Charles River Laboratories International, Inc.

Ladies and gentlemen, thank you for standing by and welcome to the Charles River Laboratories third quarter 2023 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.

Good morning, and welcome to Charles River Laboratories' third quarter 2023 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 2023. Following the presentation, they will respond to questions. There is a slide presentation associated with today's website, 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 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 for the company constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results may materially differ from those indicated. During the conference call, we will primarily discuss non-GAAP financial measures, which we believe help investors gain a meaningful understanding of the 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. I will now turn the call over to Jim Foster.

Good morning. We reported third quarter organic revenue growth of 4.1%. and earnings per share of $2.72, both of which exceeded our prior outlook. As anticipated, our growth rates declined from first-half levels, reflecting the difficult comps from last year and the moderating demand that is affecting our businesses this year. Looking at the biopharmaceutical and market environment, we believe certain demand trends showed some early positive signs, but clients also remain cautious with their spending. Biopharmaceutical clients are continuing to reprioritize their pipelines and, in some cases, conserve cash or streamline their cost structures. This has led to a meaningful impact on some of our businesses this year, including Discovery Services and our manufacturing segment, and began to have a more discernible impact on the RMS business in the third quarter. We believe the current client spending patterns will persist in the near term. However, we are also seeing some early encouraging signs starting to emerge, which support our belief that the demand environment will stabilize. In the safety assessment business, we were pleased to see sequential improvement in both the study cancellation rate and the net book to bill ratio in the third quarter. These favorable trends are supported by external indicators including a stable biotech funding environment. The third quarter was the second consecutive quarterly increase in biotech funding on a trailing 12-month basis, led by venture capital investments. I will now provide highlights of our third quarter performance. We reported revenue of $1.03 billion in the third quarter of 2023, a 3.8% increase over last year. Organic revenue growth of 4.1% was driven by all three business segments, led by a mid-single-digit increase in the DSA segment. As I mentioned earlier, the third quarter growth rate was affected by a difficult comparison to last year that included organic growth of 15.3% in the third quarter of 2022. By client segment, third quarter revenue growth was driven by solid demand from global biopharma clients and academic institutions. As has been the case throughout the year, the growth rate for small and mid-sized biotechs slowed as these clients are being more selective with their spending. Growth of biotech clients last year also outpaced all other client segments, driving the particularly difficult comparison in the second half of the year. The operating margin was 20.5%, an increase of 10 basis points year over year. The slight improvement was driven primarily by the DSA segment, as well as lower unallocated corporate costs. These improvements were largely offset by margin pressure in both the RMS and manufacturing segments. Earnings per share were $2.72 in the third quarter, an increase of 3.4% from the third quarter of last year. This exceeded our prior outlook due primarily to the top line outperformance. In addition, the year-over-year headwind from interest expense is beginning to dissipate. We have tightened our revenue and non-gap earnings per share guidance ranges for 2023 as we move into the final quarter of the year. We are narrowing our organic revenue growth guidance to a range of 5.5% to 6.5%, and our non-gap earnings per share guidance to a range of $10.50 to $10.70, which raises the bottom end and trims the top end of our prior range by 20 cents per share, respectively. The guidance update is primarily due to shifts in the gating of our forecast between quarters and the favorable impact of lower third quarter cancellations in the safety assessment business being largely offset by a reduced outlook for our manufacturing solution segment in the fourth quarter. I'd like to provide you with additional details on our third quarter segment performance beginning with the DSA segment's results. DSA revenue in the third quarter was $664 million, an increase of 5.3% on an organic basis. Safety assessment business continued to drive DSA revenue growth with contributions from base pricing and higher study volume driven by non-NHP related work and post-IND studies. NHP pricing was a modest benefit to the growth rate, but as I will discuss shortly, NHP study volume declined year over year. Discovery services remained an integral component of our end-to-end early stage portfolio because it enables us to forge relationships with clients at earlier stages of the R&D process. However, the business continues to be impacted by the overall biopharm and demand environment as clients focus on post-IND work and getting their drugs to the clinic to the detriment of discovery spending. As I mentioned earlier, we saw some early signs of more favorable demand trends in the third quarter for our safety assessment business. The cancellation rate improved sequentially and was at the lowest level since the second quarter of 2022. The net book-to-bill ratio also improved sequentially but remained below one times. As a result, the DSA backlog declined in the third quarter to $2.6 billion from $2.8 billion at the end of the second quarter. However, as the lower cancellations suggest, clients appear to be moving further along in their pipeline reprioritization processes, which we believe will lead to a higher quality and more reliable book of business. With the net book to bill remaining below one times, we believe the current demand trends will persist in the near term, including in the fourth quarter, which, as a reminder, already faces a difficult comparison to DSA organic growth of 26.5% reported last year. Overall, we believe stabilizing demand trends and significant backlog coverage will enable us to achieve our financial targets, including high single-digit DSA organic revenue growth for 2023, which is above our prior outlook for the segment. The DSA operating margin was 27.2% in the third quarter, a 100 basis point increase from the third quarter of 2022. The increase continued to be driven by operating leverage associated with higher revenue in the safety assessment business. Before moving on to RMS, I'd like to comment on our NHP-related study work. At our investor day in September, we provided some information around the benefit from NHP pricing on our DSA revenue growth rates. We believe that additional information would be useful for investors and analysts to gain a better understanding of the impact of NHP pricing and NHP-related safety assessment studies on our business. Over a three-year period ending in 2023, NHP pricing is expected to benefit DSA revenue growth by a total of just $230 million, or approximately 30% of our total DSA revenue growth since 2020. Without the impact of NHP pricing, DSA revenue would still have increased at a high single-digit growth CAGR since 2020. In total, NHP safety assessment study revenue, which includes both services and the embedded NHP revenue, is expected to represent approximately 30% of DSA segment revenue in both 2022 and 2023. NHP pricing has rapidly escalated since 2020, due to both NHP supply constraints and the continued increase of biologic drugs in development. The supply constraints began in China around the pandemic and intensified last year due to the Cambodian NHP supply situation in the U.S. This has caused NHP pricing to increase by approximately $20,000 per model in aggregate since 2020. In 2023, we expect to utilize approximately 11,400 NHPs in safety assessment studies worldwide. This represents a reduction of approximately 25% from over 15,000 in the prior year, principally driven by the current level of biopharmaceutical demand, and our clients focus on their post-IND safety assessment work, which generates higher service revenue per model due to the longer-term nature of these studies, but fewer NHPs are used to generate that service revenue. A longstanding strategic imperative of the company is responsible animal use, which includes modifying or reducing animal usage. Responsible animal use is firmly embedded in our commitment to animal welfare and the four R's principles. And its adoption accelerated this year as a result of the NHP supply constraints. One example of our progress is the introduction of virtual control groups for toxicology studies. Virtual control groups, or VCGs, replace the animals in control groups with existing randomized data sets and statistical evaluations. It will take some time to adopt, but we are having active discussions with our clients about VCGs. As many of you are aware, we have committed to providing additional disclosure on NHP sourcing and a comprehensive update on our NHP strategic initiatives in early 2024. The timing of this strategic update will be ideal as we recognize the industry is changing and these shifts are causing disruptive technologies to emerge and societal needs to evolve. With the industry at an inflection point, we will reinforce our critical role in preclinical drug development and maintain our leadership position. We will do this by leading with science, remaining committed to our essential mission of creating healthier lives and ensuring patient safety, and by consistently challenging ourselves to raise the bar. As we look to the future, we will be focused on ensuring a sustainable supply chain, particularly for NHPs, and we'll also pursue a longer-term strategy to lead the industry in adopting animal alternatives. Our team is diligently working to continue to enhance our processes and key initiatives in these areas. We've already made several investments in non-animal technologies ranging from our EndoSafe Trillium launch this summer for endotoxin detection testing to our technology partnerships with Valo for discovery AI, PathEquest for next-gen sequencing for in vitro viral safety testing, and Cypray for 3D tumor modeling. We look forward to sharing our NHP strategic update in early 2024. RMS revenue is $186.8 million. an increase of 3.2% on an organic basis over the third quarter of 2022. This is below the year-to-date high single-digit revenue growth rate for two primary reasons. Slower demand from mid-tier clients, including biotechs and CROs, and the timing of NHP shipments within China as we anticipated last quarter. The timing of NHP shipments within China is transitory. We expect NHP revenue in China will improve in the fourth quarter, although some shipments will slip out of 2023. For the year, we expect RMS organic revenue growth will be in the mid to high single-digit range. In the third quarter, we generated revenue growth in our small research models business and in the services business. My client segment demand from global biopharma clients and academic institutions remained robust, and drove RMS revenue growth. But as I mentioned, this was offset by mid-tier clients affected by the broader biopharma demand environment, as well as by softer demand from government accounts. Small molecules revenue increased across all geographic regions, including China, principally driven by price. Our services business continued to report healthy growth, led by insourcing solutions and our cradle operations. Our cradle sites, or our flexible divarium rental space, remain well-utilized overall and continue to generate significant year-over-year revenue growth. In the third quarter, the RMS operating margin decreased by 460 basis points to 18.9%. The significant decline was driven by the mix of business, which favored academic clients in our insourcing solutions business, as well as the timing of NHP shipments within China. we expect the RMS operating margin will rebound in the fourth quarter due in part to the timing of the China NHP shipments. In addition, as we mentioned at Investor Day, we are reviewing the profitability of certain insourcing solutions contracts which should benefit the RMS operating margin in the future. Revenue for the manufacturing solutions segment was $175.7 million, an increase of 0.9%. on an organic basis compared to the third quarter of last year. This segment is experiencing softness across the broader end markets, which we attribute to a post-COVID slowdown from biopharma manufacturers, CDMOs, and their suppliers. These market conditions start to more noticeably impact the microbial solutions business in the third quarter. Clients, particularly CDMOs, are cutting costs, as part of their COVID destocking efforts and reducing testing volumes as fewer programs advance into the clinic. But these clients must continue to manufacture commercial products, so we believe the long-term growth trends for our manufacturing segment will reemerge after a period of right-sizing. For microbial solutions, the global biopharma demand environment is affecting our EndoSafe endotoxin testing product line as clients reduce reduced both testing volumes and investments in new instruments. This includes China, where we have a small microbial operation, and like many life science instrumentation companies, have seen a decline in client demand. However, other areas of the business, such as aquagenics microbial identification services, continue to perform well. Third quarter trends in biologics testing were similar to those experienced since the beginning of the year. the sector continued to be challenged by the tighter funding environment, which is resulting in clients reprioritizing projects and reducing demand for services that can be conducted at various times during the development process, including viral clearance and cell banking. While not immune to the end market challenges in the other manufacturing businesses, the cell and gene therapy CDMO business had another solid quarter, Its strong double-digit growth rate in the third quarter reflected the success of the initiatives the CDMO team has implemented since the beginning of 2022 to improve performance. We are working diligently to continue to expand our CDMO sales pipeline of new products and are pleased to have cleared several regulatory audits in recent months, including European EMA approval of our Memphis site for the production of a second cell therapy product. We believe that successful regulatory audits will generate additional client interest and support our expectation that we will add new commercial clients. The manufacturing segment's operating margin declined by 410 basis points year-over-year to 24.5%. In the third quarter of 2023, but did improve again sequentially, the year-over-year margin decline reflected the lower revenue growth rate and the softer demand trends, across the manufacturing and markets. We are intently focused on driving operating margin improvement in the manufacturing segment, including the profitability of the CDMO business, as this segment is expected to be the largest contributor to achieving our 2026 margin targets. We believe our leading position as an outsourcing partner for our clients' drug discovery and non-clinical drug development efforts is helping us to manage in the current demand environment. the IND enabling and associated non-clinical services that we provide are mandatory to help clients advance their programs into the clinic and eventually to commercialize drugs. Our portfolio also differentiates us in the marketplace because of our unique focus on early stage R&D solutions and our ability to distinguish ourselves scientifically. We believe that these attributes, combined with our continued ability to leverage the significant DSA backlog, will enable us to achieve our financial targets. Our value proposition of delivering exquisite science and driving greater efficiency and speed to market continues to differentiate Charles River in the marketplace and is reinforced with today's more budget-focused client base. To conclude, I'd like to thank our employees for their exceptional work and commitment, and our clients and shareholders for their continued support. Now Flavia will provide additional details on our third quarter financial performance and updated 2023 guidance.