Charles River Laboratories International, Inc.

Ladies and gentlemen, thank you for standing by and welcome to the Charles River Laboratories Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star 0. I would now like to hand the conference over to your speaker today, Todd Spencer, Corporate Vice President of Investor Relations. Please go ahead, sir.

Thank you. Good morning and welcome to Charles River Laboratories' third quarter 2020 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 third quarter of 2020. 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 two 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 are for the company constitute four 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 from operations and prepared in accordance with GAAP. In accordance with Regulation G, you can find the comparable gap measures and reconciliations on the investor relations section of our website. In addition, today's remarks will also include estimates of the COVID-19 impact on the company. Certain methodologies and assumptions are related to how we develop these estimates can be found on slide three. I will now turn the call over to Jim Foster.

Thanks, Todd. Good morning. The global pandemic is continuing to adversely affect our world. Yet, through these challenging times, the biopharmaceutical industry is distinguishing itself by leading the way in scientific innovation that will be vital to finding a cure for COVID-19. At Charles River, we have never been so essential to our diverse and growing client base, and we remain fully operational and continue to enable our biopharmaceutical clients to move their programs forward across a wide range of therapeutic areas, including COVID-19. Our resilience through the pandemic has served to enhance our position as the partner of choice for our clients' early-stage research needs as we continue to differentiate ourselves through our broad portfolio, our scientific expertise, and our superb client service. In the second quarter, we were encouraged that our research models clients were returning to their facilities and recommencing their scientific research more quickly than anticipated. This favorable trend continued in the third quarter with a V-shaped RMS recovery as clients across North America, Europe, and Asia resumed more normalized research activities. The accelerated RMS recovery was a key component of our robust third quarter financial results, which exceeded our expectations. COVID-19 had a very limited impact on our other businesses in the third quarter, aside from Microbial Solutions, which continued to work through its backlog of delayed instrument installations. In fact, we continued to generate new business opportunities through share gains, particularly with academic clients. In addition, we are winning incremental work as clients increasingly choose to outsource in order to utilize our more flexible and efficient drug development solutions, which is benefiting our biologics, discovery, safety assessment, and GEMS businesses. These factors contributed to our robust third quarter performance, which included record revenue, non-GAAP earnings per share, and free cash flow. I'll now provide additional details on our third quarter results. We reported $743.3 million in the third quarter, 11.3% increase over last year, organic revenue growth of 7.8% was driven primarily by the strong performance of our DSA and manufacturing support segments, both of which improved their organic growth rates compared to the second quarter levels, and were consistent with our long-term targets for these businesses in the high single and low double digits, respectively. RMFs also contributed to organic revenue growth, returning to growth just one quarter after reporting an 18% organic decline at the height of COVID-19-related client disruptions and academic site closures. The operating margin was 22.7%. an increase of 330 basis points year over year. This reflects meaningful operating margin improvement across all three business segments, primarily as a result of leverage from our strong top-line performance, our continued focus on operating efficiency, and cost controls associated with COVID-19. We were extremely pleased with the strong operating margin performance, which reflected the underlying margin potential across our businesses. We also benefited from lower discretionary costs due to COVID-19-related restrictions, which included travel. Earnings per share were $2.33 in the third quarter, an increase of 37.9% from $1.69 last year, which exceeded our prior expectation of high single-digit improvement. The record EPS was driven by exceptionally strong operating performance as we emerged from the second quarter, which we believe will be the worst of the COVID-19 financial impact. A lower tax rate also contributed. Based on the third quarter performance, we are increasing our revenue growth and non-GAAP earnings per share guidance for 20. We now expect organic revenue growth in the range of 5% to 6%, or a 75 basis point increase at midpoint. Non-GAAP earnings per share are expected to be between $7.75 and $7.85, which represents a $0.60 increase at midpoint and a 15% to 16.5% increase year over year. The revenue headwind from COVID-19 is now expected to be approximately $70 million for the year, which is below our prior estimate of $100 million. Most of this revenue loss occurred in the second quarter, and we expect to exit the year with the revenue impact from COVID-19 essentially behind us. Our guidance assumes that there will be no new stay-at-home orders or wide-scale disruptions to our operations or our clients' research activities through at least the end of the year, but should this change, we will be ready to take action to mitigate the impact as we did earlier in the year. I'd now like to provide you with additional details on our third quarter segment, Performance Beginning with RMF. RMS revenue in the third quarter was $159.1 million, an increase of 2% on an organic basis, primarily as a result of strong demand for research model services, as well as for research models in China. Our recent cell therapy acquisitions, Hemacare and Solero, each had excellent quarters and contributed 11.1% to the reported RMS revenue growth rate. COVID-19 had only a modest impact on our research models business in the third quarter. Research model revenue growth in China rebounded and is approaching the historical trend for the business. As expected, China recovered earlier than other geographies as clients resumed more normalized research activities after returning to their sites in the middle of the second quarter. Despite a slight lag in Western markets, demand for research models in North America and Europe also improved significantly on a sequential basis, as clients resumed more normalized research activities during the third quarter, particularly in Europe, where we also benefited from some stock-up orders as clients returned to their sites. In the third quarter, client ordering trends for research models in Western markets moved closer to pre-COVID levels and were only moderately below prior year levels. As we exit the year, we expect ordering trends in North America to fully recover as well. We are pleased with the V-shaped recovery in RMS business to date and see other favorable trends that are also quite encouraging. We believe that we will continue to benefit from market share gains, including from academic clients, as we gain business from new academic principal investigators or PIs when we reopen their sites. Academia has been a strategic focus to drive enhanced RMS growth with tailored initiatives targeted for the unique needs of the client base. We have always contended that our global-scale, superior client support and biosecurity initiatives have differentiated our research models business in the marketplace, leading clients to choose Shell's River for their early-stage research needs. We believe our resilience and ability to remain operational during the pandemic underscores these attributes and have led to new business opportunities and market share gains due in part to competitive dislocations. The research model services businesses, specifically GEMS and insourcing solutions, also continue to benefit from the long-term trend of clients externalizing more of their work. This trend has been reinforced during the COVID-19 pandemic as clients increasingly seek the flexibility and efficiency of utilizing our sites and staff instead of their own. The GEMS business had another strong quarter as it benefited from incremental outsourcing opportunities the GEMS clients who previously managed their marble colonies in-house. They opted to outsource work due to COVID-19 restrictions at their own sites, saw the benefit of outsourcing, and we expect that many will have us retain this work. Hemacare also rebounded nicely in the third quarter. As we mentioned, in August, Hemacare's donor clinic reopened in May and demand from its cell therapy clients improved meaningfully at the end of the second quarter. Coupled with the acquisition of Solero, which was completed in August, cell therapy revenue increased more than 20% in the third quarter, re-accelerating towards a 30% five-year target for these businesses. Solero has enhanced our access to high-quality human-derived cellular products, both from healthy donors and patient populations, and expanded our geographic reach with donor sites in both eastern and western United States. We firmly believe that our ability to supply cell therapy developers and manufacturers with these critical biomaterials will lead them to remain with us through discovery, early stage development, and the manufacturing support processes. We continue to view the cell and gene therapy space as a high growth market in which we need to continue to strengthen our capabilities in order to meet clients' increasing needs and further enhance our growth profile. The RMS operating margin meaningfully improved by 120 basis points to 27.7% in Q3. The year-over-year increase was principally driven by the benefit from operating efficiency initiatives, including cost controls implemented in response to the COVID-19 pandemic. BSA revenue was $461.2 million in the third quarter, an 8.6% increase on an organic basis, over the third quarter of 19. We are pleased that the DSA performance was in line with the long-term high single-digit growth targets of the segment as the discovery and safety assessment businesses experienced a negligible impact from COVID-19 in the third quarter. DSA growth was driven by both biotechnology and global biopharmaceutical clients. Although biotech clients were the primary driver, Broad-based client spending across the entire biopharmaceutical industry is reflective of the global focus on scientific innovation and the need for our clients to utilize more flexible and efficient early-stage outsourcing solutions. The discovery services business had another exceptional quarter with broad-based growth across early discovery, CNS, and oncology services. We are winning incremental business as clients outsource programs that they have historically kept in-house, as well as some COVID-19-related projects. We believe our integrated discovery portfolio, scientific expertise, and flexible working arrangements have encouraged more clients to partner with us to counteract the challenges of COVID-19. We believe our continued success and our clients' willingness to outsource more of their discovery programs will be predicated on our ability to continue to add innovative discovery capabilities to meet our clients' critical research needs. which we are actively accomplishing through our strategic partnerships, as well as our ability to forge collaborative relationships that enable our clients to work with us in a flexible manner. As a result of one of these relationships, we received a milestone payment from an integrated drug discovery partner in the third quarter, which contributed to the top-line growth in operating margin performance. While milestone-based client relationships represent only a small portion of our discovery business, we believe that our ability to structure working arrangements to meet our clients' needs and deliver the targets or molecules they seek to develop will lead to more discovery outsourcing opportunities in the future. We are pleased to have discovered more than 80 novel molecules for clients since the inception of our early discovery business. Safety assessment business continued to perform well, with sustained growth in study volume. Bookings and backlog activity remain robust, with strength in specialty toxicology and GLP bioanalysis, as well as cell and gene therapies. Each of these areas differentiates Charles River from our smaller competitors. We are also seeing increased demand for infectious disease programs, including COVID-19, and are not seeing any corresponding spending reductions in other therapeutic areas. We believe this demonstrates both the strength of the early-stage funding environment and clients' increasing use of outsourcing to ensure the continuity of the research. The DSA operating margin improved by 310 basis points year-over-year. In the third quarter, 25.2%, with meaningful contributions from both the discovery and safety assessment businesses. Several factors drove the improvement, including operating leverage and strong top-line growth, a continued focus on operating efficiencies and cost controls associated with the COVID-19 pandemic. The discovery milestone payment contributed approximately 50 basis points to the margin improvement. Revenue for the manufacturing support segment was $130.2 million, an 11.5% increase on an organic basis over the third quarter of last year, and also in line with our long-term growth target for the segment. The biologics testing solutions business had another excellent quarter, and the revenue growth rate in the microbial solutions business improved from the second quarter level as we anticipated. Last quarter, we commented that microbial solutions was affected by delayed instrument installations at certain client sites were inaccessible due to COVID-19. As expected, the backlog of instrument installations was gradually reduced in the third quarter. We gained access to additional client sites and conducted some installations virtually, but other sites remain inaccessible as certain clients maintain a COVID-related visitor restriction. We believe microbial revenue growth will continue to gradually improve as we complete additional instrument installations, with the rate of improvement contingent upon our ability to access client sites. The biologics business reported another exceptional quarter of strong double-digit revenue growth principally driven by two factors, robust market trends and increasing utilization of our new capacity. Last year, we opened and transitioned into our new biologic site in Pennsylvania, which more than doubled our capacity in the region. We have been filling this new capacity in 2020 due in part to robust client demand for testing, cell and gene therapies, and COVID-19 therapeutics. We believe cell and gene therapy and our core biologics testing work will continue to be significant growth drivers for years to come, and that we will benefit from these trends and take market share because clients see the value in our extensive portfolio of services to support the safe manufacture of their biologics program, and because we have available capacity to accommodate client demand. the robots' biologics growth and higher utilization of the new Pennsylvania site, as well as the elimination of duplicate costs from last year's transition to the new site, were the primary drivers of the 270 basis point increase in the manufacturing segment's third quarter operating margin to 39.1%. The avian business also contributed, and we continue to be pleased with the benefits from enhanced operating efficiency in the microbial solutions business as a result of process improvements. Our third quarter performance is indicative of several important factors, that our leading portfolio of early-stage and manufacturing support solutions continues to resonate with clients even more today than ever before, that early-stage market trends are strong, that our clients' appetite for outsourcing has become increasingly robust, and that we have the vision and experience to manage through challenging periods. We believe that clients outsource more work to us this year because they trusted the resilience of our business model and our ability to remain fully operational and also our ability to partner with them to advance their programs when they face significant COVID related disruptions. As clients resume more normalized research activities, we believe they are actively reevaluating their longer term outsourcing strategies. The COVID-19 pandemic has proven the ease and flexibility of partnering with a large stable CRO like Charles River, as well as enhanced reliability as clients seek greater research efficiency and continuity. Therefore, we believe biopharma clients are already committing to outsource more than they did prior to the pandemic. Biotech funding levels were particularly strong in the third quarter, surpassing $100 billion year-to-date. Biotech IPO activities accelerating in year-to-date funding through September and has already exceeded last year's total. We believe that biotech funding is particularly significant for our clients because many of them are emerging or smaller biotechs with programs in the discovery or preclinical development stages. That said, we see evidence from our clients, including global biopharmacists, that they are emphasizing greater investment in their preclinical pipelines. The favorable market environment aids us in driving our top-line growth. but it's only one of the factors that we believe will continue to drive our strong financial performance. Operating margin expansion is also a key component of our strategy. We believe the exceptional third quarter margin improvement of 330 basis points and our ability to expand operating margins in three of the last four quarters demonstrate the underlying operating leverage in our business and our continued focus on driving efficiencies. We expect to be near our 20% target this year, essentially one year ahead of expectations. In order to continue to enhance our value to clients and our growth potential, it is imperative that we continue to expand our unique portfolio of potential products and services to more comprehensively support our clients' research needs. Strategic acquisitions have always been our preferred use of capital, and we are continuing to evaluate new opportunities after a pause in the second quarter. There continues to be an abundance of M&A candidates available, and we will also increasingly employ our strategic partnership strategy to stay current with new technologies and modalities and add innovative capabilities and cutting-edge technologies with limited upfront risk. Before I conclude, I'd like to announce two recent appointments. First, earlier this month, we appointed George Lotto to our Board of Directors. George is currently Senior Vice President and Chief Information Officer at Alexion Pharmaceuticals after serving 25 years at Merck. George's unique view from the client perspective and his technological expertise will be invaluable. He's a dynamic thought leader in the technology field, and we look forward to leveraging his insights as we continue to invest in our information technology platform and digital enterprise. I am pleased to welcome George to Charles Rivers Board. I'd also like to congratulate Vicki Creamer to her promotion to Executive Vice President and Chief People Officer. Vicky joined us last year to lead the Human Resources function as a Senior Vice President. During her time with Charles River, she has developed and executed a strategic HR plan that includes identifying and implementing world-class HR processes, developing and rewarding talent, and optimizing the organizational design. Most recently, Vicky has been instrumental in the company's COVID-19 strategy, ensuring our people are receiving the support and resources necessary to navigate this challenging time. Congratulations, Vicki. We believe that the strength and resilience of our business model, our differentiated portfolio, and our wavering focus on the client experience have enabled us to enhance our position as the leading early-stage CRO through the COVID-19 crisis. Our success would not be possible without the collective efforts of the dedicated Charles River staff. So I'd like to again express my sincere appreciation to them for their hard work and our unwavering commitment that allows us to continue to fulfill our mission every day. I'd also like to thank our clients and shareholders for their continued support. Now I'll ask David to give you additional details on our third quarter results and updated 2020 guidance.