Charles River Laboratories: Headwinds Ahead But That's Okay

Summary

• Charles River reported Q3 2019 results that were well-received by the market. The company beat on the bottom-line but slightly missed the consensus revenue estimate.
• Acquisitions and investments in operations are expected to be earnings headwinds over the next few quarters. However, I believe that the headwinds will be short term in nature.
• Long-term shareholders should consider staying the course because, in my opinion, CRL shares will outperform the broader market over the next 18-24 months.
• This idea was discussed in more depth with members of my private investing community, Going Long With W.G.. Get started today »

Charles River Laboratories' (NYSE:CRL) stock has performed well lately but shares are still lagging the broader market by almost 4 percentage points over the last 11-plus months.

Data by YCharts

However, I believe that the underperformance has created a long-term buying opportunity because, in my opinion, Charles River's most recent operating results (and guidance) show that this Contract Research Organization ("CRO") company is well-positioned for 2020 and beyond.

The Latest, Solid Results Even After Factoring In The Headwinds

On November 6, 2019, Charles River reported Q3 2019 results that beat on the bottom-line estimate but that missed on the top-line. The company reported adjusted EPS of $1.69 (beat by $0.05) on revenue of $668.0M (missed by $6.1M), which also compares favorably to the year-ago quarter.

Source: Q3 2019 Earnings Presentation

Highlights from the quarter:

• Top-line growth of 14.1%, with solid organic revenue growth of 7.9%.
• Adjusted operating margin of 19.4%, which was a 60bps improvement from year-ago quarter.
• Free cash flow increased by 27.3% YoY to $120.7M.
• GAAP EPS increased by almost 20%, while adjusted EPS increased by 16.6%.

The earnings growth was largely a result of margin expansion due to a positive mix in business, in addition to improvements made to the company's cost structure. The investments made over the last few years, coupled with the numerous acquisitions, have put Charles River in a position for future growth and greater operational efficiency. To this point, let us consider the YoY changes for each of the 3 divisions (i.e., Research Models and Services, Discovery and Safety Assessment, and Manufacturing).

	Q3 2019	Q3 2018	% Chg
RMS
Revenue	$132,546	$126,811	5%
Operating Income	34,385	32,121	7%
Operating Margin	26%	25%	2%
DSA
Revenue	420,079	352,257	19%
Operating Income	64,995	62,909	3%
Operating Margin	15%	18%	-13%
MANUFACTURING
Revenue	115,326	106,227	9%
Operating Income	39,253	33,266	18%
Operating Margin	34%	31%	9%

Click to enlarge

Source: Data from 10-Q; table created by author

As shown, the operating margin expanded for 2 of the 3 divisions with DSA being the outlier. The takeaway is that the high margin divisions, RMS and Manufacturing, are already firing on all cylinders, which is a great sign as the company heads into 2020.

DSA is a different story. However, let's remember that management is still working hard to integrate several acquisitions, and most notably Citoxlab, so the margin pressure for DSA should be viewed as a short-term headwind. This factor also contributed to management updating their full-year 2019 guidance.

Source: Q3 2019 Earnings Presentation

Notice the non-operating charges/adjustments expected over the next few months. From an adjusted EPS standpoint, earnings are expected to be slightly higher than the previously communicated guidance but the charges/adjustments will likely create a lot of noise in the numbers. But, remember that these headwinds are related to meaningful investments being made now that have the potential to be catalysts in the quarters and years ahead. When taking a step back, Charles River's strong revenue growth profile and improving cost structure (after factoring in the acquisitions/investment headwinds, of course) show that the bull case remains intact for this small-cap CRO company.

Additionally, Charles River was able to refinance its debt during the quarter, which will have a significant impact in the years ahead. The company issued $500M in long-term senior notes at a very attractive rate of 4.25%. This transaction will put the company in a position to support its long-term growth strategy of acquiring promising assets/businesses in key growth industries.

The Story Remains Intact

Charles River is a top-CRO company that operates in a broader industry that is expected to experience strong growth in the years ahead.

Source: Format Medical Research

Source: 2019 Investor Day

Specifically, Charles River's management team believes that the company operates in an over $15B addressable outsourced market. And according to management, Charles River is the top positioned company in the early-stage research and manufacturing support solutions.

For years Charles River has appeared to be well-positioned for the future but management did not sit on their hands and just hope that everything would fall into place. For example, Charles River has invested around $2B in strategic acquisitions over the last 4 fours.

Source: 2019 Investor Day

These acquisitions not only put Charles River in a great position but they are also already major contributors to the company's operating results. To this point, management highlighted the fact that the company has already generated ~10% ROIC on these acquisitions since 2015.

Charles River should be viewed as a company with a solid, defensive business that also has a great long-term story to tell.

Valuation

Charles River's stock is trading in a reasonable range based on the company's own historical metrics.

Data by YCharts

CRL shares are not cheap by any means. However, I believe that Charles River's story gets even more impressive the further that you are able (and willing) to look out. Plus, let's remember that management is investing for the future so the company is contending with earnings headwinds that will eventually become tailwinds. Therefore, this small-cap company has the potential to more than grow into its current valuation in 2020.

Risks

Investing in small-cap companies comes with many risks, but the major risk for Charles River is related to the company's reliance on pharmaceutical and biotechnology companies. If these companies cut back their operations and/or outsourcing needs, Charles River's business would be negatively impacted.

Additionally, the company's growing debt balance should be closely monitored in 2019 and 2020 (even with the lower interest rate). Please also refer to Charles River's 2018 10-K for additional risk factors that should be considered before investing in the company.

Bottom Line

Charles River has a strong bull case and the company's story keeps getting better. There was a lot to like about the company's Q3 2019 results (and full-year guidance) so I believe that investors with a long-term perspective should seriously consider at least adding CRL to their watch lists, especially if the earnings headwinds eventually create downward pressure for the stock.

Author's Note: I hold CRL shares in my R.I.P. Portfolio and I have no plans to reduce the position in the near future.

Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.

Disclosure: I am/we are long CRL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.