Charles River Laboratories (NYSE:CRL) Q4 2012 Earnings Call February 14, 2013 8:30 AM ET
Susan Hardy - Corporate VP of IR
Jim Foster - Chairman, President and CEO
Tom Ackerman - EVP and CFO
Tim Evans - Wells Fargo
Douglas Tsao - Barclays
Tycho Peterson - JPMorgan
Dave Windley - Jefferies
John Kreger- William Blair
Vijay Kumar - ISI Group
Andrew Schenker - Morgan Stanley
Garen Sarafian - Citigroup
Todd Van Fleet - First Analysis
Ladies and gentlemen, thank you for standing by. Welcome to the Charles River Laboratories Fourth Quarter 2012 Earnings conference call. At this time, all lines are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given to you at that time. (Operator Instructions). And as 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.
Thank you. Good morning and welcome to Charles River Laboratories' Fourth 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 fourth quarter and review guidance for 2013. Following the presentation, we will respond to questions.
There is a slide presentation associated with today's remarks, which is posted on the Investor Relations section of our website at ir.criver.com. A replay of this call will be available beginning at noon today and can be accessed by calling 800-475-6701. The international access number is 320-365-3844. The access code in either case is 278709. The replay will be available through February 23rd. You may also access an archived version of the webcast on our Investor Relations website.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 in our annual report on Form 10-K, which was filed on February 27th, 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 Investor Relations section of our website through the financial reconciliation link.
Now, I'll turn the call over to Jim Foster.
Good morning. I'd like to begin by providing a summary of our fourth quarter results, before commenting on our business prospects. We reported sales of $280 million in the fourth quarter 2012. Although, this was 3.7% below the previous year, the decline was due to the inclusion of the 53rd week in the fourth quarter of 2011 which had 4.3% to sales growth and also to the effect of foreign exchange which reduced sales sell by 70 basis points. When adjusting for the 53rd week on a constant currency basis, total sales increased by 1.3% in the fourth quarter with our net sales declining less than 0.5% in PCS sales increasingly approximately 4%. We were quite pleased with these results especially in lieu of that the fourth quarter of 2011 benefitted from strong year end spending by clients as compared to this year's fourth quarter when clients restrain spending.
These results underline our confidence that our market remains stable as well as the fact that we are gaining market share. Lowest sales volumes in RMS was the primary driver of the 120 basis point year-over-year consolidated operating margin decline to 15.9% and 17.1% in the fourth quarter 2011. Normal seasonality results in lower sales of research models and operating income is extremely sensitive to changes in volume.
Restraint client spending in this year's fourth quarter increased the impact on both sales and the operating margin. We have continued to focus on our process improvement initiatives which are enabling us to partially offset the impact of higher compensation cost, inflation, lower RMS volume, and cost associated with the start-up of new and expanded strategic relationships.
Earnings per diluted share were $0.64 in the fourth quarter of '12 compared to $0.69 in the fourth quarter of 2011. We generated less operating income as a result of lower sales although this was partially offset by a lower tax rate and stock repurchasing. We continue to return value to shareholders in the fourth quarter to our share repurchase plan with a purchase of approximately of 483,000 shares for $18.6 million. We repurchased approximately to 1.7 million shares in 2012, slightly higher than our last estimate of between 1.4 and 1.6 million shares.
As you know, we updated our sales guidance for 2013 in January when we completed the acquisition of Vital River to arrange between 4% and 6%. With our update to foreign exchange, we now expect that both reported and constant currency sales growth will be in the same range. We believe this anticipated growth will be driven by successful, targeted sales efforts which are enabling us to gain market share as well as the acquisition to that Accugenix and Vital River.
Our non-GAAP EPS guidance remains in a range of 280-290 or about 4% growth at the midpoint. As we discussed when we gave guidance in December, compensation costs and inflation as well as cost incurred in relation to new strategic relationships are expected to offset our cost savings and moderate earnings growth in 2013. Our fourth quarter results reflect a number of puts and takes, which are illustrative of the significant changes taking place in the bio-pharmaceutical industry. As they told us they would, many of our large clients most of which are public companies, restrained their spending as they endeavor to meet their financial goals for the year. At the same time, other clients increased their outsourcing effort as they moved forward with initiatives to gain efficiencies and cost effectiveness.
We continue to win market share in all three of our client segments, but some of the studies we expected to begin in the fourth quarter were postponed until 2013. However, taken as a whole, the fourth quarter performance was as expected and we remain confident in our guidance for 2013. Continuing discussions with our global bio-pharmaceutical clients reinforce our view that they will increase the amount of outsourcing and we intend to win the majority of the available work. We believe we achieved this goal in 2012 as demonstrated by the announced strategic partnership with AstraZeneca as well as the other strategic relationships which we won or renewed. In addition, we remain focused on our mid-tier and academic clients and expect to continue to take market share in 2013.
Investment community has asked repeatedly whether we believe our clients are refocusing their spending on early development activity. It's difficult to assess the overall market place and to separate our market share gains from increases in functional volume. But at least with regard to our global bio-pharmaceutical clients we believe that some of them are beginning to reemphasize early stage work. We base this belief on discussions with our client about where they're focusing their research as well as the types of studies they are placing with us and the volume of work. This is particularly true of regulated safety assessment. Revenues increased in each of the first three quarters of the year and we believe the moderate fourth quarter decline was a result of restrained spending rather than a change in direction.
One thing is certain, these global bio-pharmaceutical companies have accepted the fact that outsourcing will enable them to bring new therapies to market faster and at a lower cost, the challenge for them now, is to determine how they want to outsource and to choose the partners who can best support them with superior scientific expertise, best in class service and a flexibility to provide solutions that are tailored to each client's unique requirement. We believe we are extremely well positioned to be that partner and our market share gain suggests that our clients are great.
I'd like to provide you with details on the fourth quarter segment results. The RMS segment delivered sales of $171.8 million. As I mentioned, the year-over-year decline was due primarily to the 53rd week and foreign exchange and constant currency and excluding the impact of the 53rd week, sales decline was approximately 30 basis point. And on sequential basis, RMS sales increased by 3.2% approximately 1% to which came from Accugenix.
The table on slide 11 provides RMS sales by product and service line. You should note that going forward from 2012; we are realigning this disclosure in our 10-Ks and 10-Qs to show EMD as a separate business category. Avin vaccine which was formally reported with EMD and other products will now be reported in research model production. This affects only the RMS sales disclosure; it does not change what's reported in the RMS and PCS segments.
The largest RMS sales contribution in the fourth quarter came from our endotoxin and microbial detection or EMD business. Higher EMD sales were offset primarily by the model businesses both small and large. The large model business had continued to decline as we said it would when we gave guidance for 2012.
EMD business delivered an outstanding performance in the fourth quarter with sales growth of just over 20% including the addition of Accugenix. We are extremely pleased with the ongoing sectional performance of the PTS franchise. We continue to identify and penetrate new niche markets with the PTS which is increasing the number of units we are placing. The larger MCS is also selling well. So between the two product lines, we are generating higher sales of cartridges.
And with the expected launch later this year of the automated MCS or Nexus, we also hope to improve penetration of manufacturing central laboratory. Successful penetration of that market will drive even higher cartridge use and continued EMD growth.
We are very pleased with the Accugenix's acquisition which is performing ahead of our plan, in addition to the existing facilities in the U.S. when the process of establishing satellite testing facilities in France, Korea and India. This will expand our client's access to the Accugenix data base. And enable us to promote our services more broadly. Over the next several years, we intend to enhance our capabilities to both product expansion and acquisitions like Accugenix. We believe that execution of this strategy will advance our position as the market leader and endotoxin and microbial detection and enable us to continue to drive growth with the EMD business.
On an adjusted basis excluding the 53rd week in foreign exchange sales of research models decreased by 5.8%. As you know the fourth quarter is seasonally weak but the comparison to last year was compounded by the strong December we had in 2011 versus the softer December in 2012 as well as the expected continuing decline of sales of large models this year.
Our large biopharmaceutical clients continue to rationalize capacity which is no longer needed to the industry consolidation. Elimination of therapeutic areas, rationalization of pipelines or combination of all three. As a result, they are using pure research models; we have experienced this strength in North America for the last few years and recently observed it in Europe and Japan. However, as this consolidation is occurring we are seeing the corresponding increase in outsourcing as our clients replace internal capabilities with more flexible outsource resources.
We believe this is visible in our PCS results for 2012 and also in higher bookings in the fourth quarter of the year. As I mentioned on our December call, when clients outsource to us in lieu of in-house research, the associated sales to research models are reported as intercompany revenue rather than commercial sale.
Despite the softness in research model sales in the fourth quarter, we continue to expect that sales will increase in 2013. We base this outlook on information from our clients concerning their anticipated spending in our continuing market share gains across all geographies. Adjusted sales and model services including GEM, RADS, DRS and IS were down 70 basis points year-over-year against challenging fourth quarter comparison.
However sales increase sequentially where each of those businesses as a result of increase outsourcing, market share gains were about the growth rate for discovery research services or DRS flowed in the fourth quarter as a result of our client's restraint spending. As this is the case of research model sale based on indications from clients and potential new business opportunities we believe that the growth rate for services will also reaccelerate 2013. As the patent cliff continues to erode sale, bio-pharmaceutical companies will rationalize additional capacity and take further actions to implement a more flexible cost structure. We believe that they will increasingly outsource their early state testing to a partner like Charles River, because they achieve the flexibility they need without sacrificing science or quality. We believe there are two primary reasons that our clients choose to outsource the discovery testing to us - scientific expertise and breadth of our early stage portfolio, which enable them to outsource a broader segment of their discovery processes to a single partner. Expertise is critical to our client as they eliminate their internal capabilities and rely solely on a CRO.
Our expertise in the key therapeutic areas of oncology and CNS is a key differentiator between us and our competitors because the depth of our expertise is current unmatched by other CRO and because our portfolio is so focused on early stage research processes, our clients can outsource more to us take advantage of time saving as a result of fewer handoffs as well as attractive pricing as they expand the volume of work they do with us. We believe these two factors position us very well to gain market share and outsource discovery services at this pivotal time when so many of our large bio-pharmaceutical clients are making the critical decision to outsource. In total our DRS business represented just over 10% of total Charles River sales in 2012. I will remind you that approximately one third of our DRS revenue is reported in RMS and the other two thirds is reported in PCS.
When adjusted for the 53rd week and foreign currency at a 108.3 million PCS fourth quarter sales increased 4% from the fourth quarter in 2011 and 1.6% for the full year. As a result of our clients' restrained spending sales declined sequentially from the third quarter but we're down only 3.5%. We are very pleased with the improvement in our PCS sales this year, the first year since 2008 that we have reported growth. We attribute the growth in part to our market share gain including new and renewed strategic relationship and also to the fact that some of our clients are appearing to refocus resources on early stage process. The marketplace while still challenging is more predictable and, visibility has improved somewhat. The strategic relationships in which we are now engaged represent approximately 25% of total company revenues. This provides us better visibility than we have had in the past and because of the strength of these relationships better insight into our clients' planning processes.
Our facilities are operating at higher capacity utilization than the previous year and we are seeing some increased spot pricing.
We have no doubt that we are at an inflection point with regard to outsourcing by large biopharmaceutical companies. Discussions concerning additional strategic relationships are continuing as our clients grapple with the logistics as how and what to outsource. Our continuing focus on scientific expertise, operating efficiency and information technology platform and the fact that we will provide the structure which best meets each client's individual needs, positions us extremely well to compete for new business. We believe that our 2012 results are demonstrating our success with this strategy.
Our success at winning new business extents to our mid-tier and academic clients as well. Through our targeted selling strategies, we have forged stronger relationships with these clients and that have yielded returns.
Sales to our mid-tier clients increased to approximately 4% in 2012. Sales growth for academic and government clients declined 1% for the year, with a 1% increase in academic sale offset by lower sales to government clients. We have experienced lower spending in this group globally as the effect of economic uncertainty worldwide has restrained expenditures.
There has been less impact on our sales to academic clients, where market share gains are continuing to drive sales growth. We have been particularly successful with larger academic institutions in the U.S., which in general, are the beneficiaries of better and more consistent funding.
Our focus on our four key initiatives, improving profitability, increasing cash flow, investment in growth businesses and returning value to shareholders has been the foundation of our business strategy for the last two years and will continue to be. Our Profit Improvement Program generated $25 million of benefits in 2012 and we have targeted annualized benefits of $20 million in 2013
As operating profit increases so does cash flow and at $3.32 per share we generated one of the highest cash yields in the CRO universe 2012. We have used that cash flow to repurchase the stock and repay debt as well as to investment in our businesses which have the greatest potential for growth.
In 2012 we added new facilities for our END, RAD, CRS and BPS businesses and made strategic bolt-on acquisitions that extended our capabilities or expanded our global footprint. Accugenix is an example of the former and the Vital River acquisition which we closed in early January is an example of the latter.
We believe that Vital River will enable us to be a leader in setting the standards for research models and associated services in China a fast growing market for pharmaceutical research. We are experiencing a pivotal moment in time when global bio-pharmaceutical companies are reinventing the drug discovery and development models. We believe it's critical to participate in that process now so our strategy is focused on positioning Charles River as the preferred provider to outsource early stage drug discovery and development products and services.
We differentiate ourselves by a broad early stage portfolio which is unique in the CRO universe. Our extensive scientific expedites, our attention to client service, our best in class data systems and portals and our ability to structure creative, flexible solutions that support our clients goals and reducing the cost and improving the productivity of drug development.
We are dedicating ourselves to executing this strategy and to continuing to return value to shareholders.
In conclusion I like to thank our employees for their exceptional work, commitment and resilience and our shareholders for their support. Now, I'd like Tom Ackerman to give you the fourth quarter financial details.
Thank you Jim, before I recap our financial performance let me remind you that I will be speaking primarily to non-GAAP results from continuing operations. Reconciliation of non-GAAP items can be found in our press release and our website. Our fourth quarter performance was largely in line with our prior outlook. With the exceptional of favorable tax rate, operational trends track closely to the expectations that we discussed on our December guidance call.
Jim has already discussed the sales performance so I will begin my comments with the operating margin. Our consolidated operating margin declined by 120 basis point year-over-year to 15.9% in the fourth quarter but essentially in lined with our expectations. Lower margins in both segments were partially offset by a decline in unallocated profit cost.
The PCS operating margin declined by 90 basis points year-over-year to 12.1%. The fourth quarter 2011 operating margin benefitted from $1.7 million non-income base tax adjustment. Excluding this adjustment, the PCS operating margin would have increased year-over-year due to improved capacity utilization and prior cost savings initiatives.
In the RMS segment the operating margin declined by 150 basis points, year over year to 27.3%. This decline reflects the sensitivity of the RMS operating margin to changes in sales volume which was caused by the stronger client spending in 2011, as compared to restrained spending in 2012, particularly the small models. You may recall that we reported a 4 million inventory write-down in the large models business that negatively impacted the RMS operating margin in the fourth quarter of 2011. Unallocated corporate cost decreased by 1.6 million year over year and 0.6 million sequentially to 15.4 million in the fourth quarter. The year over year decline was primarily driven by the absence of the 53rd week as well as lower costs related to consulting services and performance based bonuses. Unallocated corporate costs represented approximately 6% of sales for 2012 and we continue to expect that we will maintain this level in 2013. At $0.64 for the fourth quarter and $2.74 for the year we exceeded our EPS guidance for 2012, primarily driven by a favorable tax rate in fourth quarter.
Our fourth quarter tax rate was 20.6%, 360 basis points below the fourth quarter of 2011 and 510 basis points lower sequentially. Discrete tax benefits as well as higher than expected R&D tax credits in Canada reduced our tax rate which was the primary driver of the EPS upside. These discrete benefits are not expected to repeat so we continue to forecast a non-GAAP tax rate between 26.5% and 27.5% in 2013. As expected net interest expense of 4.4 million remained relatively stable on a sequential basis in the fourth quarter and declined approximately 1.5 million year over year. For 2013 we continue to expect net interest expense of 17 to 19 million. We are working to finalize plans to refinance the (inaudible) and intend to keep interest rates low under any refinancing alternative.
Our 2013 guidance assumes that our cost of debt remains at relatively consistent levels for 2012. Our four key initiatives to improve shareholder value remain intact and continue to guide our overall strategy. Our progress in 2012 was focused on growing a stable base of larger clients that is integral to achieving our longer term financial goals, while continuing efforts internally to improve operating frequency. We believe our commercial efforts were successful as demonstrated by the strategic partnership with AstraZeneca, business, awarded from several other large clients and market share gains in mid-tier and academic accounts this led to adjusted sales growth of 1.9% for 2012 when excluding foreign exchange in the 53rd week.
We also made progress on improving operating efficiency through our Profit Improvement Program, for which we met our goal of more than $25 million in incremental cost savings in 2012. These savings does not always drop to the bottom line, in 2012 the normal annual cost increases coupled with headwinds from new strategic client relationships resulted in a consolidated operating margin that was relative stable at 17.5%.
We continue to generate strong free cash flow in 2012. Free cash flow increased by $6 million to $50.6 million of fourth quarter 2012 driven by lower capital expenditures. For the year, we generated free cash flow of $160.5 million or $.3.32 per share which was an increase of $3 million over 2011 and within our guidance range.
We continue to expect free cash flow of $165 million to $175 million in 2013. We also continue to focus on discipline capital allocation. 2012 capital expenditure totaled $47.5 million and we expect to spend approximately $50 million in 2013.
In 2012, we completed a new diagnostic laboratory in Wilmington to support growth in our RADS business and move to a larger discovery facility in Finland to support our growth in the CNS therapeutic area among other projects. We continue to evaluate acquisition candidates and as you know completed the acquisitions of Accugenix and Vital River within the last six months. Accugenix contributed nearly 2% to the RMS year-over-year sales growth in fourth quarter, which was slightly ahead of our acquisition plan. Integration of Viral River has progressed well in the first post-closing and we are confident that this is the appropriate time to enter the Research Models and Services market in China.
In addition to capital expenditures and acquisitions, our capital priorities were balance in 2012 between stock repurchases and debt repayment. For the year, we repurchased a total of $1.7 million shares for $61.4 million including 483,000 shares in fourth quarter. Since the inception of our stock repurchase program in 2010, we have bought back 30% of our outstanding shares and expect to repurchase another 1 million to 1.5 million shares in 2013. At the end of 2012, we had %54.8 million outstanding under our current stock repurchase authorization.
We also reduced that total debt balance by $51.4 million in 2012 as we repaid debt modestly ahead of the schedule installations on the term alone. We are comfortable with our leverage of $666.5 million at the end of 2012 or approximately 2.5 times EBITDA. Our goal is to maintain our leverage ratio at approximately this level in 2013.
Our debt activities in 23rd will include refinancing to $350 million, 2.25% convert and schedule payments on the term loan. Overall we believe our accomplishments in 2012 continue to position us by sustainable growth and long term shareholder value creation. One example is our free cash flow to invest the capital return which increased 90 basis point to 12.6% in 2012.
As Jim discussed we are updating our sales and reaffirming our EPS guidance for 2013. We increased our sales guidance by approximately 1% in January to refract the completion of the Vital River acquisition and expect constant currency sales growth to be 4% to 6% in 2013. We have also updated the foreign exchange impact to near current rates. We now expect the FX impact to be negligible compared to the previous 50 basis point headwind.
As a result, reported sales growth is expected to be the same as constant currency growth of 4% to 6%. Our 2013 EPS guidance range of 280 to 290 remains unchanged from December. Our sales expectations for the first quarter are in line with the outlook that we provided on our December guidance call. At that time, we said that we expected a slow start to 2013 as a result of the same trends that cause clients to restrain spending ahead of year end as well as our clients usual first quarter budget allocation process.
Since the beginning of 2013, we have experienced continued slow spending globally. However, we still expect our RMS sales to increase significantly from fourth a quarter level which is consistent with the seasonal trend and for PCS sales to be slightly higher sequentially. The first quarter tax rate is now expected to be at the higher range of our forecasted range of between 26.5 and 27.5%.
This is due primarily to a retroactive tax law change that was recently enacted in a foreign jurisdiction. The tax rate is expected to normalize for the remaining three quarters in 2013.
To conclude, we are pleased with our performance in 2012 and remain confident about our outlook for accelerating sales growth and higher earnings per share in 2013.
That concludes our comments. Cynthia would you please take questions now.
Thank you. (Operator Instructions), we'll first go the line of Tim Evans from Wells Fargo, please go ahead.
Tim Evans - Wells Fargo
Jim could you maybe tell us what's going on with small models, there was a statement about that in the press release, and then I would also be curious as to, if you can give us an update on conversations you're having with potential new strategic partners.
Sure, small models continue, the fourth quarter we had a slowdown pretty much across the board with globally we had restrained spending by our clients who told us that that would be the case and it was, so that in impacts small models as has site closures and therapeutic area realignments. We also obviously had difficult (inaudible) and we had an unusually strong fourth quarter of last year, particularly December.
We indicated that the first quarter of this year would be a little bit slow as well, although we did indicate that research model sales would be up meaningfully in the first quarter. The quarter seems to have started as we thought. January feels like December these days, takes people a long time to get back to work, researchers and the budgets to be finished and there is all of these allocation of studies internally and externally but we're getting a sense that things are beginning to tick up. Our sense going forward is that we'll continue to get price, probably 1-2% that we'll continue to get market share worldwide. I would say the emphasis on market share gains would be academic gains in the U.S., gains in Europe, particularly in the UK and continue to take share in Japan which we've been doing for the last two or three years.
Our clients are talking to us about more spending in early development and also in early discovery. Obviously if that happens that generates additional research milestones and I guess that the last thing that we said in our prepared remarks and also in our last call, it's important to note, is that as we, win additional large deals whether the multi-year or individual-year, or even month-month, the work that we were doing with external clients and providing them with the animals, we are now doing ourselves providing ourselves with the animals so those sales now are inter-company based. So, we continue to feel that, we'll have at least low double digit growth in the basic research model's business that's what our service is affiliated with it.
On the strategic deals, we have been very clear recently to try describe those in more comprehensive way, so we have several multi-year deals that are signed and some of them we're are talking about, we also have annual deals, in other words we have relationships with clients, contract with us or an annual basis, then we re-up those and we have some clients who work with us from study to study. In the aggregate, those are about 25% of total sales which is improving our visibility.
I believe we will continue to sign deals like this, we won't be able to announce them all because the clients won't let us and it's going to get a bit tedious but I would say it's a continuous process, we've had several wins recently. some of those were just re-outs of work that we had that was being re-did, one of those was incremental work but we had thought that we would got is already planned for our guidance but I would say it's a continual process and a continued emphasis of us and that we are continuing to prevail in many of these conversations.
Our next question comes from the line of Douglas Tsao with Barclays. Your line is open.
Douglas Tsao - Barclays
Hi Jim. As your business increasingly turns towards discovery services, which is often, or generally, I would argue, a more dynamic segment in terms of technological advances, I was just curious how you were thinking about keeping Charles River at the forefront in that segment in terms of potentially your own internal R&D efforts. Or is this something in which you will largely remain acquisitive and on the hunt for small, innovative companies and bring technology and sort of services that way?
Historically our pure R&D has been principally in the EMD space, we are innovating there all the time and we have strong IP in that space and it's important to have new generations of products.
I'd say that in the rest of our business both discovery and research model space, while we had some pure R&D expenditures, that's really not the way we kept up technologically which as you say, we of course have to. I would say that a lot of our acquisitions, particularly some of the small ones are specifically to gain those sorts of technologies. So we're either buying into those technologies or licensing them in.
I would say that Accugenix is a technology deal. I would say that our M&A activities right now which are pretty robust in terms of the types of businesses that we're looking at, most of which are upstream, a very much technology base and I think that going forward, you will see a sort of a greater combination of efforts between our DRS business where we branch out both further in CNS and oncology, but also other therapeutic areas, in our core laboratory business where we do and more bio market work and intermodal and also in our quest to have model creation abilities. And yes, I think the vast majority of that would be externally sourced and acquired.
Douglas Tsao - Barclays
Do you hope that the trends you're seeing in terms of in the productions business between outbred rats and the inbred models?
Yes, I didn't address that specifically outbreed rats continues to be very much tied obviously to toxicology. I did emphasize in my answer the fact that a lot of the strategic deals that we're getting both multi year and single year where we're selling those animals essentially to ourselves are showing up in intercompany and part of our overall sales effort. And upper rat sales have definitely stabilized for a while now. I would say some of the inbred rat strains continue to increase on a unit basis similarly with some of the inbreed mouse strains. We are also getting a little bit of next.
Douglas Tsao - Barclays
And then, Tom, so the Vital River acquisition is going to add about 1% to the sales guidance? And so why didn’t we get a full percentage increase to the overall consolidated revenue guidance?
Well we that in January, I think a JPMorgan we did that, that's right. So originally three to five constant currency at JPMorgan, we bumped that up to four to six.
Next we'll go to the line of Tycho Peterson from JPMorgan, your line is open.
Tycho Peterson - JPMorgan
Just wanted to follow up on some of the trends for RMS that you highlighted, can you just talk about whether all the drop-off is volume related. I know you talked about your expectations for 1-2% price increases. So can you also talk about whether you've been able to implement them at the beginning of this year?
Yes, our price increases go into effect, I think we informed our clients in December. We have them a month's notice. Obviously some of those price increases are impacted by larger deals that we have with clients where they're either price protected or they don't pay the full discount and that's why we haven't been reporting the full discount. But we're going to get sort of 1-2% this year. We'll have some share gains obviously some of that share gains that will be fewer units and that'll be unit mix. I'd say that some of the strands we have had some unit declines which is the result of just overall pullback in spending that we saw particularly in the fourth quarter.
Tycho Peterson - JPMorgan
Okay, and then your expectations for rebound in that business this quarter, how much of that is predicated on things getting better in Europe and Japan versus just normal seasonality?
It's very much a combination of normal seasonality and absolutely global spending pullback by the big pharma companies, our clients tend to move as a group and similarly we saw unusually high spending in the fourth quarter pretty much across the board globally by our clients. So, we feel that that will pick up meaningfully for both reasons in the first quarter.
Tycho Peterson - JPMorgan
Then can you just talk a little bit about expectations for Endosafe? I mean, you talked about the Nexus launch later this year. How should we think about that ramping in the back half of the year and what is kind of baked into your expectations?
I'd be careful to over analyze those. As we introduce new products and this is an automated product which will increase throughput in the central laboratories. It will enhance that whole product line particularly from a cartridge unit basis. The best way to look at that whole business is that, it's going to be double digit growth for the next few years at least, combination of growing share, introducing new technologies and essentially staying ahead of the market, also as we moved into microbial detection through our Accugenix acquisition, we've opened up larger market opportunities which will clearly benefit that business.
Tycho Peterson - JPMorgan
Lastly, to clarify, you had talked about spot pricing increases in December. You mentioned it again today. Is there any kind of meaningful underlying trends here that looks like it is improving as we start out the year, or is it just very sporadic at this point?
It's hard to tell, we don't want to over say this, in situations where we don't have very large deals that are locked in, particularly as capacity have continued to get tighter, we have testing pricing and are periodically getting it, if that periodically turns into something more consistent then it will obviously be terrific, but there is obviously going to be some correlation between available capacity and our ability to get a greater price. So we will continue to test that and hopefully continue to have pricing be more of a part of this business going forward.
Next, we'll go to the line of Dave Windley with Jefferies. Your line is open.
Dave Windley - Jefferies
I wanted to follow-up on Tycho's question there. Jim, it seems to me from your descriptions that the real opportunity for growth in this business is going to be share gains, but particularly through broader strategic relationships. Those relationships bring with them, I think as we saw with Astra Zeneca, some amount of price concession for the volume that the client is bringing to you. I guess I'm interested in your drilling in just a little deeper to help us to understand the puts and takes on pricing. Is it net positive because utilization and spot is improving, or is it going to be net negative because the mix of your volume is shifting more toward these protected-price strategic relationships?
Yes, these strategic deals are again whether they are multi-year or single-year or even shorter periods of time, sometimes we just prefer a provider. And one of our top five clients doesn't want a multi-year deal but we get virtually all of the work and obviously that's fine. Look, we've always given better prices for volume and I suspect that we always will and that's across the board in all of our products and services. So that's really nothing new. In the strategic relationship, as we have indicated, particularly for the very large complex one we're probably going to have some start up drag in margin and the revenue will come more slowly as we're learning to run the protocols and assays.
In the very earliest deal that we announced, we did that work in very aggressive margins and it's proven out over the last year to have very attractive margins given the total volume and mix of studies and other work that we were doing for these clients. So, the margin we still think it's very positive in terms of getting share, having closer partnership, definitely invigorating the top line and if we are good and if we execute well and if we drive efficiency which we're definitely committed to, while we hope to get price and we just talked a little bit about it. We can't guarantee that. So it's going to be volume and efficiency, we do continue to think that we cannot just drive the top line but continue to improve our margins. so it all conspires, I wouldn't care if you are inferences, we just would never back off of pursuing these ideals the client face particularly with the very-very large clients is relatively small.
There's a small number of clients left that probably before the consolidation will certainly be significant, dramatic additional outsourcing and to be the beneficiary of that outsourcing and it's extremely powerful and positive. And then it's up to us to drive home the value proposition. I can just tell you that every business in this company is spending a significant amount of time driving productivity and driving efficiency and doing everything they can to contribute to pushing margins going forward given our basic assumption that pricing is possible that will be a challenge.
I would just add a couple of things to that so in addition to the efficiencies either because of our familiarity with a specific client or general efficiencies across the board and more work in the parameters of the arrangement, the partnerships are agreements themselves tend to be more narrowly defined along a certain path and studies as you might imagine. And so as we move outside of those particularly defined studies, we have additional benefits to price goes a little bit more abrasively.
In addition to that, Jim talked about more volume; a lot of these are master agreements where they provide the incremental discounts across all of their buying. so it does provide for an ability to actually pull in more work in other areas of the company as opposed to just for instance in life work, so.
Dave Windley - Jefferies
Okay. And switching gears then, as I look back through my notes, I think the automated MCS, or Nexus, I believe you are calling that now, at the investor day in the late summer, was expected to launch in the second half of 2012. At JPMorgan, you talked about the first half of 2013. And today, you said later in 2013. I don't know if that means just later here in the first half or if you mean the second half of 2013. I was hoping you can kind of describe what is going on there. Is there an approval that you are waiting on externally or something like that that is impacting the launch date of that product?
Yes, Dave, these products, they're complicated; there's lots of hardware and complex and innovative software. We like to alpha and beta test these thoroughly, obviously before they go out and we often get really good ideas from our clients on additional enhancements. So we still think it'll be in the first half. Its lead a quarter or so, its fine as it tried to indicate when I was answering the last question. These additional products will have a subtle impact on the overall volume this year and mostly on the cartridges and obviously we will always delay a product to make sure it's as perfect as possible before we launch it, and I think it's all part of the wonderful world of software, trying to call the launch dates properly.
Our next question comes from the line of Himanshu Rastogi, your line is open.
Staying with the DCS segment and thinking about the evolution of EBIT margins in that segment, assuming you’ve even won Astra Zeneca life partnership every year, is the mid-teens target attainable over the next few years? And for my follow-up, how is that partnership evolving? Thank you.
Just to clarify the question is as an example on the AZ partnership, are mid-teens margin's achievable. And obviously which will be beneficial to the overall margin. While I would go back to some of the points that both Jim and I just raised, based on one of Dave's question where, these things are priced aggressively as you might imagine, that’s probably the genesis of your question. We do, as Jim said, believe in participating with our clients, particularly in these multi-year deals, it does increase our capacity utilization, it does provide stability and visibility over an extended period of time. So, I think it’s really important to participate.
The RRP process is aggressive as you said, so we are pricing these to make good margin, margin somewhere in the range of where and as we both pointed out, I think the opportunities to improve that lie with higher volume, gaining an understanding of that work and in some cases these clients work is a little bit different to us from some of our other work doing it better, general efficiencies across the board, looking to extend this master services type agreement into other areas of business in the company where we can provide incremental work and say other areas of the company products and services.
And also as I mentioned, these profiles of competitive RRPs are somewhat narrowly defined along certain study bands because each study is while similar, different in many regards. So it’s nearly impossible to provide an RRP that considers every type of possible study that might be done in the agreement. So, once you sort of start moving away from that band, pricing is less defined and therefore we have an opportunity to improve that. So, I think, the long answer to your question is I do think that we can continue to improve our margin and deals like AC and across pre-clinical and part of that depends more broadly speaking on pricing trends and capacity utilization and things like that as well, for which over the long haul we do think will improve.
And how is the partnership with AstraZeneca evolving?
How’s the partnership going? Partnership is going extremely well. We have very-very close scientific ties with AZ. And we are kind of using each other interchangeably; I think they look at us as AZ folks. So, communication is very close, we have people working together and discussing transfer of work daily, we continue to be very enthused with the long-term prospects for the relationship.
Our next question will come from the line of John Kreger with William Blair. Your line is open.
John Kreger- William Blair
Jim, could you just expand upon the comment you made earlier that you are seeing some signs of clients reemphasizing early-stage work? That is a very intriguing comment. Just maybe expand upon what are the sort of things you are seeing?
We constantly ask them what the allocation is to spending between the clinic and earlier development work and even though in discovery work we've had a significant number of clients indicate that their emphasis while shifting and had shifted. We can also tell a little bit about this ship, if you look at early development based upon the increase in regulated preclinical studies, the nature of those studies and also to a lesser extent I suppose how some of the discovery work is coming. We are a pretty good mirror image of clients spending particularly on a global basis because we do so much work with so many of them. So, that would obviously be quite positive for us if that realignment is spending between the clinic and some of the earlier activity.
John Kreger- William Blair
And then as a follow-up, if you look across both your businesses, are you seeing any change in model usage per compound? Is that going up or down or pretty stable?
I wouldn't say we've had any discernible changes in model usage.
Our next question will come from the line of Ross Muken with ISI Group, your line is open.
Vijay Kumar - ISI Group
This is Vijay for Ross. Thanks for taking my question. Jim, I just want to dig in a little bit on RMS and the comment that you made, saying volumes were down and you were beginning to see this trend in Europe and Asia, while US has been weak for several years now. I am just trying to put that in perspective. Are that Europe and Asia will sort of mimic what we have seen in the US for the next few years?
It's difficult to predict that, sometimes you Europe and Asia follows the US, but I think the phenomena we saw in the fourth quarter much, just a pullback in spending by all the drug companies on a global basis. We would be surprised if we don't continue to get competitive win, share gains, both of those look held as we happen for the last few years given the weakness of some of the competition there. We are also getting price in those locals as well. I think those locations albeit smaller are still in some ways a little bit stronger in a growth rates versus the US and I wouldn’t expect that we have any sort of dramatic change in the slope at the current time.
Vijay Kumar - ISI Group
Could you just walk us again through the sequestration assumption? If we do have a sequestration now, sort of what would be the impact or what do you guys think could be the impact?
We have a relatively small amount of our sales, specifically to the government. We only sales to NIH like everybody else and then we have a lot of government contracts, but again in the aggregate that's a relatively small number. I think it's unlikely that they're going to slash ongoing contracts particularly for, most of those are for basic animal models used for basic research which I think is pretty important part of structured research within the government. So we think that's unlikely. It's more likely to have a greater impact on things that, new contracts being let, it could have some modest impact I suppose on work directed from the NIH. But our total sales, we don't break it out for US. So I was going to say our total sales for academic and government are probably about 24%, but that's worldwide. We have a lot of government sales in Europe so I don't have the number at my fingertips but the impact if any, will be very modest.
Our next question will come from the line of Robert Jones with Goldman Sachs, your line is open.
Hey, it's Adam calling in for Bob. Just wanted a little more color on strategic partnerships, you spoke to 25% of your total revenue coming from strategic partnerships, not assuming any further partnerships what do you think the number could get to with regards to expanding your current footprint with existing partners.
That's a bit of an imponderable. Obviously we will work hard to have as many strategic relationships as possible. again whether they're multiyear or not is not particularly relevant, the point is that if you have a relationship with the client and you're either the sole source of providing work for them or the primary source of providing work for them, I've seen a lot of cases, we have that, we just got word actually this week of re-upping with a large client that we already had and working out to RRP and we're getting that on a sole-source basis. That gives you very increasingly better visibility and predictability of our business model. It also gives you better opportunity to work on pricing and also to plan for future capacity utilization. So, I don’t know what that number is going to be. We'd like it to be as large as possible because that means that we have enhanced relationships with our clients.
Just also to ask around the RMS margins, definitely somewhat disappointing relative to our numbers and the street numbers for four Q, how do you look at those going forward and was this just more completely volume and seasonal-based?
With specific as to what, I am sorry?
I am saying were the 4Q margins as, I think complete the non-GAAP was at 27.3% which was the lowest since 2008, so do you see those re-accelerating up to 30%, or is that possibly in the high-20s is the kind of normal?
No we do, I mean what we said in our December guidance call is that we expected our margin to be really in line year-over-year, I know it was a little bit lower than normal in the fourth quarter but of course the fourth quarter is typically low which I am sure you are aware this fourth quarter was a little bit lower. We did talk about that in December and a little bit earlier about seeing a little bit of pull back due to clients trying to meet their budgets at yearend and what not. So I do think other than we said about a little bit of snow is out of the gate in the first quarter, we do expect to see margins be pretty normal and stable overall in our mess year-over-year.
Our next question comes from the line of Ricky Goldwasser with Morgan Stanley. Your line is open.
Andrew Schenker - Morgan Stanley
This is Andrew Schenker in for Ricky. Just to follow-up on the margin discussion. I know you guys did discuss this in the December call, but you are expecting margins to be flat, even with benefits from the profit improvement program and increased sales. So maybe a way to word this a little differently is what do you guys think it will take to see margins expand going forward? Is it strictly a volume issue, and kind of what is that magic point where volumes kind of exceed annual cost increases maybe?
I think it’s a combination of continued volume growth, we have to work hard, continue to work hard on efficiencies but even with efficiencies we do have cost increases every year. So that’s given the limited volume increases they would had it makes very difficult to improve margin when you are not getting substantial volume or pricing so I do think we need some pricing. I think that environment will get a little bit better as we get more volume and the industry gets more volume. So, I think really it’s a combination of considering to be diligent on efficiencies, continuing to improve the top line, be it volume ultimately as capacity gets better we need to start seeing some price increases.
Andrew Schenker - Morgan Stanley
And just following up on that, you did highlight another $20 million on the profit improvement program. In which buckets is that $20 million going to fall? And then thinking forward is there more upside to that going forward as you increase your attention on efficiency or continue your attention on efficiency?
Yes there is. Obviously we talked about that for 2013 in our original guidance and talked about some of the offsets for that like normal merit increases and some inflation from some of our vendors and things like that. So I think that's the kind of thing we are going to do every year just to offset, merit increases and things like that. A lot of that would be in PCS. I think that's probably the number one area, we obviously have a number of saving in RMS as well as corporate but I think In terms of ranking that, PCS would be the rank order number one and then RMS in corporate.
Our next question comes from the line of Garen Sarafian with Citigroup. Your line is open.
Garen Sarafian - Citigroup
A couple follow-ups. One is on your strategic partnerships. You mentioned the headwinds as you invest in the relationship with these strategic partnerships. I'm just wondering, do you have anything contractually stating some sort of a volume minimum or dollar minimum so that down the road that you are assured that these investments are going to pay off?
We actually don't have dollar minimum, I can just tell you going back to the first big one we announced. We were negotiating a dollar minimum right up to the last moment. Clients decline was very resistant to that and I think given the dynamism in the pharmaceutical industry with the massive changes that they have constantly of management and drugs selling and changes in therapeutic areas that just hate that. It's not comfortable for them.
And I remember in the last day they said that you can be confident that you will get the volume that you are asking for, we just can't contractually commit to it and I know that sounds odd. And I think the only sort of euphemistic or the only example I can give you is that actually on the anniversary of that deal, the dollar amount came out exactly as we had requested and that they had confirmed, albeit not in writing.
So, yes, I suppose it would be better but not if the clients was uncomfortable by that and not if the client wouldn't contract with us so. I think we get a lot of these deals because we're flexible and because we're thoughtful and because we don't push those things too hard. I understand the essence of your question is that there needs to be a payoff at some point for taking on this work and obviously we agree with that and so far the progression of these relationships has been quite positive and there is an opportunity for us as I said earlier, through driving efficiency and also through the Nexus studies and or other work across our products and services portfolio that do have an opportunity to enhance both the top line and the bottom line, so we continue to feel really good about our ability to impact the contribution that these large deals will make almost as much as the clients do.
Garen Sarafian - Citigroup
Sort of related to the strategic partnerships, with nearly 25%, you are fortunate that these relationships bring in business. But could you just perhaps talk about the competitive environment, maybe from your smaller competitors that do not have these partnerships? And with the volumes still into 2013 not yet picking up, how are your competitors reacting to fill their capacity? Just overall pricing pressure, are you seeing anything change?
Not really, we have smaller competitors whose capacity is definitely not very those who are very aggressive on price. Here’s an anecdotal example for you. We just won some work this week from a large client that we already had but it was competitively bid, and we were not the lowest price, and so as we say, every time we talk to you folks, science is the most important thing to our clients, and in the final analysis it really is so, we know what our walk away point is, we know how much we are willing to be aggressive with pricing on the downside, we also know at what location the volumes would be most beneficial, but we’ve been able to compete very effectively for the last year or two with very large comparison, very small ones, almost regardless to the pricing that they throw at us. And as I said with this anecdotal example, we stopped because the client wanted great science, we knew that the price point we were giving them, we could deliver that great science and we got the work even though we weren't the lowest price. So lowest prices doesn’t always prevail in this market, sometimes it does, sometimes we are the lowest price. But we do that always with our eyes open.
Thank you. And our final question comes from the line of Todd Van Fleet with First Analysis. Your line is open.
Todd Van Fleet - First Analysis
Jim, the free cash flow yield of the Company is pretty attractive. The growth profile for the Company overall is relatively steady. Acquisition appetite you guys have seems to be more kind of the bite-size than something that is more significantly sized these days. So I'm wondering at what would the circumstances have to be before Charles River would consider paying out a cash dividend to investors.
We take a look at use of cash all the time, we actually have board committee that discuss that along with common eye. It's hard to characterize acquisitions because I think our acquisitions are supposed to be quite good and we could have a larger number of small deals. We could have a more modest sized deal. We have no intensions of doing anything gigantic, but we could upsize the deals a little bit. Again that would always be the best use of our cash for strategic accretive acquisition which help us to grow and service our client. If for some reason we were sitting here and had gone, I don’t know - a couple of three years without doing any acquisition and cash flows mounting and we thought our leverage was where we wanted to be, I suppose we could determine that dividend would be the best use of cash at the time or buying back stocks. So it's always circumstantial, we always look at all of the possibilities - continue on. You know what our preference is, but we have a responsibility to utilize our cash responsively and gives you a hope of best return. So I would never say we would never do anything and so we will continue to watch it, although I would have to say there are M&A pipeline that's unusually strong because we have been working on it very-very hard and I was seeing some things now that are of significant strategic merit.
With that speakers I'd like to turn it back over to you for any closing comments.
Thank you for joining us this morning. This concludes the conference call.
And ladies and gentlemen, that does conclude your conference call for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.
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