Charles River Labs: The Short-Term Headwinds Will Eventually Be Long-Term Tailwinds

Summary

• Charles River reported Q1 2020 results that beat the top and bottom line estimates.
• The COVID-19-related headwinds will impact Charles River's results over the next few quarters, but the company is positioned to eventually benefit from the disruptions in the industry.
• This small-cap drug discovery and early-stage development company has a great long-term story to tell. Additionally, I believe that the company's investment thesis keeps getting stronger.
• We are long Charles River, and we are looking to add to our position later in 2020.

Charles River Laboratories' (NYSE:CRL) stock has performed well so far in 2020 (this is one of the few stocks in my portfolio that are actually up on the year).

Data by YCharts

And it helps the bull case that the company's Q1 2020 results were well-received by the market, even with management ratcheting down their full-year 2020 guidance.

I believe that Charles River's long-term investment thesis remains intact. Therefore, look no further than this contract research organization ("CRO") if you are trying to find a company that will eventually benefit from the COVID-19 disruptions.

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The Latest, Results Will Be Under Pressure But The Long-term Thesis May Be Stronger

On May 7, 2020, Charles River reported strong Q1 2020 results that beat the top and bottom line estimates. The company reported adjusted EPS of $1.84 (beat by $0.38) and revenue of $707.1mm (beat by $14.95mm), which also compares favorably to the year-ago quarter.

Source: Q1 2020 Earnings Slides

The highlights:

• Revenue increased by 17% YoY (~8% organically).
• The company's largest operating unit, Discovery and Safety Assessment ("DSA"), reported revenue growth of 24% (~12% organically).
• Adjusted EPS increased by 31% YoY (prior acquisitions came into play here).

The company reported solid operating results but, as expected, investors were most concerned about how Charles River was positioned to deal with the COVID-19-related headwinds, and rightfully so. But, management was prepared for the discussion and they did a great job highlighting the steps that have already been taken to deal with the economic uncertainty caused by the spread of the virus.

Management disclosed that they have almost $900mm in borrowing capacity (after drawing down $150mm), they plan to slow the pace on the M&A front and have implemented other direct cost-saving initiatives (mostly within the RMS operating unit). Simply put, management was able to properly position the company to deal the near-term COVID-19 headwinds.

It should be noted, however, that it will likely not be smooth sailing for Charles River over the next few quarters. To this point, the following outlook was provided:

Source: Q1 2020 Earnings Slides

As shown, revenue and earnings (and almost everything in between) will be negatively impacted by the virus. This year.

On the other hand, looking ahead, Charles River is already starting to see some long-term "benefits" from the disruptions caused by the virus, especially in the safety space. But don't listen to me, listen to management (all quotes were from the Q1 2020 conference call):

... we are partnering with more than 40 clients in our DSA and manufacturing segments on their development programs for potential vaccine candidates and therapeutics to treat COVID-19

... We are conducting pathology studies in Maryland on an antibody treatment. Our Biologics site in Pennsylvania is conducting a study and reusing N95 masks. And we will work with our partner, Distributed Bio, on antibody-based therapeutics.

... Clients are also opting to outsource more projects to us for non-COVID-19-related programs across multiple therapeutic areas, either because their own sites have become inaccessible or because of the ease and flexibility of outsourcing projects to an integrated early stage CRO like Charles River. We believe that providing continued support to clients during the COVID-19 pandemic will lead to more outsourcing and long-term business opportunities for Charles River.

... We're looking for a strong back half of the year, particularly in safety assessment, which is the largest business that we have, given the desire of our clients to continue to prosecute the drugs that they have in development, particularly for IND-enabling studies, both for COVID-related de novo work for COVID stuff, but also multitude of therapeutic area-based work.

... So I would say, it's pretty clear that Manufacturing is happening, in some ways, in a more robust fashion than pre-COVID. I mean lots of drugs are being manufactured. Lots of new drugs will be manufactured to be tested in the clinic for COVID, and hopefully, to get into the market in the fall, both vaccines and drugs.

And there were other positive developments noted in the quarterly earnings material. Management seemed to watch how much they highlighted the benefits of the current environment but I believe that there could be several positive catalysts that were caused by the virus. In my opinion, Charles River is well-positioned to benefit from the COVID-19 uncertainty over the long term.

The takeaway from Charles River's Q1 2020 results and management commentary: the investment thesis for this CRO company is still intact and may actually be stronger as a result of the disruptions caused by the virus.

The Thesis

Charles River's story is straightforward: this company is a vital part of its customers' business processes. The company provides value-added products and services that are fully integrated into most of the drug discovery and development processes around the globe. Furthermore, management continues to tuck in valuable assets, which allows it to provide additional value to its customer base. The company is viewed as a critical business partner, and rightfully so, for most of the major players in its industry.

And let's not forget that Charles River is a top CRO company that operates in an industry that is expected to experience strong growth in the years ahead.

Source: Grandview Research

And more specifically, Charles River's management team believes that the company has a significant addressable outsourced market in several different key industries.

The backdrop is promising but there are also company-specific reasons to like Charles River in today's environment. For years, the company has appeared to be well-positioned for the future but that did not stop management from putting money to work. For example, Charles River has invested around $2B in strategic acquisitions over the last 4 years.

Source: 2019 Investor Day

These acquisitions not only put Charles River in a great position for the future but they are also already major contributors to the company's operating results. I believe that Charles River should be viewed as a company with a solid, defensive business that also has a great long-term story to tell.

And if you ask me, the COVID-19 short-term headwinds will eventually turn into strong tailwinds for this well-positioned CRO company.

Valuation

Charles River's stock is richly valued based on its own historical metrics.

Source: Morningstar

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. As such, this small-cap company has the potential to more than grow into its current valuation through 2021.

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 through 2021 (even with the lower interest rate). Please also refer to Charles River's 2019 10-K for additional risk factors that should be considered before investing in the company.

Bottom Line

Charles River's Q1 2020 operating results and forward guidance was negatively impacted by COVID-19. However, the company's long-term investment thesis remains intact. Moreover, I believe that Charles River will eventually benefit from the COVID-19-related changes that will impact the industry for many years to come. Therefore, investors with a time horizon longer than 3 to 5 years should consider adding CRL shares on any pullbacks.

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.