Operating income for the RMS segment included an insurance settlement related to last year’s disaster in Japan, which benefited the second quarter RMS operating margin by approximately 100 basis points and EPS by approximately $0.02. In addition to the normal seasonal trends which impact the RMS segment in the second half of the year, we expect the second quarter insurance settlement to be a sequential headwind to the RMS margin in the third quarter.

Unallocated corporate costs were also a significant contributor to the sequential operating margin and EPS increase. Unallocated corporate cost declined by $3.3 million sequentially to $16.3 million in the second quarter, almost entirely due to very favorable health and fringe-related costs. We continue to expect unallocated corporate cost to be at or slightly above 6% of sales for the full-year.

Net interest expense was stable in the second quarter at $4.4 million, representing a slight improvement from the first quarter level of $4.8 million. We continue to benefit from lower average debt balances as well as lower interest rates. Based on these continued benefits we now expect net interest expense to be approximately $18 million to 20 million in 2012.

As I mentioned earlier, other income was unfavorable by $2 million on a sequential basis. This was driven by several factors, including losses related to certain investments, primarily those associated with the deferred compensation plan and changes in foreign exchange translation. Since changes to other income are primarily driven by market based returns, we do not forecast this line item.

Our non-GAAP tax rates of 26.1% for the second quarter and 26.4% for the first half was slightly more favorable than our guidance range of 26.5% to 27.5% for the year, primarily due to true-ups of prior-year tax returns in Canada. Since this discrete item was not expected to recur in the second half of this year, we continue to forecast that our tax rate for 2012 will be within the guidance range.

I will now provide an update on cash flow and capital priorities. Free cash flow in the second quarter was $47.9 million compared to $58.6 million last year. Year-to-date free cash flow totaled $59.1 million. We continue to expect to achieve free cash flow in a range of $160 million to $170 million for 2012 because we typically generate greater free cash flow in the second half of the year. CapEx in the first half was $23.6 million, which puts us on track to spend approximately $50 million in 2012 as we previously expected.

We continue to balance our capital priorities between modest capital expenditures, stock repurchases and debt payment, while evaluating potential smaller acquisitions. We repurchased approximately 458,000 shares for $15.3 million in the second quarter and 806,000 shares for $27.8 million in the first half of 2012. As of June 30th, we had $88.5 million outstanding under our stock repurchase authorization.

We continue to anticipate that we repurchased between 1 million and 2 million shares in 2012. Our total debt declined by approximately $18 million in the second quarter as we continue to repay debt modestly ahead of the scheduled installments on the term loan. We expect accelerated repayment activity to continue over the remainder of the year.

You may have noticed that our balance of current debt totaled $134 million in the second quarter, the increase relates to the June 30, 2013 maturity of our $350 million convertible debt, which now occurs in less than one-year. As a result of the impending maturity, we require to include a portion of the debt as short-term, but only the portion of the convert that could not be refinanced utilizing the existing capacity available on our current revolving credit facility. The remainder continues to be classified as long-term debt.

We are currently evaluating our options to address the convert obligation, but do not expect to provide further details until a decision has been made. We are very pleased that S&P reaffirmed our investment-grade credit rating and upgraded our outlook to stable from negative during the second quarter.

As Jim discussed, we’ve maintained a 1% to 3% constant currency sales guidance, while upgrading our reported sales outlook to reflect more significant headwind from foreign exchange. Foreign exchange is now expected to reduce reported sales by 2% compared to our prior estimate of 1%. Based on our current estimate, foreign exchange is now expected to reduce full-year 2012 sales by nearly $25 million and EPS by approximately $0.07 versus last year. The primary driver of this change is related to the weakening of the euro which has a more significant impact on our RMS segment.

We recently completed an extensive review of our Eurozone exposure and concluded that our exposure to higher-risk regions is quite limited. We generate less than 5% of total sales in operating income and higher-risk Eurozone countries, including Italy and Spain and have thorough and continuous credit monitoring for clients in this region as we do for all of our clients.

In addition, while sales growth in Europe slowed somewhat in the second quarter, our European businesses continue to perform quite well and posted another constant currency sales increase. We believe the slower growth rate was related to ongoing site consolidations and cost-saving programs at several large biopharmaceutical clients, and not the macroeconomic conditions in Eurozone.

Since our exposure is weighted towards the more stable Western European economies, such as Germany and France, we do not anticipate that macroeconomic issues will have a meaningful impact on our second half results beyond the translational impact of the weaker euro.

For the year we raised our non-GAAP EPS guidance to a range of 263 to 273, we recognized our EPS exceeded expectations in each of the first two quarters of 2012 were remained conscious with our outlook due to a number of factors. First, as I just mentioned movements in foreign exchange rates particularly the euro, were unfavorable during the second quarter leading to the $0.07 headwind for the year. In addition, we expect normal RMS seasonality in the second half of the year, which would result in slightly lower sales than the first half level, and an operating margin slightly below 30%.

Following the significant sequential increase in PCS sales, we remained cautiously optimistic that PCS trends will be stable in the second half of the year. The business has stabilized and demand improved in the second quarter. However, visibility remains limited and based on our experience in the last few years, preclinical activity has trended lower in the second half. As a result, we expect preclinical sales to be slightly lower in Q3 and Q4, versus the second quarter level of $111 million with some moderation in the PCS operating margin.

I would also like to point out that the lower end of our sales and EPS outlook takes into account the uncertain macroeconomic and funding environment. We understand that demand would need to take a meaningful step down to approach the lower end of our guidance range and while we do not expect this will occur, we believe our guidance range is appropriate in light of the market uncertainties that persist.

Our outlook incorporates these headwinds, which we believe will culminate in third quarter consolidated sales and EPS being at the low point for the year. This is consistent with historical seasonal trends in the last two years although we do not believe the RMS sales decline from Q2 to Q3 will be as quite as pronounced this year. In addition we expect the tax rate and unallocated corporate cost to be slightly higher sequentially and we do not expect to benefit from the Japan insurance settlement that contributed $0.02 to second quarter EPS.

To conclude, we are pleased with our strong first half performance and remain cautiously optimistic that underlying business trends will remain stable for the remainder of the year. Thank you.

Susan E. Hardy

We are happy to take your questions now.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question is from Ross Muken with ISI Group. Your line is open.

Ross Muken - ISI Group Inc., Research Division

Hi, good morning guys. So, as we think about sort of the assumption on PCS for the rest of the year, I mean, I realize some of the visibility is limited. I mean, as you feel like the trend just happened in terms of the roll in of the new strategic partner as well as maybe some of the moving parts on the big-pharma and mid-pharma side, I mean where do you feel like you were most surprised, it seems like positively relatively to how kind of the second quarter or the entire sort of first half has played out in that business?

James C. Foster

Where were we most surprised, is that what you said?

Ross Muken - ISI Group Inc., Research Division

Yeah.

James C. Foster

I am not sure we were surprised. We were certainly pleased with the results. I think we’re executing quite well. I think we’re doing extremely well competitively. The strategic deal that we did we worked several years to get that and so we’re now seeing the benefit of that. So, the strength that we’ve seen in the first half of the year, particularly in the second quarter with preclinical, I think has been a long time coming. I think it’s a combination of our competitive strength, our flexibility in the marketplace and how we’re utilizing our capacity.

Given what's going on for the last four years, given the lack of visibility, the inherent volatility in the business model, really difficult for us to just assume that things will continue to improve going forward and that we’ll continue to build share sort of at the rate that we have in the second quarter, we would obviously be delighted for that to happen. So, I think we’re taking a very an appropriately realistic look at the business.

We have also had sort of a second quarter decline for the last few years just generally. People seem to get out of the starting gates faster and crank out off into the second quarter. We see some seasonality in the third and fourth quarter. So, again I think we’ve defined the year as we see it based upon our historical experiences and kind of real life activity.

Ross Muken - ISI Group Inc., Research Division

Thanks. I guess on the cost side, I mean you guys have been very strong in terms of pulling extraneous costs out of the business. You’ve gotten some pretty good leverage even when top-line wasn’t sort of where it needed to be. I guess, in the context of and I don’t want to steal too much thunder from later, but do you feel like the margin progression, the path that you’re on, there’s still quite a bit of headroom there in terms of rationalizing the SG&A line, and do you feel like more of the benefit going forward as we think about margin expansion here is probably going to come more from the gross line?

Thomas F. Ackerman

Yes, yes. We continue to have a process improvement program internally. We did mention at the outside of the year that, through that program we expect it to realize $25 million in savings during 2012 which we’re on track to do. And given these competitive environment that we continue to find ourselves in process improvements for our efficiency and quality continue to be a high-priority within the company.

So, I continue to believe that we’ll do that. We’re focused a lot more on a preclinical environment historically. We’re focusing aggressively as well in the research model market and services segment as well at the current time. We’ll continue to leverage SG&A as best we can. Some of those expenses were a little bit lower this quarter as we mentioned due to some of our health related benefits which were a little bit hard to predict.

I do think that those will pick-up a little bit. So, I think looking forward as you asked, I think we’ll probably find a little bit more leverage in the operating margins and probably a little bit less of that will come from the SG&A, that’s our target and we’re going to continue to work hard at that.

Ross Muken - ISI Group Inc., Research Division

Great. Thanks Tom.

Susan E. Hardy

Thank you.

David Windley - Jefferies & Company, Inc., Research Division

Okay, thanks. Dave Windley at Jefferies. I have a three-parter on the strategic deal. So first, can you call out how much it really improved sequentially on revenue, how much did it contribute sequentially in revenue? From your comments -- the second part of it, from your comments on the protocol transfers affecting the margin, was it actually dilutive to margin in PCS in the second quarter?

And then third, in your bullets in some of the slides you talked about this moving toward 5% of revenue in 2013. Jim, I’ve also heard you talk about it trending toward kind of $100 million run rate which would I think be quite a bit higher than 5% of revenue in 2013, and so I wanted to get clarification on what the top-end looks like for the strategic deals; so sequential revenue, margin and then top-end.

Thomas F. Ackerman

Well I think we talked about the client increasing to 5% of sales, right? going from 2.5%, there. This particular client historically has been 2.5% so they would increase to 5%, so essentially doubling to put the upper-end range on where we are. We do hope ultimately they will do more than that with the client but as defined in the terms of the agreement that’s kind of where we expect it to be, but we’re looking at and have been successful in some areas of actually pulling in other ancillary business not contemplated within a deal in with that client.

We didn’t say specifically what we drew sequentially in from the strategic partnership, but sales are up. I don’t think at this particular point in time we want to break that out quarter-to-quarter, but the sales have improved somewhat. And given the number of facilities that we are using, some facilities actually the margin has increased and other facilities where there is a greater transfer of assays, we have actually seen some expense headwinds which was I think the comment that Jim had made a little earlier.

James C. Foster

Okay, I was at this client for most of the day, a couple of days ago. And there’s an enormous amount of additional opportunity for us to work with them beyond this particular deal and we really have gotten to the point that the conversation was such that, it wasn’t the client and a bunch of Charles River people, it was really -- it felt like we were the client which is definitely our goal here.

So, I certainly think $100 million is in our foreseeable future maybe 2013 was a little bit early, just to clarify that, maybe not, but perhaps, but where we continue to talk about additional services that we can provide them as they continue to rationalize their cost structure and I do think as we said before, this is a really good template for other deals and other relationships and other conversations we’re going to have with clients. All of the big drug companies are going to have to rationalize their infrastructures faster and as we continue to demonstrate our capability to have multiple sites working in units and great IT interface quality of the science and data and as they begin to see us the same I think it’s a very powerful transformation that we’re actually in the midst of right now.

David Windley - Jefferies & Company, Inc., Research Division

Okay, and if I could follow-up on a clarification on the guidance if we do the math, the second half Tom as you kind of talked about, second half is pretty substantially down on a kind of run rate basis from what you’ve done in the first half. And if I -- I want to make sure I interpreted your comments, unless things get really bad, you’re kind of taking the bottom-end of the range off the table, but the factors that could drive sequentially the earnings down would be, the healthcare cost were a big benefit about $2 million swing in the second quarter. Tax rate was a little low. The insurance settlement was a couple of pennies, its positive in the second quarter, those kind of factors. Is that the right interpretation and did I leave anything else? Thanks.

Thomas F. Ackerman

Pretty much Dave, that’s a good summary. We have, as Jim said earlier the research model business is down in the third quarter due to seasonality both in the top-line and the margin. As we said we think that the preclinical business itself on a sales basis will be reasonably stable. We did say that it would be moderately lower, but still higher than Q1 – meaningfully higher than Q1 and a little bit lower than the Q2 numbers. So, I think it’s fairly consistent with what we have seen in the past years with the exception of a couple of the one-off that you actually referred to.

Garen Sarafian - Citigroup Inc, Research Division

Hi. This is Garen Sarafian, Citigroup. Well, first congratulations on that PCS the uptick after some numerous quarters of declines. I was just wondering, how …

(Multiple Speakers)

Garen Sarafian - Citigroup Inc, Research Division

All right, sure. Garen Sarafian, Citigroup. On PCS, how has the recent changes in the toxicology competitive landscape contribute to the results, is it just -- its coincidence or if you could just, you can qualitatively speak to the supply consolidations, rationalizations in the sector impacting your results, and how typically -- how long do they typically last, if it’s a tailwind?

James C. Foster

Our competitive situation is really strong in preclinical. We did a lot of our internal rationalization of space and staff earlier than some of our competition. We spend a lot of time on IT interface and we’re really listening to the clients and not trying to drive this -- sort of this is the way we work and you need to work with us in this fashion. And we’re seeing share gains with multiple competitors, large and small.

And so -- and a lot of that has to do with the fact that we’ve been working really hard with what we call our mid-tier clients kind of small pharma and value tech clients to make sure they understand that. And not only we not to large came to face with them, but we can do that well and that we’re structured to do that efficiently. So as we’ve seen an uptick in our mid-tier clients we have several clients that we have all of the share; we have increasing share with others.

We have seen share gains with some clients and in competitive bid processes which we are in constantly with large and small competitors we’re winning sort of an undue number of those bids versus what happened historically. So, I don’t know, it’s a lot of factors where I think we really figured out how to put our best foot forward.

In the final analysis putting price aside which is hard to do but as we’re able to compete competitively it continues to be all about the science, and all about the interface and all about the responsiveness and turnaround time and I think we’re actually continuing to do that better, and the conversation for instance that we had with this large client that we’re working with, we have this big contract with.

We’re serving this contract for multiple child service sites and what this, and they said the other day that they’re so pleased with the fact that the molecule goes in one place and they get the answer back and they have no sense that they’re dealing with multiple sites and that’s actually been our goal in preclinical for years. I do think that we have achieved that in large measure and we’re continuing to enhance driver efficiency that we can do that even better going forward.

Garen Sarafian - Citigroup Inc, Research Division

And you mentioned price, and when does pricing -- when capacity becomes more rationalized then there’s more leverage for stable and perhaps even increasing pricing. How has pricing trended in toxicology in the last 6 to 12 months then?

James C. Foster

I think pricing is relatively stable. It’s a big issue with everyone. And our capacity is feeling, as I said in my prepared remarks some of our sites are actually at what we call our full capacity utilization levels, optimal capacity utilization levels. I think that’s going to be -- continued to be helpful. We constantly test pricing as we did on things. But we’re not assuming that we’re going to have it, so we just sat down and did our three year plan and we have very little price in there, we have some but we have very little price. The assumption is that we’re going to have to drive efficiency which we are in the combination of efficiency and volumes I think it is conspiring to, help improve the operating margins.

Garen Sarafian - Citigroup Inc, Research Division

Thank you.

James C. Foster

Sure.

Timothy Evans - Wells Fargo Securities, LLC, Research Division

Hi, thanks. This is Tim Evans, Wells Fargo. Could you talk about, a little bit about your IT infrastructure; where you’re in that build out, where you have left to go and how that might be contributing to the, I guess, improved win rate that you were just talking about?

James C. Foster

Sure. We went through an ERP process a few years ago, and we saw the benefits in our preclinical business almost immediately. We were able to get very refined data and particularly on the cost side to enhance our ability to bid successfully. So, I think, some of the share that we’re getting frankly, particularly with these competitive pricing scenarios is based on really understanding our cost well and knowing how far we can go. So, that’s improving dramatically.

We have to still roll out our ERP with, in our European locations, in RMS we are in the final stages of developing a plan to do that, and we understand what -- where the benefits came and how to rollout certain aspects of that. So, that’s in the drawing board. In terms of our IT interface with our preclinical clients we have very, very specific needs.

In particular, they want to get online and see the data. They want to know that it’s confidential, they want to know that its relatively real time and they don’t want you to necessarily tell they want to see it or discuss it with you, and the space yield that we did last November and in others that we’re beginning to work on, we’re putting together I don’t want to call them unique, but sort of QUOSA unique structural relationships with the clients from an IT point of view.

So, they’ll have to be somewhat customized, the point being that they want to see the reports and not recognize them as coming from Charles River. So the best compliment we got the other day was the client saying, we’re getting all these reports from you and it feels exactly like its coming from our internal operations. So, we’ll continue to do that, we’ll continue to refine our interface with them and we’ll continue to build out our ERP capabilities.

Timothy Evans - Wells Fargo Securities, LLC, Research Division

Great. And then just one clarification on the strength that you’re seeing in regulated safety assessment; how broad is that from a client perspective and from maybe – are you seeing in both, small clients, large clients et cetera. And also can you just clarify is it up both year-over-year and sequentially?

Thomas F. Ackerman

Yeah of both, we have a really good composite right now. So, we’re seeing particular strength in the small clients. The problem with the big clients is, you have very, very big wins and then you have major consolidations with some of your customers that can kind of outset that but for the companies that aren’t so dismantling themselves we’re seeing some very big wins there as well.

So, yeah its -- the studies are still shorter than we would like them or that they have been historically but having said that we’re seeing more specialty work right now. We’re seeing the studies elongate, so the better we’re seeing more complexity in this studies and we’re seeing higher quality proposals from the clients coming in asking us to bid.

So, this is all sort of working together to improve the mix a little bit and to improve the overall volume. Obviously the sequential pop was more significant.

Douglas Schenkel - Cowen and Company, LLC, Research Division

Good morning. This is Doug Schenkel. Can you hear me now?

Thomas F. Ackerman

I think it’s on there -- I can hear you but it’s not on.

Douglas Schenkel - Cowen and Company, LLC, Research Division

It’s not on. All right, I’ll talk louder.

Thomas F. Ackerman

Okay.

Douglas Schenkel - Cowen and Company, LLC, Research Division

Here we go. Doug Schenkel from Cowen. Thanks for taking the questions and thanks for hosting this, this morning. First, really a question for I think Tom; a very nice improvement in PCS margin in the quarter. It doesn’t sound like the strategic partnership had a meaningful impact on operating margin, good or bad relative to what you reported in the quarter. At least if I am understanding things correctly, if that’s the case, would you be willing to provide any color on how much of the margin improvement is attributable to utilization versus product mix versus any other notable contributors FX price again it seemed like there was a very nice improvement relative to Q1.

Thomas F. Ackerman

Yeah, I think the largest contribution to the margin improvement in PCS is obviously volume which relates to capacity of utilization of course. I think the strategic partnership is contributing. It’s contributing at or above where all of our preclinical businesses are. So we are seeing some headwinds in at least one location as we ramp up assays, but a couple of the other locations that are more managed have been doing better, and of course some of that work is actually on the RMS, so we’re seeing some benefits in the RMS from the strategic partnership as well. So, I think the key driver as I said and you sort of referred to is really the capacity utilization.

Douglas Schenkel - Cowen and Company, LLC, Research Division

Okay, thanks for that. And then, I may be jumping the gun on Foster’s presentation for later this morning, but I guess, I’ll ask the question anyway. Any changes in how you’re thinking about the total addressable market opportunity and then In Vitro you have a pending launch of the automated MCS, it’ll just be interesting to hear how things are building into the second half, any backlog details that you’ll be willing to share and anything that you might be willing to share in terms of just how things are going geography by geography?

Thomas F. Ackerman

I am not sure exactly what you’re getting at. From an addressable market point of view as we continue to enhance these products and particularly as we move into the central average we’ve increased the market size.

Douglas Schenkel - Cowen and Company, LLC, Research Division

Yeah, that’s where I am getting at; it’s just how has that evolved over the last few quarters?

Thomas F. Ackerman

And we’re taking share as we convert our clients from our competitions technology. It’s still early days there, so that’s actually quite positive as our technology improves and we get deeper with our clients. We’re quite confident we’re going to be able to continue to grow those business at sort of 10 percent-ish top-line run rate. We’ve got very, very attractive operating margins in that business as well and we’ve gotten very efficient in terms of our ability to both manufacture the devices and price them, and our approach has basis the price is actually higher for the client, but their overall labor component internally will drop in the speed at which they get the answer is so much more profound, that they’re happy to do that. So, we feel we’re going to be able to continue to convert the market over the next few years. And I am sure we’ll have new products coming out over that timeframe as well.

Douglas Schenkel - Cowen and Company, LLC, Research Division

Okay. Thank you.

Thomas F. Ackerman

Sure.

Tycho Peterson - JP Morgan Chase & Co, Research Division

Hi, good morning. It’s Tycho Peterson, JP Morgan. Just following up on your comments in the strategic deal; I am wondering if you can talk to your appetite and bandwidth for other deals and should we assume that these all would also come with some margin pressure initially as you ramp. And, as you’ve had success with the first deal, do you expect follow-on deals to start kind of piecemeal with the trial period or can you actually go and shop a larger deal from a strategic perspective to other partners?

Thomas F. Ackerman

Yeah, this deal has definitely helped us generate conversations with other clients, in fact we always indicated a couple of times now that we have actually used the big clients that we have, by the way I was with them as I said earlier this week and we talked about how nice it would be to be able to name them. So we don’t have to euphemistically keep talking around in circles here, but nevertheless, yeah I mean it helped us in a lot of ways to enhance the conversations and sort of two things are happening at once.

One is that we’re establishing the fact that this sort of work can be done externally by someone like Charles River over multiple therapeutic areas without losing speed. Speed is a big issue for these clients. So, without losing speed and without in anyway sacrificing the quality of the science. At the same time, many, many other companies have drugs rolling out patent, reducing infrastructure and are going through exactly the same situation.

The preclinical capacity is and can be used for regulated studies and non-regulated studies. So from a capacity point of view we definitely have the bandwidth to add additional large contracts. I think we’ve said publicly two or three of similar scale. We have much of the senior scientific staff that we need, but in specific therapeutic areas I think we’re going to need to flush that out further. So, we’re talking about adding primarily technician level people and making sure that the IT interface is specifically designed for that client.

So, we’ll be able to do them faster perhaps, it really depends on the client and the geography and the mix and their therapeutic area and what their individual assays look like. For sure there’s going to be a startup here with everyone where you’re transferring the protocols and we’re making sure that we are getting them right and they’re happy with it. So, if it takes a half a year to wrap these things up I think that will be fine. There’s a modest impact on large initiative there and its modest and I think once you’re up to full strength we’ll be able to offset that.

Tycho Peterson - JP Morgan Chase & Co, Research Division

Okay, and then there’s a follow-up, you touched on M&A as one of the uses in capital, I mean should we assume that [by a series] to add additional capabilities and if so whether obvious areas clients are asking about and alternatively, geographically are there areas that would be interesting, there’s obviously another Chinese asset up for sale, so just curious just to your thoughts there.

James C. Foster

So without specifically answering that question; we’re quite active in M&A right now and I would say it’s across three of four different buckets. Yes, we’re looking geographically. We’re looking to expand some of our current service offerings with additional technical capabilities and we’re looking to expand the whole offering with some capabilities that we don’t have now and we continue to look entirely upstream. So, the whole focus is earlier as the drugs are developed, and perhaps more to come on that.

Gregory Bolan - Sterne Agee & Leach Inc., Research Division

Hi, Greg Bolan from Sterne Agee. So to follow-up on the earlier question on the In Vitro business, would you characterize the addressable market as kind of going from $50 million about three or four years ago, to about $200 million today?

James C. Foster

Yeah I think we’ve sized it about $400 million now.

Gregory Bolan - Sterne Agee & Leach Inc., Research Division

And is the multi-cartridge system included in that $400 million estimate?

James C. Foster

Yeah.

Gregory Bolan - Sterne Agee & Leach Inc., Research Division

Okay. And then just thinking again about the leverage ratio now seems low, what's the thought process between accelerating debt payments versus adding more to the share repurchase program?

Thomas F. Ackerman

Yeah, well we’re comfortable with our leverage ratio at this particular point in time. As we have mentioned in the past we have a split rating with the two agencies, one is investment grade and one is a couple of notches below and for a lot of reasons the other company is pretty comfortable with that. So, we did lever up to do a lot of share repurchases last couple of years. And as we look at capital deployment going forward, we’ll continue to buy some shares which we’re doing this year.

In terms of M&A Jim mentioned there is some things that we’re looking out, out there smaller type acquisitions we’ll look at the impact that, that has on our available cash and we’ll probably monitor our debt closely. We did talk about the convert briefly. We’ll be working hard to look at options for that next year which we have been doing already. So, now I think the company is pretty comfortable with our debt basically where it is.

Gregory Bolan - Sterne Agee & Leach Inc., Research Division

Thanks, Tom.

Operator

Thank you. We will go to the line of Ricky Goldwasser with Morgan Stanley. Your line is open.

Ricky Goldwasser - Morgan Stanley, Research Division

Thank you. Good morning.

James C. Foster

Good morning.

Susan E. Hardy

Good morning.

Ricky Goldwasser - Morgan Stanley, Research Division

So, Jim it sounds like your strategic partnership provides you with a lot more clarity and an insight into how your large customers are thinking about prioritizing to work. Has this change in anyway your overall view on the value given the type of work not necessarily the pricing and the margin structure for the PCS segment on a steady state perspective?

James C. Foster

Sorry Ricky, it’s really hard to hear your question.

Ricky Goldwasser - Morgan Stanley, Research Division

I can repeat it. Can you hear me better now?

James C. Foster

A little bit.

Susan E. Hardy

A little bit.

James C. Foster

Speak slowly.

Ricky Goldwasser - Morgan Stanley, Research Division

The question is really around, how the strategic partnership that you now have that gives you more clarity and more insights how large customers are thinking about their work. Has this change your overall view on the value and margin structure for the PCS segment on kind of like longer term basis?

Susan E. Hardy

Does it change our view on what Ricky?

Ricky Goldwasser - Morgan Stanley, Research Division

On the value and margin structure for PCS and it’s given the type of work that the large customer wants to do with you and not necessarily the pricing structure.

James C. Foster

So I think you’re asking about the additional large strategic deals and the impact it will have on operating margins in that sector going forward. And so if that’s the question, with regard to the preclinical assets and margins we’re aspiring from mid to high teens these days and I think we should be in the hunt to do that. Some of the services that we actually reported in the RMS sector particularly from our Finland and North Carolina facilities have higher operating margins and we would be quite confident that we would be able to maintain those as well.

Thomas F. Ackerman

Ricky what I would add and Tycho referred to that a little bit before is, certainly the strategic partnering environment is competitive from a pricing standpoint. Some of the benefits to the company are clearly the incremental volume which allows us to fill some of our space. We do collaborate quite closely with our clients and as smart as we think we're we have found a number of different ways to actually do the work more efficiently through our clients and interacting with them.

As Jim mentioned and we have already seen this in some small areas, there is incremental other work that can be gained outside the partnership and one of the things that we’re learning more closely with our partners in these particular areas is the importance of gaining consistent stream of work. So, our clients are coming to learn that better as we work more closely with them the value of providing forecast and a steady state of work that allows us to use our workforce and our space more consistently and keep running more smoothly.

So I think that, while that continues to be a competitive pricing environment, I think there are a number of other factors that will allow us to believe and as Jim said our margin will stay about where it is and improve into higher levels as we move forward.

Susan E. Hardy

We just have time for one more question. At this point we have other periods of time for question and answer later in the program.

Operator

Thank you. We’ll go to the line of John Kreger with William Blair. Your line is open.

John Kreger - William Blair & Company L.L.C., Research Division

Hi thanks very much, hopefully you can hear me. Just a follow-up question on the strategic discussions you are having. First of all the current strategic client; can you give us a sense of when you would expect that to get up to the 5% revenue range and then more broadly the other questions you’re having -- the other discussions you’re having with other strategic opportunities. Are you seeing those focused mainly on the discovery services areas or are you seeing a mix of both, regulatory and non-regulatory tox work?

Thomas F. Ackerman

So we’ll exit the year at the 5% run rate and we’re tracking nicely towards that pretty much according to schedule in terms of the protocols being transferred to us and that’s getting up to speed. So we’re quite confident and we’ve just reviewed that with them two days ago. Conversations with other clients are both sort of classic non-GLP discovery and also safety assessment. So I think we’re going to get some relationships that are one of the other or some that are both. That sort of space is being dismantled at multiple pharma companies, they’re taking vivarium space out that will impact all of that. So, on the safety assessment side, they have obviously known for years so we can do that, so that’s a little more straightforward. On the Discovery side, a lot of it has been getting the word out that we have those capabilities, particularly across multiple therapeutic areas. I think we will continue to see it in both lines of business.

John Kreger - William Blair & Company L.L.C., Research Division

Great. Thanks. And Jim, one quick follow-up, it sounds like you’re getting some nice list in your capacity utilization on the PCS side. Can you give us a sense about in aggregate how much more the business would have to grow before you just started bringing on additional staff?

James C. Foster

Additional staff? We’ve been bringing on additional staff this year, at a couple of our locations. So we’ve been running lean, appropriately lean and as new work has been coming in we’ve been adding staff to make sure that we have the capability to do that and we will continue to do so, mostly at the technician level.

John Kreger - William Blair & Company L.L.C., Research Division

Great. Thanks very much.

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