Charles River Laboratories International, Inc.

Ladies and gentlemen, thank you for standing by and welcome to the Charles River Laboratories third quarter 2022 earnings conference call. This call is being recorded. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during this period, you will need to press star 1 on your telephone. If you want to remove yourself from the queue, please press star 2. Lastly, if you should need operator assistance, please press star zero. I would now like to turn the conference over to our host, Todd Spencer, Vice President of Investor Relations. Please go ahead, sir.

Good morning, and welcome to Charles River Laboratories' third quarter 2022 earnings conference call and webcast.

This morning, I am joined by Jim Foster, Chairman, President, and Chief Executive Officer, and Flavia Pease, Executive Vice President and Chief Financial Officer. They will comment on our results for the third quarter of 2022. Following the presentation, they will respond to questions. There is a slide presentation associated with today's remarks, which will be posted on the investor relations section of our website at ir.criver.com. A webcast replay of this call will be available beginning approximately two hours after the call today and can also be accessed on our investor relations website. The replay will be available through the 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 this 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 gap measures and reconciliations on the investor relations section of our website. I will now turn the call over to Jim Foster.

Good morning. I'm very pleased to speak with you today about our third quarter results. A solid financial performance was highlighted by 15.3% organic revenue growth and non-gap earnings per share of $2.63 per both of which exceeded our prior outlook. Third quarter organic growth rate accelerated 580 basis points from the second quarter level due primarily to the DSA segment, which delivered an outstanding growth rate of more than 20% in line with our outlook since the beginning of the year. The DSA growth acceleration reflects continued robust price increases and meaningfully higher study volume in the safety assessment business, trends which have been supported by the strength of its backlog that continues to afford us with excellent visibility into the future client demands. The strong operating performance against the backdrop of escalating macroeconomic pressures demonstrates the power of our unique portfolio, which differentiates Charles River from other companies that provide R&D support services to the biopharmaceutical industry, especially from the late-stage clinical service providers. We are uniquely positioned as the leading global non-clinical drug development partner working with clients from discovery and early stage development through the safe manufacture of life-saving therapies. Our focus is centered on preclinical R&D, which requires extensive scientific knowledge and the ability to innovate, understand, and distinguish viable molecules from those that are not. Post-pandemic, we are an even more essential partner to our biopharmaceutical clients because our core competencies are precisely tailored to their intensified focus on scientific breakthroughs, personalized medicine, and speed to market. With a comprehensive portfolio spanning small molecules, biologics, and cell and gene therapies, we provide a flexible and efficient platform that accelerates early-stage biomedical research and therapeutic innovation. We are a leading global partner for outsourced discovery and regulated safety assessment services. We are also the largest provider of small research models and associated services that enable our clients to conduct their own research, and we offer a comprehensive portfolio of manufacturing solutions from quality control testing solutions to the production of cell and gene therapies that enable us to continue supporting our clients as they work with other providers to conduct human clinical trials and reach commercialization. We have a large and diversified client base, which makes us an exceptional barometer for the health of the broader biopharmaceutical industry. And unlike clinical providers, greatly reduces our reliance on a small group of clients. We have worked with more than 2,000 biopharmaceutical clients this year, and our top 25 clients are primarily large biopharmaceutical clients that are well-financed and have been a stable source of sustained revenue growth with accelerated spending in the third quarter. Our top 25 clients represented only 28% of total revenue last year, and our largest client represented just above 3% of total revenue. We also believe that our biotech clients will remain a sustained growth engine for Charles River. We have averaged adding more than 400 new biotech clients per year since 2017 and are already above that level this year. Our biotech clients continue to be a principal driver of revenue growth, increasing at healthy double-digit growth rates in the third quarter and year-to-date, a trend that we believe supports our view that biotechs with promising molecules are continuing to find available funding. In addition, we saw early indications of the return of IPOs and secondary offerings in the third quarter. Venture capital funding remained very healthy, and large pharma continued to support the biotech industry. our concentration of at-risk biotechs remains low at approximately 5% of both DSA and total revenue for public biotechs with less than two years of cash on hand. This is slightly below our prior estimate, which evaluated DSA backlog. We believe that early-stage research that we conduct is instrumental in our biotech clients' achievement of the important milestones that enable them to secure their next rounds of funding. And therefore, we believe they view continuing their regulated safety assessment programs as critical to their continued success. The total cost of a safety assessment program is a fraction of the cost of clinical trials, typically ranging from $6 to $8 million, including post-IND studies, Yet, it is an important milestone to demonstrate that clients' efforts are driving innovation and validating the efficacy and safety profile of their lead compounds. At five to ten times less than the cost of clinical trials, biotech clients are motivated to plan their spending around the achievement of IND approval before seeking additional funding or finding a larger biopharmaceutical partner to move into clinical trials. As a result of the importance, both biotech and larger biopharma clients are continuing to move their regulated safety assessment programs through their pipelines. I will now provide additional highlights of our third quarter performance. We reported revenue of $989.2 million in the third quarter of 22, a 10.4% increase over last year. Organic revenue growth of 15.3% exceeded our prior outlook of at least low double-digit increase. All three business segments reported solid revenue growth, particularly the DSA segment, due to the robust performance of the safety assessment business. The operating margin was 20.4%, a decrease of 100 basis points year over year. The decline was driven by lower margins in the manufacturing and RMF segments, as well as higher unallocated corporate costs, both of which were previously anticipated. Earnings per share were $2.63 in the third quarter, a decrease of 2.6% from the third quarter of last year. Higher revenue was offset by the operating margin decline, increased interest expense, and a higher tax rate. Based on the third quarter performance, we are narrowing our 2022 revenue growth and non-GAAP earnings per share guidance to the upper ends of the previous ranges. We expect organic revenue growth in a range of 11% to 12% and non-GAAP earnings per share of $10.80 to $10.95. I'll now provide details on the third quarter segment performance, beginning with the DSA segment. Revenue for the DSA segment was $619.5 million in the third quarter, a 20.8% year-over-year increase on an organic basis. The DSA growth rate surpassed the 20% level, tracking to our initial plan that had forecast meaningful DSA growth acceleration throughout the year. The exceptional demand, which has manifested itself in sustained backlog growth, is a function of our clients' robust pipelines, our competitive strengths, and the scientific breadth and geographic reach of our portfolio. Ride-based growth in the safety assessment business was the principal driver of the nearly two-fold increase in the DSA revenue growth rate from the second quarter level. The factors that led to this meaningful step-up were substantially higher study volume and continued meaningful price increases. Study volume was a significant contributor, driven by strong demand across the safety assessment business for most major study types of general and specialty toxicology. As expected, study volume rebounded meaningfully from first half levels, and we were able to accommodate additional client demand as a result of having hired and trained additional staff over the last year. We are continuing to successfully recruit and retain staff to support future growth and do not foresee challenges with staffing levels as we head into next year. Pricing also continued to trend meaningfully higher year over year and sequentially, which we believe reflects the complexity and specialized nature of the work we do. today's inflationary cost environment, and the fact that capacity remains well utilized. Although pass-throughs or higher costs for certain study-related resources that are passed directly to clients were higher in the third quarter, they accounted for less than half of the sequential step-up in the safety assessment growth rate and had effectively no margin impact. pricing, exclusive of the impact of pass-throughs, increased broadly in the third quarter. Clients continue to emphasize the breadth of capabilities, study lead times, and the availability of space more so than price when determining the preferred partner for their preclinical programs. As the premier partner for our clients' non-clinical development programs, it's not surprising that clients are continuously choosing to work with Charles River for our broad and scientifically differentiated portfolio, superior client service, and speed as we aim to take an additional year out of the early stage development timelines. As expected, the discovery services growth rate moderated in the third quarter, primarily due to the lengthening of clients' decision-making timeframes to start new projects, a trend which we discussed in August. We believe the discovery business will demonstrate favorable long-term growth prospects, as many of our clients, including biotechs, prefer to outsource their drug discovery projects rather than maintain in-house infrastructure. And given the critical importance of the early-stage research in which they are engaged, they prefer an integrated, full-service partner like Charles River. We continue to expect mid-teens DSA organic revenue growth in 2022. DSA backlog and booking activity through the third quarter continues to support sustained growth. And for next year, we have a significant amount of safety assessment work already booked. The strong safety assessment performance has been under the leadership of Shannon Parasoto. Shannon has been with the company for over 20 years, starting at our Nevada site shortly after it became our first acquisition in the safety assessment space. With significant operational and finance experience, Shannon recently assumed responsibility of our discovery services in addition to safety and was promoted to an executive vice president. I would like to congratulate Shannon and wish her continued success in driving the long-term growth of our global discovery and safety assessment segment. DSA operating margin increased by 190 basis points to 26.2% in the third quarter, driven primarily by operating leverage from the substantial quarterly increase in safety assessment study volume and pricing. RMS revenue is $180.1 million, an increase of 8% on an organic basis over the third quarter of 2021. The RMS business continued to sustain high single digit growth consistent with our outlook for the year. The RMS growth potential has trended upward recently from low to mid single digits several years ago due to a combination of accelerating growth for research model services and research models. The Cradle Initiative or Charles River Accelerator and Development Labs including a recent Explorer acquisition is a significant driver of the growth rate increase In addition, a renewed focus on biomedical research has led to increased demand and share gains for small research models, particularly in North America and China. We are also benefiting from meaningful price increases, in part to offset inflationary cost pressures. These factors were the principal drivers of RMS revenue growth in the third quarter. In the research models business, North America continued to generate strong revenue growth And China rebounded following the impact from COVID-related restrictions in the second quarter. There was no meaningful impact on client order activity from COVID-related restrictions in the third quarter. We are also continuing to expand in China outside of Beijing and Shanghai regions to gain additional market share and believe the level of biomedical research activity, coupled with our expansion plans in China, will continue to generate robust double-digit growth in the region. Research model services also had another excellent quarter led by the insourcing solutions business, particularly our cradle and explorer operations. Clients are increasingly adopting this flexible model to access laboratory space without having to invest in internal infrastructure. Explorer has continued to perform very well with the integration on track. We added five new sites over the last six months in California and Washington State and now operate 27 vivarium facilities totaling over 370,000 square feet of turnkey rental capacity. Cradle and Explore provide us with a new and unique pathway to connect with clients at earlier stages, enabling these clients to easily access additional services across our comprehensive discovery and non-clinical development portfolio. In the third quarter, the RMS margin declined by 260 basis points to 23.5%, driven primarily by the revenue mix and higher costs in China, due in part to our regional expansions. We also experienced a modest margin impact from opening new cradle and explorer sites this year, for which the profitability will improve as client utilization increases in the newly opened sites. Revenue for the manufacturing segment was $189.6 million, an increase of 6% on an organic basis. Lower revenue in the CDMO business, the drivers of which we discussed last quarter, was more than offset by higher growth rates for both the biologics testing and microbial solutions businesses. The growth prospects for these legacy manufacturing quality control businesses remain robust. and they will continue to be principally driven by demand for biologic drugs, including cell and gene therapies, and other complex biologics. Microbial solutions benefited from broad-based growth across its endosafe, endotoxin testing, and acugenics microbial identification testing platforms. We are continuing to convert the marketplace to our more efficient and reliable quality control testing platform. The continued expansion of the installed base of instruments drives demand for the consumable cartridges and reagents, which provides a healthy, recurring revenue stream. The biologics testing business also had a strong quarter with virology, viral clearance, and microbiology testing services driving growth in both the U.S. and Europe. Demand for traditional biologics remains strong, but cell and gene therapy clients are driving a disproportionate amount of recent growth. We have been continuing to add capabilities to our extensive portfolio to support the manufacture of biologics, including the addition of new cell and gene therapy assays. The initiatives that we have implemented to improve the performance of our CDMO business are beginning to gain traction and earn positive feedback from clients. It's still early, and we don't expect the financial performance to meaningfully improve until next year, but we're pleased with the initial progress. Our creation of centers of excellence for cell therapies, viral vectors, and plasmids has been well-received, and coupled with our focus on CDMO business development efforts, we are generating new client interest. We recently announced a gene therapy manufacturing partnership with Nanoscope Therapeutics, to produce plasma DNA and viral vectors for their late-stage clinical trials of a therapy targeting degenerative ocular diseases. We have a number of other clients who are in late-stage clinical trials with their cell or gene therapies, and we are investing in our sites to ensure that we are commercially ready should our clients receive regulatory approval. As we mentioned last quarter, our Memphis Cell Therapy site received European approval from the EMA to commercially manufactured cell therapy products. We continue to believe in the long-term growth prospects for cell and gene therapies and are enhancing our service offering to generate new business and provide incremental opportunities for clients to streamline their biologics development workflows by utilizing Child's River for their analytical testing, process development, and manufacturing activities. The manufacturing segment's operating margin declined by 410 basis points to 28.6% in the third quarter of 2022, and similar to the second quarter, was almost entirely driven by the CDMO business. As we announced this morning, we have signed an agreement to divest our avian vaccine business which is part of our manufacturing solutions segment, for approximately $170 million in cash, plus potential contingent payments of up to an additional $30 million. We routinely evaluate the strategic fit and fundamental performance of our global infrastructure, and as we did at this time last year, have sold or closed operations that did not meet our key business criteria. The decision to divest the avian business was consistent with this evaluation process as we determined the production of SPF eggs principally for avian vaccine manufacturers and researchers was no longer a core competency. Flavia will provide additional details on the financial impact of this transaction. We are confident that we will finish the year on a strong note and are encouraged by the solid growth prospects as we head into the new year. The economy will present challenges in the coming year, but we believe we are well positioned to meet these challenges and continue to deliver exquisite science, superior client support, and greater efficiency to our clients. Our focus in recent years on enhancing our capabilities in biologics and cell and gene therapies, investing in our people and space, and continuing to build greater digital connectivity with our clients has further differentiated us from the competition. and enabled us to forge even deeper relationships with our clients. We are the bridge between the biopharmaceutical industry and patients that enables innovation to move forward, and we will continue to distinguish ourselves scientifically and through our preclinical focus. To conclude, I'd like to thank our employees for their exceptional work and commitment, and our clients and shareholders for their support. Now, Flavia will provide additional details on our third quarter financial performance and 2022 guidance.

Thank you, Jim, and good morning. Before I begin, may I remind you that I'll be speaking primarily to non-GAAP results, which exclude amortization and other acquisition-related adjustments, costs related primarily to our global efficiency initiatives, gains or losses from our venture capital and other strategic investments, and certain other items. Many of my comments will also refer to organic revenue growth, which excludes the impact of acquisitions, divestitures, foreign currency translation, and the 53rd week in 2022. We're very pleased with our third quarter results, with revenue and earnings outperforming prior outlook. Organic revenue growth of 15.3% resulted in earnings per share of $2.63. I will now provide some additional details on the non-operating items that drove our third quarter performance. Unallocated corporate costs increased in the third quarter, totaling $57.5 million, or 5.8% of total revenue, compared to 5% of revenue last year. The increase was primarily the result of higher health and fringe-related costs. For the year, we continue to expect unallocated corporate costs to be approximately 5% of total revenue. Total adjusted net interest expense for the third quarter was $27.3 million, an increase of $4.4 million sequentially, and $6.6 million year over year, reflecting the Federal Reserve's interest rate increases this year, and on a year over year basis, higher debt balances from recent acquisitions. For the year, our total adjusted net interest expense outlook remains unchanged in a range of $106 to $110 million because we expect that more aggressive interest rate hikes will be offset by additional debt repayment. Our current interest expense guidance can accommodate an additional 75 to 100 basis point increase should that be the outcome of today's Federal Reserve meeting. Given the late timing of a potential December increase, we do not expect it would have a material impact on interest expense for 2022. This week, we entered into an interest rate swap agreement on $500 million of U.S. dollar-denominated debt on our revolving credit facility. For the next two years, the swap will effectively fix the interest rate at 4.7% plus our current spread of 112.5 basis points for a total of 5.825%. With the swap, approximately two-thirds of our $2.9 billion in debt is now at a fixed rate. Of the remaining floating rate debt, our revolving credit facility uses the one month LIBOR rate or equivalents plus the current spread. Looking beyond 2022 and to help with modeling in light of the Federal Reserve's current policy of more aggressive interest rate hikes, a 100 basis point increase in rates is expected to result in incremental interest expense of approximately $9 million on an annualized basis, based on our remaining floating rate debt levels after the swap. Our growth and net leverage ratios were both approximately 2.7 times at the end of the third quarter. Over the longer term, we continue to believe that strategic M&A will generate the greatest shareholder returns and enhance our growth potential. But in the near term, we'll also focus on shorter-term initiatives like debt repayment. As Jim mentioned, We plan to divest our Avian vaccine business by the end of the year. We'll receive gross proceeds of $170 million up front and intend to redeploy that capital with a portion used to repay that. The third quarter gap tax rate was 20.2%, representing a 320 basis point increase from the same period last year. The higher tax rate year over year, was due primarily to a lower tax benefit associated with stock-based compensation related to the lower stock price, as well as higher discrete tax benefits in 2021 associated with the R&D tax credit. For the full year, we now expect the tax rate to be approximately 20% on a non-GAAP basis, slightly below the outlook provided in August and at the low end of our longer-term target of low 20%. Pre-cash flow was $60.4 million in the third quarter compared to $119.2 million last year. The 49% decrease was primarily due to changes in working capital and higher capital expenditures. Capital expenditures were $72.4 million in the third quarter an increase of nearly $17 million compared to the $55.5 million last year as we continue to make growth-related investments. For the year, our free cash flow and CapEx guidance remain unchanged at approximately $360 and $340 million, respectively. As Jim mentioned, we have narrowed our revenue growth and non-GAAP earnings per share guidance to the upper end of the prior ranges. We now expect reported revenue growth in a range of 10 to 11% for the full year, including the 350 basis points foreign exchange headwind that we forecasted in August. Our organic revenue growth outlook was also narrowed to a range of 11 to 12%. We continue to expect that the consolidated operating margin will be essentially flat with 2021, and that will have narrowed our earnings per share guidance to a range of $10.80 to $10.95, or approximately 4.5 to 6% growth versus the prior year. Excluding an estimated foreign exchange headwind of 43 cents this year, as well as a 20 cent headwind from interest expense compared to our initial outlook, earnings per share growth would be in the low double-digit range this year. By segment, our revenue growth outlook for 2022 remains unchanged. We expect organic revenue growth in the high single digits for the RMS segment, mid-teens for the DSA segment, and mid-single digits for the manufacturing segment. As noted in this morning's press release, the Avian divestiture will not have a meaningful impact on our 2022 financial results. In 2023, the transaction will reduce annual revenue by approximately $80 million and non-GAAP EPS by approximately 35 cents. But we expect to offset a portion of this dilution through the benefits of redeploying the proceeds towards other capital priorities. A summary of our updated financial guidance for the full year can be found on slide 43. With one quarter remaining in the year, our fourth quarter outlook is effectively embedded in our full year guidance. I'd like to remind you that this year includes a 53rd week at the end of the fourth quarter to true up our fiscal year to a December 31st calendar year end. The 53rd week historically has been characterized as a partial week of revenue and a full week of costs. And for 2022, we expect the impact will be a benefit to reported revenue growth of approximately 550 basis points for the fourth quarter and a modest operating margin headwind in the fourth quarter, particularly in the RMS segment. For the fourth quarter, On a year-over-year basis, we expect reported revenue growth will be in the low to mid-teens, and organic revenue growth will be at least in the low double-digit range. Earnings per share growth is expected to be in a range of approximately $2.65 to $2.80 in the fourth quarter, based on our updated full-year guidance. In conclusion, We're well positioned to finish the year on a strong note. The second half DSA growth acceleration is occurring as expected, and our substantial backlog firmly supports our full-year financial guidance. As we look to the future, we're focused on continuing to drive growth, executing on our strategy, and enhancing our position as the leading global non-clinical drug development partner working with our clients from discovery and preclinical development through the safe manufacture of their life-saving therapies. Thank you.

That concludes our comments. We will now take questions.

Thank you. At this time, if you would like to ask a question, please press star 1 on your touchtone phone. You may remove yourself from the queue at any time by pressing star 2. And to allow everyone the opportunity to ask a question, we ask that you please limit yourself to one question. Once again, that is star one to ask a question. Our first question comes from Eric Caldwell with Baird. Your line is open. Please go ahead.

Okay. First question, worst question. Probably one of the biggest debates this quarter is when are you going to give 23 formal outlook? I was hoping I could maybe put the put the pressure on for you just to tell us when that will be so we can end the debate?

We very much want to see the end of the year.

We want to see how the following year begins. We moved away from that last year, but that's our normal cadence, given the uncertainties and the complexities in the world. So we are highly likely to do this in February.

Yeah, I appreciate that, Jim. Fundamental question on the avian divestiture. I'm a bit curious. You say it's no longer a core competency, but you've been here forever. You've run it well. It's been extremely profitable, and there is some earnings dilution with the divestiture. It's not the first time here in the last year you've sold something that had a similar, I guess, characteristic of maybe low growth, no growth, but very high profit and very earnings accretive. what do we learn from that? I'm interested on why this was no longer a core competency. What was the main driver? Was it more the revenue growth rate, or was there something more to that, or would maybe this be a signal that you're shifting your attention on higher growth businesses? Thanks so much.

This was a business when we bought it that had much higher growth characteristics. It was a more meaningful part of the company. It was more strategic. It was more central to what we were doing. I would say it's more of a core competency. So margins are good. It's a true statement. I would say that it's moved into a no-growth genre, which we obviously don't like, so it's dilutive to our top line. It's a business that has been okay but we've been we've been unable we've owned that business by the way uh since the mid 80s we've been unable to really um crank it up in any meaningful way by moving into adjacencies which we tried so it seems that we should um monetize it you know use the proceeds for uh in this case probably debt pay down but um use our assets for more basic and relevant activities. So just sort of moved out of our central focus. You know, the other risk is when a business is not within your major focus, you don't give it the time and attention that maybe you would have otherwise. you know, given that we're in a kind of double-digit growth methodology right now, we certainly want to maintain that.

Yeah, sounds good. I'll cease the floor here. So thanks, Jim. Thanks, Eric.

Our next question comes from Derek DeBruin with Bank of America. Your line is open. Please go ahead.

Hey, good morning, everyone. Thank you for taking my question. So realizing that a lot has moved in the world since your 2021 analyst day. But can you talk a little bit about the margin cadence as we sort of think about going into 2023 and 2024? You know, you have that roughly 22.5% margin target for 2024. And I'm just sort of curious how we should think about it, realizing you've got FX moving, divestiture is just the investment in the business, inflationary cost. Would love some thoughts on how you're thinking about the margin progression.

Sure. Hey, Derek, good morning. It's Flavia. And to your point, since we provided that long-term outlook about 18 months ago, a lot has changed, right, in the world, in macroeconomic conditions. So we're certainly going to take the time to finish the budget for 2023, which will be an important jump-off point for us to consider the longer-term outlook. We continue to aspire to deliver long-term outcomes high long-term healthy revenue growth and operating margin expansion. So, the tenants of our long-term aspirations remain, but we're obviously going to need to go back to the drawing block and look at, you know, the numbers in more detail since, to your point, a lot has changed since we went out 18 months ago.

Got it. And if I can do a follow-up, you know, one of the other CDMOs in the space yesterday called out some headwinds in their developmental services across biotech and pharma, which was sort of a surprise to us. You know, I hate to belabor the point given your conversation on biotech, but do you see any sort of like weirdness, you know, did the discovery business get worse? Did anything sort of soften between the time you had August, between August and now to sort of make you more cautious on the outlook? It doesn't sound like it, but I'm just trying to reconcile some of the comments from some other companies. Thanks, and I'll get back to you after this.

We didn't see anything conservatized slow down anymore. The discovery growth rate has moderated pretty much, pretty much totally in line with our expectations. As we said in our last call, we've had a lengthening of decision making. We've had no clients or very few clients really focus in on the reason for the delay relative to funding. But if they have to make those decisions of doing slightly less discovery in order to do more IND work, they're going to do that all day long. So we haven't seen any fundamental difference in the cadence since the last time we talked about this.

Thank you.

Our next question comes from Sandy Draper with Guggenheim. Your line is open. Please go ahead.

Thank you very much. Maybe just a question on the price side, and I'm sure if this is for you, Jim, or Flavia. When I think about your comments about strong pricing and et cetera, should we think about that as a, you know, that's going to flow through the model for the next four quarters or really into next year? Is that something that's just hitting This quarter, I'm just trying to think about the cadence of the pricing changes and how they flow through the model. And just to think about, because that's clearly been very impressive. Sounds like it's going to spill into next year. I'm just trying to understand how we should be thinking about those price increases flowing through and how sustainable they are. Thanks.

Yeah, we were very clear about the fact that the back half of this year, as exemplified by the third quarter, would have increased volume and increased price, which, of course, we just delivered. and tightened up our guidance for the year, so that cadence is pretty clear. We have an unusually high amount of our safety assessment booked for next year at escalating and increasing prices, both related to inflation, but primarily related to the increased complexity of the work, the depth of the science that we do vis-a-vis our competitors and vis-a-vis big pharmaceutical companies. So we feel very good about our price and power and sort of the leverage we have with our clients. We feel really good about capacity utilization. We feel really good about headcount where we have it right now and our ability to do the work. And as we've been saying for a few years, as the work has gotten more complex, we really feel that we ought to be paid well for it. There were years historically where we didn't think we were being paid well for it. I do think that that's changed. So as we look to next year without getting too granular, of course, we haven't even finished the plan yet, but we do have a lot of work booked at higher prices.

That's really helpful. Thanks so much, and congrats on the quarter in a challenging environment. Thanks, Sandy.

Our next question comes from Dave Windley with Jefferies. Your line is open. Please go ahead.

Hi, good morning. Thanks for taking my question. Jim, I wanted to kind of understand, I guess, relative movement within discovery and safety assessment. You commented on that this morning and previously. I guess we're hearing, you know, Derek mentioned it from yesterday, but we're hearing from a number of different players, including you, talking about slower decision-making. I guess I'm wondering how you distinguish between discovery and safety assessment. What's the protection or the boundary if they slow down discovery? Should we be braced or are you braced for that bleeding over into safety assessment? And maybe another way to get comfortable with that, you mentioned the $6 to $8 million in kind of total cost of, I think, an IND enabling program, I think was the point of those numbers. How much of that comes after IND such that it might run congruent with or, sorry, coincident with clinical trial activity and be, you know, therefore very important?

So we think it's a tale of two cities, right? So we think that any company, large or small, where the promising compound, particularly for unmet medical need, will do anything humanly possible or financially possible to get this thing to an IND and ultimately into the clinic where they often monetize the asset, right? Sell the company, sell the drugs, sell the U.S. rights. whatever. So that would jive with the strength of the backlog, which is increasing, the prices that are escalating, the sheer volume that we're seeing in 2023, which is unprecedented, even though we had some of that in 22. Obviously, the discovery war comes earlier. And at some point, Dave, if you don't have a significant volume of discovery work that will impact the volume of safety work, but I think we're a long way away from that. I think we're seeing some thoughtful pauses with some of our clients, just saying, and a small number of clients, by the way, a very small percentage, just saying a lot of uncertainty in the world in terms of access to additional capital, particularly in the capital markets, and so we're going to prioritize our discovery assets well. Having said that, the inflows from the capital markets are increasingly better. Third quarter was better than the second, second better than the third. This will end up being a strong year. Venture capital inflows are at an all-time high, and pharma access to capital for pharmaceutical companies is probably at an all-time high. So, again, we feel strongly that quality assets will be funded in one of those three incarnations or all of the above. So we're watching closely as we just reiterated, really not hearing a lot of conversation from clients saying, you know, we really have to pause because we're worried about our cash. They're just pausing. So we're inferring that, which I think is the right inference, but Discovery is still a relatively small percentage of DSA, and so we're really thrilled with what we delivered in the third quarter, optimistic about what we'll be able to deliver in the fourth quarter, and pleased with the backlog that we have into fiscal 23.

If I may add, Dave, we started sharing the DSA backlog earlier this year, and I know that has been a slowdown in biotech funding going into this year. So, we're now 11 months into the year, and every quarter we have seen the DSA backlog increase sequentially and pretty substantially over a year. So, We really haven't seen any slowdown on the DSA backlog that would point to any adjustments or anything, you know, being impacted by the biotech funding dynamics, which every quarter I know you all ask about. So, we feel good, as Jim said, that we have a substantial portion of the backlog booked already for 2023.

Excellent. I don't have to use a question for that one. Thank you. I did want to follow up on your comments around pricing and complexity. You did include some comments around pass-throughs in the deck today, which I think is the first time you've done that. Maybe that might be my fault. I guess I'd love for you to comment on that because obviously we do think that the pricing of some of the inputs to some of your studies has gone up just massively. I guess the part that I wouldn't quite be able to follow is if you are treating those as pass-throughs, those would have a very dampening effect on your margin, and we're not seeing that. And so maybe you could, I know you're not going to get into great detail, but maybe help us understand the mechanics of that just a little bit?

Yeah, so Dave, you're correct that some costs have increased, and we are passing those increased costs to clients and keeping the same level of margin that we have whole. So they're neither dilutive or accretive to margin, if that makes sense.

That does help.

Yes. Thank you.

We'll go next to Elizabeth Anderson with Evercore ISI.

Hi, guys. Thanks so much for the question. I was wondering if you could comment on how sort of Delara's Human Care growing in the quarter. I know that you guys obviously did a lot of work to sort of make changes earlier in COVID to sort of increase the growth of that part of the business. How is that sort of panning out in these current days?

Panning out slowly. You know, we've made a bunch of changes in that business. I think the two most fundamental changes in that business are the product line, the nature of the product line versus sort of off-the-shelf things and specialty items, and also our access and social methodology to access donors. So all of that is now in place. We're optimistic that things will – and continue to improve, but I would say it's improving slowly.

Got it. So it's more of across the, like, 2023 kind of dynamic is the way we should think about that.

We certainly hope so.

Okay, got it. And then just in terms of the CDMO sales pipeline, we had heard that there were some sort of rebalancing efforts maybe between some biopharma sponsors in terms of having some internal capabilities for some of the CDMO work that they had developed during COVID and then potentially some dynamics in terms of using up some of that capacity versus starting to outsource as they grow. What have you heard on that front in terms of that? Are people sort of continuing to sort of outsource theirs or any kind of residual like internal capacity demand? Or maybe you haven't actually been seeing that at all.

I'd say that capacity is tight and expensive and the capabilities are complex, both in terms of analytical work and process development and ultimately scale up. It's inconceivable to us that biotech companies sort of large or medium would even contemplate this. Just a few big companies that we've heard of that have built their own space. less because they don't trust or like the external providers, but more about concerns about available capacity. So, you know, I think there's going to be a lot of work outsourced. There's going to be some work that's going to be internally, facilities built internally and the work done internally. We'll see, though, whether that work is just for clinical trial lots or whether that will be commercial Work as well, you know, I think the biotech companies have done a wonderful job utilizing external resources to do their work. And so we have, we think plenty of work and lots of conversations going on right now and have added incremental capacity and feel that we're in a good place to get our share of the pie.

Got it. That's helpful. Thank you. We'll go next to Patrick Donnelly with Citi. Your line is open. Please go ahead.

Hey, guys. Thank you for taking the questions. Jim, maybe on the DSA side, I talked a little bit about the backlog there. On the staffing piece, I've heard this earnings season from some of your peers. You've seen some labor shortages out there that prevented other companies from converting over a pretty strong demand backdrop. Your guys' backlog is growing, as you talked about. You seem to be ahead of the curve there, kind of prioritized hiring late last year into early 22. Are you better positioned here now as a potential candidate for share gains given you're able to take on more work? How capacity constrained are you guys given the labor side? Maybe just talk through that a little bit.

Yeah, we feel really good about our labor component. We've worked really hard at it for several years now, both in terms of starting wages, both in terms of numbers of recruiters, in terms of explicit career development opportunities so we can attract really talented people and keep them. I'm thinking about some of the cell and gene therapy folks that we've added over the last year or so. So in terms of numbers of people to initiate work or to continue to do work as we move into fiscal 23, we feel really good about where we're at. I think we got ahead and stayed ahead of the Salary levels both starting and otherwise for fiscal 22 and we had that embedded in our plan and our guidance. While our 23 plan isn't done yet, we will do the same thing. You know, we hope. I mean, it's a little bit vague out there, but we will continue to be appropriately aggressive in terms of being able to bring in new folks. So we feel really good about our labor component. We feel really good about our capacity, available capacity of multiple sites. We feel really good about our pricing power. We feel really good about clients waiting. a significant amount of time to initiate studies, getting in line and prioritizing what studies they want to do first. That's so new. We've been doing this a long time. That's sort of new the last couple of years. This is an industry that historically hasn't planned well, and there's lots of changes, but they really do have to plan well now, and that's, I think, holding us in good stead. So labor component is in a good place.

Okay, that's helpful. And then maybe just on the capital deployment side, you guys obviously have some money coming in the door from the divestiture. Sounds like maybe near term a little more priority on the debt pay down. But maybe just talk about, I guess, the M&A funnel. You guys are actually executing on some of the more recent deals. Is it, you know, put a pause on that, pay down some debt? What's the right way to think about near term priorities before you kind of get back to the normal kind of cadence there?

So both Flavia and I will answer aspects of that question. I would say a couple of things. Number one, that we're deep into the integration of our cell and gene therapy assets, which obviously has been more complex and more challenging than we thought, given the nature of the science and the newness of the science and some of the challenges. So going well, really pleased with the facilities, the staff, the sales organization, the regulatory folks, and new clients, and also sort of a massive marketing initiative to make sure that people, you know, understand that we're in this business. I think I want to use the word pause, you know, because we did the Explorer deal, and we would do a small tuck-in deal of a technology deal Depending on when it was available, you know, we certainly don't always control the timing of these deals. But I would say that directionally, our balance sheet is increasingly in good shape to do some meaningful M&A. I don't want to say when that might be, except to say that we have multiple conversations going on right now. with potential acquisition targets, almost all of which are owned by private equity, and we are always having conversations with them. I'll let Flavia answer what we're likely to do with the proceeds from Avian.

Yeah, Patrick, so thanks for the question. And we regularly evaluate, obviously, uses of capital. As Jim said, M&A has served us well and has been a strategic lever for the company, for the growth, for us to acquire the scientific wherewithal to distinguish us with our clients. But in the short term, the near term, we're likely to focus capital priorities on that repayment. And so I would expect a portion of the avian proceeds to indeed go towards paying down debt. And we'll continue to look at capital priorities. You know, we discuss it regularly with our board, and we'll continue to evaluate other uses. But in the short term, likely a sizable portion of the AVN proceeds will go towards that pay down, especially given the high interest expense, interest rate environment that we're in right now.

Appreciate all the color. Thank you, guys.

Your next question comes from Casey Woodbring with JP Morgan. Your line is open. Please go ahead.

Hi. Thanks for fitting me in. Can you guys just talk toward the volume growth and DSA in the quarter? How much of that was just based on the increased capacity that you had come online? And then also just wanted to get a sense on if volumes are trending meaningfully higher than where maybe you had expected them to be heading into 2023, maybe at the time of the initial Initiation of guidance and maybe versus even several months ago. And then just as a follow up, I don't think I caught a backlog growth number for DSA. I'm wondering if you could provide that and if you have any line of sight towards, you know, double digit growth in DSA next year. I think the street has you at 9% in 2023 for DSA growth. Thanks.

So, we've worked really hard for a number of years, probably longer than I recall. probably approaching a decade, actually, of adding incremental capacity at multiple locations simultaneously every year. And then that was increasing as the size of the business has increased. And we have to build it 12 to 24 months in advance. So we have to call it right now. So we're building space out right now. We have to call that for the end of 23 and much of 24. So to some extent we have to be prescient. It does help, obviously, to have so much backlog and so much in the future and so much demand and us having such a strong franchise. So, yeah, we're getting a lot of volume. We're for sure taking share. That's our goal and necessity. We have new companies. 300-400 new companies every year that are going to need safety assessment eventually, and we want to have as much of that work as possible. We have a lot of big pharma work, increasingly so, and intensifying, and obviously a lot of mid and large biotech. A lot of share gains from competition and a lot of just de novo work that wasn't available for anybody. So we will continue to hopefully get price. We will continue to hopefully get volume as we have the space. We're very careful not to build too much incremental capacity so that we're swimming in it and its adverse impacts are operating margins by the same token. particularly if you look at last year, where we definitely crushed our operating plan, it was very important that we had incremental space and we were able to take on new business. Yeah, sure.

And, Casey, just a couple of additional comments before I give you the backlog number. I think, as Jim pointed out, it's incumbent upon us to get it all right, right? We have to have physical capacity, expanding our facilities at the appropriate time, not too soon, not too late. We have to have the people. I think Patrick talked about that. We feel really good that we got ahead, if you will. And you saw the you know, when we provided guidance earlier in the year, we talked about a stronger second half for DSA, which I think, you know, there might have been some skeptics out there, but we are seeing that materializing in the volume acceleration in the second half vis-a-vis the first half. As all of those folks that we hire now become productive, they are out of training, and they can really be available to support the strong client demand that we're seeing and allow us to gain share, as Jim said. So I think we really have done a nice job of ensuring we have the available physical labor, you know, input resources capacity available to absorb the increase in demand. In terms of the backlog, the backlog in the third quarter was $3.2 billion, so it was about 7.5% sequentially growth versus the second quarter.

That's helpful. Thank you.

We'll go next to Jacob Johnson with Stevens. Your line is open. Please go ahead.

Hey, thanks. Good morning. Just one. On the CDMO business, you call out that you don't expect it to meaningfully improve until next year. So as we think about improvement into 2023, as Derek and Dave alluded to, there was, you know, CDMO talking about the funding environment impacting their development pipeline yesterday. I'm just curious, any thoughts on kind of the demand backdrop for CDMO services as we think about kind of that business returning to growth next year? Thanks.

Yeah, so we are optimistic about next year. It's a business that has limited providers, both of the services or the products required, so that provides enormous opportunity for us, going back to the previous question about clients doing it themselves. 3,000-ish molecules, at least two-thirds of which are in a preclinical domain, so there's an awful lot of work available. So, you know, we've been working hard to have the right staff, the right facilities, and the right dialogue so the clients know that we're deep in this in concert with our biologics business, which gives us, I think, a competitive advantage, also in concert with our safety assessment business. So we feel really good about our portfolio and the ability to service a whole range of cell and gene therapy customers across the whole CDMO really paradigm.

Got it. Thank you. We'll go next to Justin Bowers with Deutsche Bank. Your line is open.

Please go ahead.

Hi. Good morning. Could you give us a sense of what the the growth was for the QC business and manufacturing. And then, gosh, I mean, I think it's been like eight to 10 years since Todd and I went in depth on the avian business. But if I recall, there is some seasonality to that. Can you just remind us of that as we just think about modeling?

Yeah, so we're not going to break out the growth rates of the specific pieces of manufacturing, except to say that we were pleased with the growth rate of microbial and pleased with the growth rate of biologics and not pleased with the growth rate of avian, which is why we sold it. I don't think that business was particularly seasonal, by the way. We had a pretty consistent client. Orders throughout a long period of time for almost entirely avian vaccines, a little bit of human flu. So it was time to divest that business.

Yeah, and I'll just add that the other component of manufacturing is obviously the CDMO business. And to Jim's point, while strategically we have determined not to be the best fit with our strategic aspirations and ambitions, the biggest headwind, I would say, currently in manufacturing is CDMO, as we have talked about in the second quarter earnings.

For some reason, I thought I recalled the first quarter, there was kind of an outsized contribution there, but that's clearly not the case. Maybe just a quick follow-up one. What's kind of like the rule of thumb for every kind of one-point move in FX on the year in terms of like the operating profit impact?

Yeah, I think, Justin, we can take that offline with you.

Okay. You know, we have exposure into various different currencies, so it's hard to give you, you know, a precise impact depending on which currency it moves. It can have more or less of an impact. So it's not, you know, one point equals X. Got it.

I'll take the rest offline. Thank you.

We'll go next to John Sabir with UBS. Your line is open. Please go ahead.

Hi. Thanks for taking my question. You know, maybe just one on the CDMO and cell and gene therapy manufacturing and just the turnaround recovery next year. Do you see any areas of gaps or maybe areas that could be complementary within the portfolio there that, you know, invest in organically or inorganically that could help accelerate that turnaround into next year?

Not really. I mean, we probably have some subtle gaps that, as this business matures and strengthens, that we'll take a look at. I think while it's possible to do it organically, it's probably some modest amount of M&A. But I wouldn't say that any of those issues are getting in the way of the growth and development of business. So I think it's – We feel that we're making all the right moves to strengthen it, to access clients, to distinguish our portfolio from the competition, and to have both the space and the people and the regulatory acumen to move work forward, certainly into the clinic and hopefully eventually into a commercial genre.

Yeah, and I'll just add, I think in the second quarter earnings, we talked about obviously what we've learned in the CDMO as we took the assets. They're longer sales cycles, but I think actually at this point, those longer sales cycles and the efforts that we have been doing and putting in our BD teams are bearing fruit in us having good visibility into potential opportunities for next year. So we feel good not only that we're going to have easier calls, but that we have light aside to, you know, the underlying demand that Jim talked about.

Got it.

Thank you for taking the question.

We'll go next to Dan Leonard with Credit Suisse. Your line is open. Please go ahead.

Thank you. Just a question for you, Flavia. I just want to make sure I'm clear on how you're framing interest expense for 2023. Did you say that if rates go up by 100 basis points, today, then the starting point for interest expense is $119 million for 23, or is there a different base on which you're calculating this sensitivity?

So I just, I provided, I tried to provide some help for your guys' how-you model that, you know, in 2023, about 100 basis point change in interest rates would result in about $9 million of impact to our interest expense. It's, to your point, this year, because the Fed has moved pretty much every quarter, right, and every quarter we have updated our interest expense outlooks, it's hard to establish from which base. So I just wanted to provide you some modeling help that for next year, 100 basis points is worth 9 million.

Would the Q4 number be a good base, the Q4 run rate be a good base to calculate from?

You have different bases, so every quarter is going to be a little bit different. That's why it's challenging given what has been the escalating interest rate highs this year.

Okay. I understand. Thank you.

Our next question comes from Max Smock with William Blair. Your line is open. Please go ahead.

Hi, it's Christine Raines on for MaxMock. Just one for me. So for the DSA business, if you're willing, how much of the 20.8% organic growth is coming from price increases? Assuming that you're not willing to quantify that, what do you currently view as the more normalized sustainable growth in demand for both discovery and toxicology? Thank you. Thank you.

Not going to give you the price increase. We really don't want to unpack it. So we're really pleased with both the volume growth and the pricing power in that business, which has improved pretty much sequentially year after year as the demand has increased, as our competitive posture and capabilities have increased. So We're happy to be getting share, taking share, and getting paid well for our business. We're very pleased with the improvement in operating margin in third quarter and particularly pleased with the volume of work that's already booked into fiscal 23.

Great.

Thank you.

We'll go next to Tia Savant with Morgan Stanley. Your line is open. Please go ahead.

Hey, guys. Good morning. So quick one on safety assessment here. Is there any color you can share on proposal volume growth in the quarter? And, Jim, if you can comment on lead times. I mean, do you see those sort of moderating at all sequentially, or are they still where they were a couple of quarters ago for the business?

Proposal volume, we're busy. Lots of proposals and lots of work being booked. don't really see any rationale structurally, demand-wise, or otherwise, why things would moderate. We'll talk more about that as we finish the year and see how the year ends, obviously, but our competitive posture seems to continue to strengthen. Pricing power, as I said, continues to strengthen. Then there's a lot of work. Clients are really busy with a whole range of large and small molecules, a lot of cell and gene therapy work. And so the thing that we've seen most of is prioritization of what drugs they want to get in earlier. We try to accommodate that. We also, we didn't have it in our prepared remarks, but we do have some clients that have signed up for dedicated space with us. I think that's a really important happening and really an important sort of commentary on both the acknowledgement on the client's part that they need some vehicle to move relatively to the front of the line. So we'd be surprised if we don't see more arrangements like that.

Got it. That's helpful. And a quick follow-up on RMS, a near-term one and then sort of the medium-term one. So in the near-term, Jim, can you just comment on thoughts on RMS margins in China and how you see those trending? And can you just parse out how much of the headwind there was from your expansion plans versus other factors? And then the medium term question was related to this, you know, FDA modernization act. How are you thinking about that over the medium term for the animal model side of things? And are you starting to hear anything from your clients at all on that?

So China has been a place with strong growth rate and, with margins, some price and power. And a lot of that is associated with access to incremental animals and other geographic locales in a very large country. So we've continued to increase capacity both for the product and the service side in RMS in China. And we're really, we're pleased with the results. While we definitely have competition over there, most of it's local and most of it is much less sophisticated from an animal quality and veterinary point of view. The dialogue about in vitro technologies, 3D models, AI, I mean, all of that, it is not new. We're interested and have always been interested at Charles River in making sure that minimal amounts of animals are used and used appropriately for studies. We've seen a mix in animal models over the years with more refined, higher ASP models, so hypertensive animals, immunocompromised animals, double, triple, quadruple immunocompromised animals, inbreds, hybrids. et cetera, with higher ASPs and less sort of outbred models. I'd say a couple of things, that while I think there's a desire on the part of whomever, public maybe, for there to be a reduction or replacement of new technologies for re-enrollment models. And by the way, we see most of those technologies They will not provide a sufficient safety profile. Many of the diseases for which we have drugs, scientists don't understand the mechanism of action. And most diseases, we don't have drugs, we definitely don't understand the mechanism of action. So trying to replicate that with a computer or cell culture or ex vivo system is very complicated and It's unlikely that the drug companies would take the time to validate those technologies or the regulatory agencies would. Would be comfortable with that. Yeah, I think it's a little bit different with discovery. So that's regulated safety. So we don't see any changes. You're going to need a whole. animal model to get good results, and in most cases, two different species. On the discovery side, most of the big pharma companies have their own in vitro screens, which they don't share with anybody else. We've made a couple of investments right now in AI and machine learning. We'll make more investments in AI and machine learning. And we can see a time where some of the early discovery answers pre-getting into animals could be done in vitro and could be done faster. I think that's one of the places that we will all save time. So a little bit of a tale of two cities.

Got it. Super helpful. Thank you. Sure.

Our next question comes from Tim Daly with Wells Fargo. Your line is open. Please go ahead.

Great, thanks for the time. Just a quick modeling question from me. So the comps for DSA growth ease from 3Q to 4Q, and historically there's been a bit of a sequential lift in the dollar revenues into the fourth quarter. So just curious, is there anything specific that you all are seeing today which would limit quarter-over-quarter expansion in either the revenue dollars or the percent organic growth in DSA down the year?

No, I don't think so.

Just remember, Tim, that there's also a 53rd week this year that I alluded to. So from a reported perspective, there's going to be that impact.

All right. Great. Thanks. That's it for me.

Thank you. And that is all the time we have for questions. I'll turn the conference back to Todd Spencer for closing remarks.

Great. Thank you for joining the conference call this morning. We look forward to seeing you all at upcoming conferences. Thank you and have a good day.

Thank you. Ladies and gentlemen, that will conclude today's Charles River Laboratories third quarter 2022 earnings conference call. Thank you for your participation. You may disconnect at this time.