Earnings Call Transcript - CRL Q3 2021

Todd Spencer, Vice President Investor Relations

Good morning and welcome to Charles River Laboratories 3rd Quarter 2021 earnings conference call and webcast. This morning, Jim Foster, Chairman, President and Chief Executive Officer, and David Smith, Executive Vice President and Chief Financial Officer, will comment on our results for the 3rd Quarter of 2021. Following the presentation, they 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 webcast replay of this call will be available beginning approximately 2 hours after the call today, and can also be accessed on our Investor Relations website. The replay will be available through next quarter's conference call. I'd like to remind you of our Safe Harbor. All remarks that we make about future expectations, plans, and prospects for the Company constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated. During the call, we will primarily discuss non-GAAP financial measures, which we believe help investors gain a meaningful understanding of our core operating results and guidance. 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 on the Investor Relations section of our website.

Jim Foster, Chairman, President and CEO

Good morning. Our strong third quarter results demonstrate the effectiveness of our strategy and the progress we've made on its execution, as well as the sustained strength of the industry fundamentals. As anticipated, third quarter revenue increased at a low teens rate organically, and we reported mid-teens earnings per share growth. We believe that Charles River is a stronger Company today than it has ever been. We have seen unprecedented demand across most of our businesses, and we believe that this, coupled with the strength of our leading non-clinical portfolio, will enable us to achieve our low double-digit organic revenue growth target over the longer term, as well as in 2022. As a result, we are continuing to invest to add people on capacity, to accommodate growing client demand, and to build a scalable operating model. To enhance our scientifically distinguished portfolio, we are strengthening our relationship with clients and working with them to devise outsourcing solutions which enable them to increase productivity and speed to market. We have maintained our focus on non-clinical drug research and manufacturing solutions, strategically expanding our portfolio to provide clients with the critical capabilities that require to discover, develop, and safely manufacture new drugs. Last month, we divested our RMS operations in Japan and our CDMO site in Sweden for a total of approximately $115 million plus potential contingent payments of up to an additional $25 million. We routinely evaluate the strategic fit and fundamental performance of our global infrastructure for acquisitions and legacy sites alike, and have sold or closed operations that didn't meet our key business criteria but may have been underperforming financially. The decision to divest these 2 operations was consistent with our evaluation process, and we intend to redeploy the capital in other growth areas of our business. Moving to the third quarter, highlights of our financial performance are as follows. We reported revenue of $895.9 million in the third quarter of 2021, a 20.5% increase over last year. Organic revenue growth was 13.6%, with each of our business segments contributing to a strong performance. Last year's COVID impact resulted in a modest 170 basis point increase to organic revenue growth. From a client perspective, biotech continued to drive revenue growth with global biopharmaceutical clients also making solid contributions to the quarter. Third quarter reported revenue growth was affected by a $10 million foreign exchange headwind compared to our prior outlook. Notwithstanding the FX impact, we continue to see strong, sustained client demand across most of our businesses with trends largely consistent with the first two quarters of this year. The operating margin was 21.4%, a decrease of 130 basis points year-over-year. As anticipated, the decline was primarily driven by the comparison to the strong third quarter of last year, which benefited from COVID cost controls, as well as the impact of Cognate and Vigene acquisitions on the manufacturing segment's operating margin. With an operating margin of 21% for the first 9 months of the year, we are squarely on track to achieve our goal of approximately 21% for 2021, which represents a 100-basis point increase over the prior year. This also demonstrates our commitment to driving efficiency and achieving our longer-term margin target of 22.5% in 2024. Earnings per share were $2.40 in the third quarter, an increase of 15.9% from $2.33 in the third quarter of last year. This result was favorable to our prior outlook, largely due to a lower-than-expected tax rate. David will provide some additional details on the tax rate shortly. With the sustained strength of the demand environment, our revised financial guidance for 2021 reflects three primary factors: unfavorable movements in foreign exchange, a lower tax rate, and the divestitures. Reported revenue growth was lowered by approximately 150 basis points at midpoint to a range of 19.5% to 20.5% to primarily reflect current FX rates, as well as the impact of these RMS Japan and CDMO Sweden divestitures. We have narrowed our organic revenue growth outlook to 13.5% to 14.5%, with approximately 275 basis points of this increase generated by the comparison to last year's COVID-19 impact. Normalized organic growth is expected to be squarely in the low double-digits range this year and is consistent with our targeted growth rate next year as well. We also narrowed non-GAAP earnings-per-share guidance to a range of $10.20 to $10.30, which represents just over 25% year-over-year growth. We are pleased to have maintained our EPS growth within the previous range, even after absorbing the impact of the divestitures. I'd like to provide you with details on the third quarter segment performance beginning with the DSA segment. DSA revenue in the third quarter was $531.83 million, a 13% increase on an organic basis, with Strength and Safety Assessment including Lab Sciences and Bio-analytical Services and Discovery Services. Demand for our services and price increases are driving low double-digit organic growth in the DSA segment, which is a trend that we expect to continue into next year. Biotech clients are leveraging our expertise rather than investing in internal capabilities and global biopharmaceutical clients are choosing to partner with us because it's more efficient to leverage our flexible infrastructure instead of maintaining or expanding their own. We believe we have become the principal partner of choice for biotech clients of all sizes. Demand for our services is high because the sustained level of biotech funding is enabling clients to meaningfully invest in early-stage research at an accelerated pace. Because they don't have the internal capabilities to do the type of work that we perform for them, we have focused our business on unmatched scientific expertise, rapid turnaround times, flexible creative solutions, and the ability to accommodate the increasing complexity of our client’s research programs. The Safety Assessment business continued to perform very well in the third quarter, and bookings and proposal volume continued to track at record levels. As we have mentioned throughout the year, clients are choosing to book the Safety Assessment studies further in advance, which enhances their ability to start working with us as soon as the molecules are ready. These early bookings, which now extend well into 2022, translate into greater visibility and a stronger book of business for us. Strong demand for our services requires us to closely manage the current workload by adding staff, capacity, and other necessary resources while managing the continual shifts in client timelines and study protocols that are associated with booking work further out. Because of our client-focused business approach, we believe we can balance their priorities and our capabilities effectively, making Charles River an even more indispensable research partner for clients, both large and small. We're also making progress on our goals to continually improve our connectivity with clients, including through digital enhancements as we strive to take an additional year out of our client’s drug development timelines. The discovery business had a strong year driven by our comprehensive portfolio of oncology CNS, early discovery, and antibodies discovery capabilities. Biotech clients continue to choose to invest in their pipelines instead of infrastructure and utilize our integrated services to move their programs forward. Global biopharmaceutical companies are continuing to increase their reliance on outsourcing strategies for the Discovery Programs because they prefer to leverage our cutting-edge and industrialized discovery capabilities, and flexible solutions to create a more efficient R&D model. We are pleased to be working with both biotech and global biopharma clients, partnering with them to discover, develop, and bring critical therapies to patients who need them. To support the robust demand from these clients, we will continue to strengthen our portfolio by expanding our scale, our science, and our innovative technologies through a combination of internal investment, M&A, and our strategic partnership strategy. By doing so, we are enabling our clients to remain with one scientific partner from target identification through IND filing, and beyond, solidifying our position as the leading non-clinical CRO. The DSA operating margin decreased by 90 basis points to 24.3% in the third quarter, but increased sequentially. The year-over-year decline was due to foreign exchange, which reduced the DSA operating margin by approximately 70 basis points, and a Discovery milestone payment which contributed 50 basis points to last year's DSA operating margin. RMS revenue was $171.3 million, an increase of 10.7% on an organic basis over the third quarter of 2020, with approximately 200 basis points of the increase attributable to the comparison to last year's COVID-related revenue impact. The RMS performance largely reflects the trends that we have experienced all year. Robust demand for research models, particularly in China, broad-based growth across Research Model Services has partially offset continued headwinds for the cell supply business. The Research Model's Business continued to experience strong double-digit growth in China, as well as solid performance in North America, which we believe correlates with the increased level of non-clinical research activity being conducted by biopharmaceutical and academic clients. We believe the global focus on scientific innovation is sustainable and will continue to drive client demand. However, the biopharmaceutical market in Japan has not participated in this trend. As a result, we chose to divest our RMS operation in Japan with an opportunistic sale to the Jackson Laboratories. We have established a licensing agreement under which Jacks will produce and distribute our models in Japan. Research Model Services performed very well. GEMS has benefited from strong outsourcing demand as our clients seek the greater flexibility and efficiency they gain when we managed their proprietary model colonies. The greater complexity of scientific research and our proprietary models that our clients are creating further reinforced the value proposition for the GEMS business. Our clients' need for greater flexibility and efficiency is also driving demand for our Insourcing Solutions or IS business, our CRADL initiative, which provides both small and large biopharmaceutical clients with turnkey research capacity at Charles River sites. Last month, we announced the expansion of our cradle footprint in the Boston Cambridge biohubs and will continue to expand in other regions including South San Francisco to provide a flexible capacity solution for our clients globally. Utilizing cradle also provides clients with collaborative opportunities to seamlessly access other Charles River services, which further enhances the speed and efficiency of the research programs. The cell supply business, which consists of HemaCare Cellero, continues to be affected by limitations on donor availability as it has not fully recovered from last year's COVID-related restrictions. We have implemented several improvement initiatives including expansion of donor capacity across multiple sites, productivity initiatives, and enhancing the digital engagement with donors. We anticipate that revenue will improve in the coming quarters because the robust demand in the cell therapy market sector remains firmly intact. The RMS operating margin decreased by a 160 basis points year-over-year to 26.1%, primarily due to the cell supply business. Like many of our businesses, cell supply is leveraged to sales volume. So we expect profitability will meaningfully improve once donor availability and the growth rate rebound. Revenue for the manufacturing segment was $192.9 million, a 19.1% increase on an organic basis over the third quarter of last year. The increase was primarily driven by continued strong double-digit revenue growth in both the Biologics Testing Solutions and Microbial Solutions businesses, as well as approximately 350 basis points attributable to the comparison to last year's COVID-related revenue impact. Microbial Solutions' growth rate in the third quarter remained well above 10%, reflecting strong demand across our portfolio of critical quality control testing solutions. We were pleased with the strength of the underlying demand for our endotoxin testing systems and cartridges, which performed FDA mandated low-release testing on injectable drugs and medical devices. The advantages of our comprehensive portfolio continue to resonate with our clients, and we believe that our ability to provide a total microbial testing solution will enable Microbial Solutions to deliver at least low double-digit Organic revenue growth this year and beyond. The Biologics Testing business reported another exceptional quarter of strong double-digit revenue growth. Robust demand for Cell & Gene Therapy Testing Services continued to be the primary growth driver, with COVID-19 vaccines and traditional biologics also being meaningful contributors. We believe Cell & Gene Therapies will continue to be significant growth drivers over the longer term to support our 20% growth target for this business. Strength of the demand for these services necessitates that we continue to build our extensive portfolio of manufacturing services to ensure we have available capacity to accommodate client demand. The third quarter marks the first full quarter of the Cognate and Vigene pilot at Charles River. As anticipated, when we acquired Cognate, a large COVID-related project was completed in the second quarter, and we are actively adding new projects in its place. We continue to make great progress on the integrations and believe our cell and gene therapy CDMO business will be highly complementary to our Biologics business and our portfolio as a whole. We also believe that we now have a comprehensive cell and gene therapy portfolio, which spans each of the major CDMO platforms: gene-modified cell therapy, viral vector, and plasmid DNA production. Our goal is to enable clients to conduct analytical testing, process development, and manufacturing for these advanced drug modalities with the same scientific cadre, allowing them to achieve their goal of driving greater efficiency and accelerating their speed to market. As mentioned earlier, the decision to divest our CDMO site in Sweden was based on several factors. For us, its capabilities including plasmid DNA were already duplicated at other CDMO sites in the U.K. and U.S. Second, we determined it would be advantageous to invest in and expand capacity at our other CDMO hubs that are more centrally located and proximate to clients. Finally, this was our smallest and least profitable CDMO site. This divestiture does not reflect any changes in client demand or the Cell & Gene Therapy CDMO sector, as we firmly believe that the growth profile for this business remains at or above 25% over the longer term. The manufacturing segment's third-quarter operating margin declined by 640 basis points to 32.7%. The primary driver of the decline was the inclusion of Cognate and Vigene for the full quarter. These businesses are profitable, but their margin is below the overall manufacturing segment. As noted last quarter, we continue to expect the full-year manufacturing margin will be slightly below the mid-30% range reflecting the addition of the CDMO business. However, beyond 2021, we expect this headwind to gradually dissipate as we drive efficiency and as the significant growth we anticipate generates greater economies of scale and optimizes throughput at our CDMO sites. We are operating in a robust business environment with excellent growth potential. Biotech funding in 2021 is continuing to track at or above the robust pre-COVID levels. The sustained funding environment, both from the capital markets in the biopharmaceutical industry, and the biotech industry's cash reserves are enabling an accelerated pace of scientific innovation. Clients, both large and small view us as their partner of choice from concept to non-clinical development to the safe manufacturer of their life-saving therapeutics. To continue to successfully execute our strategy to maintain and enhance Charles River's position as the leading non-clinical CRO and accommodate our clients' growth needs, it is essential that we continue to make investments in our scientific capabilities through M&A, technology partnerships, and internal development, enhance our digital enterprise to provide real-time access to critical data for both internal and client use, and also to expand our capacity and staff. Demand for our services in the current market environment has outpaced our expectations, and we have been hiring ahead of our initial plan this year to accommodate this growth. We have hired 4,000 talented people this year to both support growth and offset attrition, and plan to hire an additional 1,000 people in the fourth quarter. We believe we attract qualified employees because our mission and the critical work that we do to help our clients develop life-saving therapies distinguishes us from other companies. For a business like Charles River, staffing is a consistent challenge and which we have placed a disproportionate focus. We believe we are effectively managing staffing levels, including increased costs. We will continue to be thoughtful with respect to compensation heading into 2022 as we strive to maintain or reduce turnover and remain competitive in the marketplace. It will be a headwind, but one that will help us to support the robust client demand and achieve our low double-digit organic growth target that we expect in 2022. By focusing intently on our strategy, we have become a trusted scientific partner for pharmaceutical and biotechnology companies, academic institutions and government and non-government organizations worldwide. We have demonstrated the value we can provide to clients and believe that is why they have trusted us to work on more than 80% of the drugs approved by the FDA over the last three years. We believe that our steady focus on our strategy to continue to enhance our portfolio will enable us to continue to achieve our long-term financial targets and deliver greater value to shareholders. In conclusion, I would like to thank our clients and shareholders for their support and our employees for their exceptional work and commitment. I'll now ask David to give you additional details on our third quarter results and updated 2021 guidance.

David Smith, Executive Vice President and CFO

Thank you, Jim, and good morning. Before we begin, may I remind you that I'll be speaking primarily to non-GAAP results, which exclude amortization and other transaction-related costs – related primarily to our global efficiency initiative, our venture capital, and other strategic investment performance. Many of my comments will also refer to organic revenue growth which excludes the impact of acquisitions, divestitures, and foreign currency translation. We are pleased with our strong results for the third quarter, which included 13.6% organic revenue growth and the 15.9% increase in earnings per share. Operating margin in the third quarter was 21.4% while lower than the prior year as anticipated. It represented a 60-basis point sequential increase and was in line with our full-year target of approximately 21%. In addition to the COVID cost controls last year and the CDMO acquisition this year that Jim mentioned, the third quarter operating margin was also lower than last year's robust 22.7% level because of our foreign exchange headwind, and last year's discovery milestone payment. Although cost inflation and supply chain pressure have made headlines recently, we believe we are effectively managing the tighter labor market in our supply chain and higher costs in these areas have been reflected in our updated guidance. Lower unallocated corporate costs contributed to the third quarter operating margin coming in at 5% of revenue or $45 million compared to 5.5% of revenue last year. Corporate costs are nonlinear, fluctuating from quarter to quarter due to several factors including health and fringe related costs and performance-based compensation. Despite the third quarter capability, we continue to expect unallocated corporate costs in the mid-5% range as a percentage of revenue for the full year. The third quarter non-GAAP tax rate was 17%, representing a 490 basis point decrease from 21.9% in the third quarter of last year. A lower tax rate was due primarily to two factors: discrete tax benefits associated with R&D tax credits and a favorable excess tax benefit related to stock-based compensation associated with the higher stock price. These benefits will also result in a reduction of our full-year non-GAAP tax rate to a range of 18% to 19% from our prior outlook of 19.5% to 20.5%. Total adjusted net interest expense in the third quarter was $20.7 million, an increase of $2 million year-over-year, reflecting higher debt balances to fund the Cognate and Vigene acquisitions but was essentially flat sequentially. At the end of the third quarter, we had an outstanding debt balance of $2.9 billion representing a gross leverage ratio of 2.7 times, and a net leverage ratio of 2.6 times. For the full year, we now expect total adjusted net interest expense to be slightly lower than our prior outlook, in the range of $80 to $82 million, reflecting debt repayment and continued low-variable interest rates. Free cash flow was $119.2 million in the third quarter, representing a decrease of 21% over $151.1 million for the same period last year. The lower free cash flow was primarily due to higher capital expenditures, which increased by nearly $13 million to $55.5 million. There are two reasons for the increase in capital expenditure: we continued to invest in capacity additions and other growth projects to meet client demand, and last year's level was still constrained on COVID-related project delays. For the year, our free cash flow and CapEx guidance remains unchanged at approximately $500 million and $220 million respectively. CapEx is expected to total over 6% of total revenue in 2021, with the robust demand environment exceeding our expectations this year, and expected to continue across our portfolio. We now believe CapEx will be about 9% of total revenue next year as we continue to add capacity to support our growth, particularly in our legacy businesses including Safety Assessment. With respect to 2021 guidance, we are updating our full-year revenue growth outlook to a range of 19.5% to 20.5% on a reported basis, reflecting the impact of the divestitures and foreign exchange, and organic revenue growth to 13.5% to 14.5%. Foreign exchange is now expected to be less of a benefit than previously anticipated due to the strengthening of the U.S. dollar over the last three months, particularly when compared to the British pound and euro. We now expect a 150 to 200 basis point headwind from FX for the year compared to our prior outlook of approximately 250 basis points. As Jim mentioned, the strength of the dollar resulted in a headwind that reduced third quarter reported revenue by approximately $10 million compared to our prior outlook. We have narrowed our earnings per share guidance to a range of $10.20 to $10.30 primarily due to the lower tax rate outlook, partially offset by the divestitures. Please keep in mind that the divestitures are expected to reduce revenue by nearly $20 million and non-GAAP earnings per share by less than $0.10 in the fourth quarter, which is reflected in the full-year 2021 financial guidance. By segment, our updated outlook for 2021 continues to reflect a sustained and healthy business environment. With our organic revenue growth outlook narrowed within our previous range, we have maintained our segment growth expectations, including organic revenue growth in the high-teens for the RMS segment, low double-digits for the DSA segment, and high-teens for the manufacturing segment. On a reported basis, we moderated the segment outlook to reflect updated FX rates and the divestitures. We now expect revenue growth of the RMS segment in the high-teens range, manufacturing in the low 40% range, and DSA unchanged in the mid-teens. With regard to operating margin, our segment outlook remains effectively unchanged from our prior outlook. A detailed summary of our updated financial guidance for the full year can be found on slide 39. With one quarter remaining in the year, our fourth-quarter outlook is effectively embedded in our guidance for the full year. The RMS Japan divestiture will affect the year-over-year comparison in the fourth quarter. On a year-over-year basis, we expect organic revenue growth will be in the high single-digit and reported revenue growth in the low double-digits range. When normalized for the COVID impact, we expect our organic revenue growth for the full-year to be squarely in the below double-digit range, which is also consistent with the growth that we expect next year. Non-GAAP earnings per share is expected to be flat to a low single-digit increase in the fourth quarter when compared to last year's level of $2.39. The fourth quarter tax rate is expected to return to the low 20% range, which, along with the divestitures, will meaningfully constrain the earnings-per-share growth rate. I would love to provide one modeling comment regarding next year. We will add a 53rd week at the end of the fourth quarter of 2022, which is periodically required to true up our fiscal year to a December 31st calendar year-end. A 53rd week has historically been characterized by partial week revenue since it occurs during the holiday, but a full week of costs. To conclude, and before we try to think about next year, we intend to finish the fourth quarter on a strong note and achieve our updated financial guidance for this year. Our expected 2021 performance demonstrates the progress that we're making, as well as the investments that are necessary to achieve the 2020 financial targets that we provided at our Investor Day in May, which include low double-digit organic revenue growth, an operating margin of approximately 22.5%, and non-GAAP earnings-per-share growth at a faster rate than revenue.

Jim Foster, Chairman, President and CEO

That concludes our comments. Operator, we will now take questions.

Operator, Operator

Thank you. Our first question comes from the line of John Kreger with William Blair. Your line is open.

John Kreger, Analyst

Hey, thanks very much. Jim and David, I heard you guys make a few comments about 2022. Just wanted to make sure we heard that right. I think you said low double-digit organic growth expected and CapEx spending of around 9%. Anything else you can add to that early 2022 look? And maybe where should we expect the higher CapEx investing to be targeted? Thanks.

David Smith, Executive Vice President and CFO

We mentioned that we are experiencing extraordinary demand across our entire portfolio. Given the current spending trends, the strength of new scientific modalities, and developments in Cell & Gene Therapy, we expect our portfolio to continue performing well at least into next year. This year has been quite interesting and unique for us. Although we had a well-thought-out plan, we have surpassed our operating targets, as shown by our recent guidance increases. We are actively working to expand our capacity and hire enough personnel to meet the demands.

Jim Foster, Chairman, President and CEO

So we have terrific growth rates in the Safety Assessment business. We're by far the market leader. A lot of clients depend on us as we have many new biotech companies being created and minted, and have no internal capability to do the work. We thought that both at 9% and a double-digit would be a good early glimpse of what we anticipate for next year.

David Smith, Executive Vice President and CFO

I'll add a bit more color on the puts and takes as well, because I think that's clearly of interest to a number of people, and while we're not going to talk about the 2022 full guidance, there are a number of things that we have called out, but there's a lot of materials this morning to go through. Jim talked about the strong demand environment so I won't repeat that. That low double-digit organic growth does help fuel some of the headwinds that we're seeing. And by the way, you're aware of microglial headwinds that we've had this year, which are behind us. The cell supply, we hope that would be fully behind as we move into 2022, as well because that's another tailwind. And of course that buoyant double-digit growth helps with our margin expansion goals. You know that we're trying to get to a 150 basis points over the next three years. That won't be linear. For instance, the investments that we're making in digital, we won't see the returns really kick in until the out-year. Next year, we have this modest headwind from the 53rd week, which I called out in my remarks.

Jim Foster, Chairman, President and CEO

We are very pleased with the pricing we are receiving and continue to be satisfied. Clients are currently focused on when they can begin a study and the availability of study slots. There are often questions regarding the geography or status of the study. Therefore, we are making considerable efforts to ensure we have enough personnel and space to meet the demand, which has exceeded our initial business plan expectations. This is a challenging situation that we are diligently managing.

Tycho Peterson, Analyst

Hey, thanks. I want to revisit the 2022 discussion for a minute. You also talked about earnings leverage. David, as you talked about, obviously, you've got some headwinds here with the extra week, wage inflation, and three quarters of the divestiture headwinds. Can you help us think about the leverage you can pull to drive that earnings leverage next year, given the Street expectations sit about 11.5% on earnings in line with revenue?

David Smith, Executive Vice President and CFO

Look, we've got really strong revenue demand. This year as the demand has increased more than we expected, which is great. It's setting us nicely for the future. We've made meaningful investments this year and will continue to make investments in the business with that revenue. One of the benefits of having high revenue and double-digit growth is we're going to invest some of that additional profit into the business for the short-term in terms of headcount and in the medium-term in terms of digital. So we will continue to do that.

Jim Foster, Chairman, President and CEO

It’s a very attractive supply-demand paradigm, and we're making necessary investments to accommodate it.

Todd Spencer, Vice President Investor Relations

Great. Thank you for joining us on the conference call this morning. We look forward to speaking with you during our upcoming investor conference. That concludes the conference call. Thank you.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.