Charles River Laboratories International Inc (CRL) 2006 Q2 法說會逐字稿

Good day, everyone and welcome to today's Charles River Lab International second-quarter 2006 earnings conference call. Today's call is being recorded. At this time I'd like to turn the call over to Corporate Vice President Investor Relations, Susan Hardy. Please go ahead.

Thank you. Good morning and thank you for joining us today. This morning Jim Foster, Chairman, President and Chief Executive Officer, and Tom Ackerman, Executive Vice President and Chief Financial Officer, will comment on our second-quarter results and outlook for the balance of the year. Their comments will be directed to continuing operations which exclude the clinical Phase II to IV and Interventional and Surgical Services business. Following the presentation we will respond to questions. There's a slide presentation associated with today's remarks which is posted on the Investor Relations section of our website at ir.criver.com.

A taped replay of this call will be available beginning at noon today and can be accessed by calling 888-203-1112; the international access number is 719-457-0820. The pin number in either case is 842-3456. The replay will be available until August 23rd; you may also access an archived version of the webcast on our Investor Relations website.

I'd like to remind you of our Safe Harbor. Any remarks that we may make about future expectations, plans and prospects for the Company constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by any forward-looking statements as a result of various important factors including, but not limited to, those discussed in our annual report on Form 10-K which was filed on March 14, 2006 as well as other filings we may make with the Securities and Exchange Commission.

During this call we will be discussing some non-GAAP financial measures. We believe that the inclusion of these non-GAAP financial measures helps investors to gain a meaningful understanding of our core operating results and future prospects consistent with the manner in which management measures and forecasts the Company's performance. 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 to those GAAP measures on our website. Now I'll turn the call over to Jim Foster.

Good morning. Three months ago we announced strategic initiatives designed to move us forward toward our goal of building a larger more profitable Charles River Laboratories. These initiatives included the strategic alignment of our portfolio to focus on core competencies, a more efficient cost structure and investments across the spectrum of our business. We are pleased to report that we have made progress on all of these initiatives and delivered solid performance in the second quarter. I'd now like to review the highlights of our second-quarter results from continuing operations and share our perspective on the industry and what it means for our business in the second half of this year.

Net sales for the second quarter from continuing operations were $268 million, an increase of 6.8%. Preclinical sales drove the increase reporting net sales of $137 million, a gain of 14.1%. The preclinical sales increase reflects a number of factors including new capacity which opened in the second quarter in Edinburgh, Massachusetts and Nevada; a favorable study mix, particularly in Montreal; stable pricing; and more business from existing clients as well as awards from new clients as they increase their use of strategic outsourcing. Our MS sales were unchanged in the second quarter, but 1.4% higher than Q1 sales due primarily to higher sales of large research models, vaccine products and in vitro products.

On a year-over-year basis the consolidated GAAP and non-GAAP operating margins were lower in this year's second quarter; however, 1.3% of the difference was due to the adoption of FAS 123R. On a sequential basis the benefit of the actions we implemented in the second quarter is already evident in our second-quarter consolidated non-GAAP operating margin which was 23% compared to 20.6% in the first quarter, a gain of 240 basis points. On a GAAP basis our second-quarter earnings per share from continuing operations were $0.46, an increase of 7% from $0.43 for the second quarter of '05. On a non-GAAP basis earnings per share from continuing operations were $0.57 compared to $0.55 in the second quarter of '05.

Higher sales, improved operating efficiency, a lower tax rate and fewer shares outstanding drove the improvement, more than offsetting the cost of 123R. On a GAAP basis, lower amortization and stock compensation expense related to the Inveresk acquisition also improved earnings per share. On a sequential basis GAAP earnings per share increased 18% from $0.39 and on a non-GAAP basis increased 21% from $0.47.

Before I comment on the segment results I'd like to highlights two pharmaceutical industry trends which we believe are strongly influencing our business. The graphic on slide 8 depicts two trends -- one, of lower capital spending, and the second, lower spending as a percent of sales. With weaker topline growth prospects due to drugs coming off patent, generic competition, pricing pressures and slower drug development pipelines, pharmaceutical companies are evaluating their options for more efficient drug development.

On the capital spending trendline, which indicates that Pharma is investing less in internal capacity, we strongly believe that pharmaceutical companies will continue to use strategic outsourcing to achieve their goals. So while their cost reduction activities may restrain our research model sales in the near-term, we expect that will be the case for the balance of this year, it should also continue to drive higher outsourcing spending both in Preclinical Services and research model preconditioning services over the longer-term.

This is why we believe the Massachusetts and Nevada preclinical expansions are critical and while we are intently focused on bringing them online on time and with what we believe will be the best scientific and operational staff in the industry. Strategically located on the East and West coasts of the United States where there is a high concentration of biotech companies, these facilities are necessary if we are to continue to absorb the volume of work that pharmaceutical and biotechnology companies outsource. Furthermore, we believe the timing of our expansions and those of our competitors are geared to the growth level of outsources service.

I'll give more information on our expansion in a moment, but first I'd like to review the segment results. RMS segment sales were unchanged from the second quarter of '05 and were up just 6/10 of a percent when excluding the effect of foreign exchange. Although we were disappointed with the overall growth, we were pleased with the performance of some of our RMS businesses. The vaccine products business reported stronger sales benefiting from a USDA contract for avian influenza test kits.

In vitro achieved a midteens sales increase primarily as a result of continued strong demand in Europe where customers are performing additional in process testing due to stricter enforcement of existing regulations. Sales of large research models were still below the second quarter of last year when we reported one of our strongest quarters, but were up sequentially from the first quarter and we expect substantially higher sales in the second half of the year. Preconditioning services reported another very good quarter as demand for outsourced services, particularly surgery, continued to increase.

The segment sales growth was restrained by research models in Europe and the United States which, as I mentioned, were pressured by the continuing cost reductions at some of our largest Pharma clients. As a leading provider of high-quality research models to large Pharma, these cost reduction activities affect us disproportionately. We are seeing the effect of these reductions in lower sales volumes; however, we're also experiencing higher sales to other clients, both large and small Pharma and biotech and believe that there continue to be growth opportunities in this market.

Transgenic services declined in the second quarter when compared to last year; however, our second-quarter sales represent the third consecutive quarter of stable sales. The sales decline began in the third quarter of last year, so assuming third- and fourth-quarter sales are maintained at the current level, we believe that compared to last year we will report only a small sales decline in the third quarter and flat sales in the fourth quarter.

As you know, we implemented a number of actions in the RMS segment in the second quarter to improve operating efficiency. In those areas where actions were taken, transgenic services and vaccine products, we did see a sequential improvement in the operating margin which is an important indicator of our progress. However, lower-than-expected research model sales volume and the costs associated with stock option expense offset these gains and the non-GAAP operating margin declined to 30.8% from 32.9% in the second quarter of '05. Stock option expense, which was $1.3 million, reduced the operating margins by approximately 1%.

For the balance of the year we expect that the sales and operating margin trend that we saw in the first half of '06 will continue with second half '06 sales growth in the low single digits and an operating margin around 30%. We believe that some of our major pharmaceutical clients focused on reducing spending will exert pressure on our research model sales, but we expect that the rest of our RMS businesses will track in line with our earlier expectations.

Transgenic services will continue at a similar level with year-over-year sales flat by the fourth quarter. Large research model sales will be stronger in the second half of the year, bringing our full-year results in line. Preconditioning services will continue to grow at double-digit levels and we expect in vitro to continue its upward trajectory, especially in view of the FDA approval for the first portable endotoxin testing system, the Endosafe PTS.

I'd like to take a moment to talk about the reception that this revolutionary technology has received so far. Following receipt of our FDA approval letter on July 13th, we launched a broad campaign to introduce the PTS to a larger audience. The responses have been gratifying with interest from numerous customers and many new leads. It will take clients approximately three months to validate the PTS in their manufacturing process. So while we do expect higher sales of the PTS this year, the incremental impact will really be felt in 2007 and beyond.

Based on expanded testing, which is enabled by the portability, ease-of-use and quick results of the PTS as well as pricing, which recognizes the value and efficiency which it provides to our customers, we believe that the market will expand nearly four times to at least $200 million. We believe that over the next few years we will convert many of our customers to the PTS as well as gain significant market share.

The Preclinical Services segment reported very strong sales growth in the second quarter, increasing 14.1% over the second quarter of '05. As I mentioned at the outset, we achieved this growth rate through a combination of throng customer demand for our services, an optimal study mix which favored high-end specialty toxicology, stable pricing and the addition of new capacity. We opened new capacity in Montreal early in the second quarter of last year.

In the second quarter of this year our new space in Edinburgh and also in our existing facilities in Massachusetts and Nevada where we were are able to redesign existing space. As a result of the new capacity and strong demand we expect that sales growth in the second half of this year will be similar to the first half. Furthermore, issues which impacted the first-quarter results improved in the second quarter.

Discovery services at our Worcestershire facility, for which demand has been limited, improved significantly as a result of more targeted sales initiatives and we expect that demand to continue. And in our Pennsylvania facility one of the three studies that were delayed from the first quarter started in the second quarter and the other two are scheduled for the third quarter.

We were exceptionally pleased with the preclinical operating margin, a combination of strong sales, the closure of ISS and the effect of cost-saving initiatives we implemented in the second quarter drove the GAAP operating margin to 16.4% which included $1.6 million of costs related to 123R compared to 15.5% in the second quarter of '05 and to 11% in the first quarter of '06. The non-GAAP operating margin increased to 24.8% from 24.3% in the prior year including 123R expense which reduced the second-quarter '06 margin by 1.2%. And sequentially the second-quarter non-GAAP operating margin gained 720 basis points, an excellent performance.

With a second-quarter preclinical non-GAAP operating margin at 24.8% including 123R we nearly achieved our goal of 25% non-GAAP operating margin and all indications are that we will improve the margin in the second half of '06 from the first half. We believe we can do so for three main reasons.

First, our continuing conversations with existing and potential customers indicate that strategic outsourcing will continue. Whether our discussions involve a single study, multiple studies or dedicated space, it is clear that there is a shift in pharmaceutical companies' perception of the value of outsourcing Preclinical Services and outsourcing them to Charles River in particular. Second, we should be operating at capacity for the balance of the year and high utilization rates drive our margin. Third, we are continuing to invest in our fourth-generation Six Sigma initiative and expect to continue to achieve efficiencies.

While there is some margin pressure as we bring our new facilities online, we believe we will be able to manage those costs and maintain our '06 non-GAAP operating margin in a range of 22 to 23% through a combination of best practices, Six Sigma improvements and the greater operating efficiency of the new facilities. We are moving closer to completion of our Shrewsbury, Massachusetts facility which is scheduled to open in the fourth quarter of '06. Construction is moving ahead rapidly and plans are already in place for validation of the facility.

Many of you have asked us about our staffing plan. So I'd like to give you an overview of where we are in that process. First, I want you to understand that recruitment is an ongoing process at Charles River. As a growing company we have a continuous need for knowledgeable and experienced personnel and as we hire those people we are mindful of the opportunity to improve our ability to serve our customers and drive our growth.

When we hired the new general manager of Massachusetts last year, one of his critical priorities was to build the bench strength at the Worcestershire facility. He spent the last 12 months enhancing the management structure, upgrading a number of existing positions and adding new ones. He then attracted top talent, including a number of highly experienced senior scientists from large Pharma and other prominent life sciences companies along with several proven experts from our Montreal facility, a move which enhances communication between our facilities and advances our efficiency initiative.

As a result we now have a very strong contingent of senior scientific experts who will lead our Massachusetts operation and an equally experienced group of managers to optimize our infrastructure, site operations and training efforts. We believe that this management team is one of the strongest in the industry and will attract clients and other new hires who want to work with some of the industry's best and brightest people.

While we continue to recruit for the first phase of the new Massachusetts facility the magnitude of that task has been greatly reduced by the fact we have already hired a number of personnel to staff the recent expansion of our Worcestershire facility. The remaining positions are primarily study technicians and facilities personnel. We are also fortunate that Massachusetts has a large, highly educated talent pool which further facilitates the hiring process. To recruit the additional employees we have developed a plan which addresses issues from branding to sourcing to training and are monitoring our progress against that plan very carefully.

We've commented previously on the fact that we are leveraging our investment and experience we've gained in building Massachusetts in our new Nevada facility. Nevada is coming online approximately six months behind Massachusetts which allows us the opportunity to benefit from our earlier experience. In addition, we are using the same architect, builder and product manager promoting further project efficiencies. We are on scheduled to occupy the first phase of the building in the summer of '07.

I'm also pleased to say that we have hired a new general manager for our Nevada facility, a senior scientist with an international reputation from a large pharmaceutical company. As was the case in Massachusetts, the Nevada general manager's role will be to enhance the management team and drive new business to our new facility as it expands over the next few years.

As I've said before, our ongoing discussions with customers concerning their long-term plans confirm our belief that the market for toxicology services will continue to increase as Pharma and biotechnology companies increase the volume of services they outsource to full service providers like Charles River.

Our state of the art strategically located main facilities in Massachusetts, Nevada, Montreal in and Edinburgh, and the outstanding people who work there, position Charles River as a premier provider of preclinical drug development services, one with whom customers can build long-term relationships.

Our investments in facilities and personnel are incorporated in our '06 non-GAAP guidance which we are reaffirming today. We continue to expect that sales growth from continuing operations will be between 6 and 8% or a range of $1.50 billion to $1.75 billion with RMS sales growing at low single digit rates and Preclinical Services at a low double-digit rate.

Given the trends in pharmaceutical spending which I've discussed, we expect that the non-GAAP operating margin in the RMS segment will be pressured for the balance of this year, but we expect it to stay at approximately 30% for '06. We also expect Preclinical Services segment non-GAAP operating margin to be in the range of 22 to 23% for the full year. In combination our guidance for the consolidated non-GAAP operating margin is approximately 22% for '06.

We expect the full-year GAAP EPS range to be between $1.73 and $1.79. On a non-GAAP basis in line with our earlier guidance the earnings range is still expected to be $2.12 to $2.18 per share. And given our expectations for continuing strength in our preclinical business, improving performance in some of our RMS businesses, and a continued focus on operating efficiency, we are confident that we can achieve these targets.

We are pleased with the progress we've made to date and expect improved performance in the second half of the year. Furthermore, we are continuing to execute the plans we implemented earlier this year which are targeted at strengthening our competitive advantages, increasing our market share and positioning Charles River as the premier integrated provider of preclinical drug development. We will continue our intense focus on organic growth and operating efficiency going forward. This includes the successful execution of our capital expansion plans, recruiting the best and brightest in the industry, investing in our infrastructure and operating efficiency improvement gains for our fourth-generation Six Sigma process.

In addition, we will continue to evaluate strategic bolt-on acquisitions which will expand our capabilities enabling us to better support our clients' drug development efforts. Our customers, ranging from large Pharma to emerging biotech firms to government and academic institutions, choose to partner with Charles River because of the value we provide. Specifically our deep scientific expertise and operational leadership, high-quality products and services, state-of-the-art facilities and our exceptional customers support. Combined these key differentiators are enabling us not only to expand our relationships with current customers, but also to attract new business during a period of tremendous opportunity.

I'd like to thank our 8,500 employees for their exceptional work and commitment and our shareholders for their continuing support. Now I'll turn the call over to Tom Ackerman.

Thank you, Jim and good morning. As you know, beginning in the second quarter we are reporting our clinical Phase II to IV and ISS businesses as discontinued operations. In addition, we reclassified the clinical Phase I financial results to the preclinical segment and restated our first-quarter 2006 and year-to-date 2005 financial results. Given these changes, I'd like to review the summary second-quarter results to ensure that there are no misunderstandings.

Starting with the second quarter 2006 results of continuing operations compared to the restated second quarter of 2005, you'll see that sales increased by 6.8%. I'll point out here that foreign exchange reduced consolidated sales by 30 basis points. Both GAAP and non-GAAP EPS improved year-over-year as a result of lower amortization of intangibles related to Inveresk, a lower tax rate and reduced net interest expense. In addition, there was a lower number of shares outstanding in the second quarter of this year as a result of our share repurchases. The increase in EPS was in spite of 123R costs which reduced second-quarter 2006 results by $0.03. Excluding that amount non-GAAP EPS for the second quarter would have increased at a rate of approximately 9% higher than the 6.8% sales growth rate.

Looking at the same data points for the second quarter compared to the first quarter of 2006, we have a sequential increase in sales of 5.4%, EPS increased 17.9% on a GAAP basis to $0.46 per share and 21.3% on a non-GAAP basis to $0.57 per share. As Jim said, the sequential improvement is due primarily to improved operating efficiencies as a result of the cost savings initiatives we implemented. We are very pleased with this performance.

We reported a $7 million loss from discontinued operations in the second quarter of 2006 which reflected a number of items including $3.9 million for a clinical Phase II to IV asset impairment; $2.1 million for clinical amortization; $1.1 million for an impairment of our ISS assets; and a $1.9 million ISS operating loss for the quarter. For the first half of 2006 the $135.7 million loss from discontinued operations also included the $129.2 million clinical Phase II to IV goodwill impairment which was recorded in the first quarter of the year, the first-quarter amortization of goodwill of $2.1 million related to the Phase II to IV business, and a $0.7 million ISS operating loss.

I'll turn now to the second-quarter charges associated with our planned cost savings initiatives. As we said when we reported our first-quarter results, we expected to report a charge of approximately $7.2 million in the second quarter for actions associated with underperforming areas. The actual cost of these actions totaled $6.5 million with $5.3 million recorded in continuing operations and $1.2 million in discontinued operations. Savings from these initiatives are expected to be approximately $13.9 million, $2.2 million of which is in discontinued operations.

I'd like to take a moment to recap the cost and savings which are detailed on slide 29. Beginning with the charges reflected in continuing operations, we reported $2.3 million in the RMS segment which is comprised mainly of costs related to the closure of two small vaccine facilities and, to a lesser extent, a management consolidation within our transgenics services business. We expect total savings of approximately $1.2 million in 2006 from these actions.

In the preclinical segment we recorded a $3 million charge related to our cost savings initiatives. $2.3 million of this cost was related to headcount reductions primarily in Montreal, and the balance was attributable to the closure of a portion of a small facility in Ireland. Savings associated with these actions is expected to be approximately $5.9 million in 2006.

We also implemented cost savings initiatives at the corporate level to further support the Company's goal of operating efficiency. These included selective headcount freezes, cuts in discretionary spending, and adjustment of incentive compensation. While we did not record any charges associated with these actions, the expected savings for 2006 are approximately $4.6 million.

The $1.2 million charge for closure of our ISS facility in Massachusetts is reflected in discontinued operations. While we have already seen improvements in operating efficiency as a result of these initiatives, the benefits are weighted toward the third and fourth quarters with additional savings in later years.

I would like to take a moment to clarify our 123R expense, since on a year-over-year basis there are differences in the presentation. As you may recall, last year we made a restricted stock grant, the cost of which is being amortized over a three-year period. Those costs were included in unallocated corporate overhead last year and amounted to a total of $7.6 million. As a result of the adoption of 123R in January 2006, in addition to amortizing the restricted stock grant, we are expensing stock options and allocating the stock compensation expense to the operating segments. Slide 31 shows the effect of 123R on the second-quarter 2006 non-GAAP operating margin.

If you adjust second-quarter 2006 for 123R, you can see that the consolidated margin would have been 24.3%, down only 40 basis points compared to 24.7% in the second quarter of last year. And on an EPS basis, the cost of 123R $0.03 in the second quarter 2006. Adjusting the second-quarter result to exclude 123R, non-GAAP EPS would have been $0.60 compared to $0.55 per share in the second quarter of 2005.

I will turn now to other income statement and balance sheet factors, starting with net interest expense which was $3.7 million in the second quarter of 2006 compared to $4.8 million in the same period of 2005. We are revising our guidance on 2006 net interest expense to be approximately $15 million, due to increased debt as a result of the convertible offering, partially offset by higher interest income and capitalized interest.

The GAAP tax rate for the second quarter of 2006 was 22.8% due to a change in the geographical pretax earnings mix and a onetime evaluation of our Canadian deferred tax assets and liabilities following a reduction in the Canadian federal income tax rate. The new Canadian tax rate won't be effective until 2008, but we were required to revalue the assets and liabilities in the period in which the tax reduction was enacted. The non-GAAP tax rate for the second quarter was 27.35%. In addition to the items excluded for non-GAAP purposes, we also excluded a portion of the adjustment for the Canadian tax rate change which decreased the non-GAAP rate by 1.1%.

As a result of the changes I've described we now estimate our full-year GAAP and non-GAAP tax rates will be in a range of 28.5 to 29.5% compared to our early estimate of 29 to 30%. At the end of the second quarter we had cash and cash equivalents of $193.1 million plus $47.5 million in short and long-term marketable securities, or a total of $240.6 million. Accounts Receivable $177.6 million at the end of the second quarter, up slightly from the fourth quarter of 2005. Our DSO increased slightly to 33 days in the second quarter of 2006 when compared to 31 days for the fourth quarter of 2005.

On a year-to-date basis operating cash flow was $60.2 million compared to $82.2 million for the first half of last year. The key driver of the decline was higher tax payments. Capital expenditures year-to-date were $56.8 million versus $23.8 million in the first half of last year, reflecting the increased investment in our preclinical and RMS facilities.

Depreciation for the first six months of 2006 was $21.7 million, just slightly above $20.9 million for the first half of 2005. And total amortization expense was $18.5 million compared to $23.1 million in the first half of last year. These amounts reflect a reclassification of Phase II to IV and ISS assets to discontinued operations. Our full-year 2006 guidance for some of these numbers has also changed as a result of discontinued operations. Our revised expectations are free cash flow in a range of 25 to $50 million, depreciation at $48 million and amortization at $37 million. Our estimate for CapEx remains in a range of 175 to $200 million though likely at the high end of the range.

Turning now to treasury actions -- in the second quarter we issued 350 million of convertible Senior Notes in a private placement. As we stated in our June 12th release, these notes bear interest at a fixed rate of 2.25% and mature in 2013. They are convertible into cash or shares at Charles Rivers' options and are not dilutive to earnings until the stock price exceeds 122.5% of the issue price or $48.94. In order to provide economic protection above $48.94, we have entered into hedge transactions and issued warrants.

So while there would be share dilution above $48.94, the head transactions protect the Company from the economic impact of the convert up to a stock price of $59.93 per share. The net cost of the hedges was $32.3 million which is being amortized over the life of the notes. And currently with the convertible offering we've repurchased slightly more than 3.7 million shares at a cost of approximately $149 million. Combined with our purchases under the 10B51 plan since August 2005, we have now repurchased in excess of 4.6 million shares at a cost of $186.4 million.

As noted in our second-quarter earnings press release, we intend to implement an accelerated stock repurchase or ASR program for approximately 75 million. At the initiation of the ASR program we will pay for and receive shares. Following the ASR we will estimate that we will have approximately 67 million shares outstanding, although that number could vary depending on stock price and other factors. Once the ASR has been executed we would still have approximately 39 million remaining under our current stock repurchase authorization.

The last treasury action I'll discuss is the recent amendment to our credit agreement which was finalized on July 31st. We were able to negotiate some favorable changes including reducing the interest rate by 12.5 to 37.5 basis points depending on leverage, modifying certain restricted covenants, and extending the facility termination date by two years to 2011. Given our increased cash balance, we also reduced the borrowing capacity to $428 million. We were pleased with the outcome of these negotiations, particularly the reduced interest rate.

Finally, I'd like to clarify a few points in relation to our 2006 guidance. You should note that our restated first-quarter 2006 non-GAAP EPS from continuing operations were $0.47, $0.03 below our originally reported results of $0.50. In order to achieve our 2006 non-GAAP guidance of $2.12 to $2.18, we need to make up the $0.03 from the first quarter which was contemplated in the guidance we gave on May 9th. Our 2006 guidance also includes a total charge of $0.03 to $0.04 for other expenses and minority interest expense. The charges were also included in our original guidance.

The revised GAAP EPS range is now $1.73 to $1.79. And the difference between this range and the $0.09 to $0.15 per share loss we gave in May is entirely related to discontinued operations. The following items have been reclassified as discontinued ops -- $1.81 for the clinical goodwill impairment; $0.05 per share for amortization related to clinical Phase II to IV operations; and ISS cost-saving actions of approximately $0.01 per share. As you know, our non-GAAP guidance has remained the same at $2.12 to $2.18 per share. That concludes our remarks. We'll take your questions now.

(OPERATOR INSTRUCTIONS). Chris McFadden, Goldman Sachs. Eric Schmidt, Cowan and Company.

Good morning, congrats on a nice quarter. Jim, I was curious about your comments on the RMS segment in terms of lower pharmaceutical spending, U.S. and Europe affecting research models. What are your customers doing there? Are they going to any of your competitors or are they just reducing the number of experiments they're conducting? What's going on?

It's actually a small number of clients as we take a look at sort of our top clients both in the U.S. and Europe. Interestingly the majority of them are up nicely year-over-year. We have a few very large clients who are clearly in a cost-cutting mode. You could name several of them just from the statements that they've made in the public press about doing this. And we have confirmed that it's not a share issue.

So it looks like there's a cut back in some of the discovery spending; a concerted effort to simply spend less. There are some anecdotal information or a conversation with them that these trends would likely reverse at sometime in the not too distant future, but we certainly want to see that happen before we play that into our guidance.

So it's sort of the convergence of a handful of very large clients both in the U.S. and Europe who are really pulling back on their spending. And if you talk to them it's pretty much across the board in their company, but in our case it seems to be more discovery oriented than development oriented.

Okay. Tom, in terms of the guidance, I think in May you suggested we'd have a share count at the end of the year, about 70 million shares outstanding, has that kind of been revised downward now to 67?

That would be correct, Eric. And the biggest difference would be that we implemented the repurchase program alongside the convert. And when we originally expected the shares to come down it was principally a result of the proceeds associated with the sales of the Phase II to IV business.

Okay. So when I look at the '06 guidance now it appears you're forecasting modestly higher topline revenues in the second half of the year than first half and I don't expect margins would compress much if at all. Yes with the lower share count we would be seeing a higher run rate maybe in EPS. The guidance doesn't -- your EPS guidance doesn't forecast that. What am I missing there?

I don't think you're really missing anything. I think the sales will be a little bit up in the second half of the year, as you mentioned, particularly in the preclinical where we'll see more sequential growth. We've pointed out where we think the margin rates will be which is fairly similar to before. So I guess the way I would answer the question is we do have additional interest expense obviously from the convert, a little bit of improvement in the tax rate. We set our original guidance at $2.12 to $2.18; that's a $0.06 range. And I guess based on where we are in the middle of the year we don't feel compelled to move outside of that range at this point in time.

That's helpful. Thanks a lot.

Chris McFadden, Goldman Sachs.

Can you hear me now? I apologize about the earlier telecommunications issue. Thanks for the detail on the call, everyone. Just two follow-on questions. Firstly, can I get you, Jim, to kind of build on your prepared comments in terms of second-half margin expectations for your preclinical business? It sounded like the margins that we saw in the quarter represented a lot of very kind of positive dynamics within the business efficiency mix, demand and the like. Are you suggesting that the second half margins should be flat to up from the second quarter or what we would look to see the first half kind of blended operating margin?

We'd expect to see some improvement in margins for the balance of the year as we have stronger capacity and continue to get the efficiencies playing through the system. We had a slightly weaker first quarter so we anticipate that it will continue to build through the balance of the year.

Understand. And then secondly, it sounds like you're on track for Shrewsbury. At what point do you think you will begin to see -- study projects, either more tactical projects or even perhaps longer term relationships with customers, begin to get signed on to that facility? We're obviously now a handful of months away. What's your expectation and I guess what's been your experience in the past with bringing on new capacity?

It's a little early, still, Chris. We have opened some new space in our Worcestershire facility, as we indicated in our prepared remarks. And that has skilled -- actually that gives us some leverage moving into the new facility. People have utilized the space in our older facility, acknowledging that they'll be over to move over at some point. We are already having a fair number of discussions with clients about myriad different types of relationships with them in the Shrewsbury facility and have shown the facility, even its present condition, to clients.

So we would certainly begin to see business signing up I would say in the fourth quarter and we're going to open it early in the middle of the fourth quarter. And probably around that time I would think that we would confirm some business which would take us into the first quarter of next year.

Relative to that facility, is there a key milestone whether it be a permitting or licensing process or a phase of construction that once you get to that point you can sort of say with the highest assurance level that, yes, we're going to open on time? And if so, what are those kinds of key milestones and when do you think in your current planning process you'll be at those points?

The construction trajectory is on schedule -- ahead of schedule and going very well and all of the major pieces of equipment are on-site. So it's not foreseeable that we would have any delays in that. The validation of the facility is something that will happen pretty much in the fourth quarter and the plan is in place and we're confident to be able to do that.

As I indicated in my comments, the staffing initiative which sounds more daunting than it actually is, we're well on our way with senior staff already hired and having populated the technical staff of the new facilities we brought online. We're really looking at technicians both for the animal facilities and maintenance and have plenty of time to do that.

So it's not foreseeable that either from a business or validation -- construction validation staffing point of view that we should have any delays that would throw us off a schedule. And in answer to your earlier question, we're beginning to see the filling up of the facility with business through conversations that are taking place at this moment and utilizing the strength that we're enjoying in the current Worcestershire facility to sort of transition over to Shrewsbury once it's open.

I understand. And then finally, I came on the call a few minutes late, so if you touched on this in your prepared comments sorry for the duplication. But any update in terms of the supply/demand and other market characteristics of the large primate business would be helpful. Thanks.

Yes, what we said about that was that sales were actually slightly below the same period last year when we had an extremely strong quarter. They were sequentially up from the third quarter. We anticipate that we'll have a very strong second half of the year and be where we initially indicated that we would be. So as we've said fairly often for the last year or so, it's a business with a finite number of large research models to sell with a client base that pretty much takes them or commits to them early on in the year. And the actual shipments of them are a little less predictable so we do have or we can have some variability between quarters but really have variability from year-to-year. So we're confident that the back half of the year will be very strong.

Very helpful, thank you.

Doug [Tsao], Lehman Brothers.

Thank you very much. Could you guys provide a little color on the contributions of the Phase I unit to the preclinical segment performance in terms of both revenues as well as margin in the quarter?

We don't really break that out and I don't think we will going forward. I mean, just to say that it is included in that segment, we did say that Phase I had a strong quarter. It has different financial metrics and growth rate metrics than the preclinical business, although we deem it really sort of the last stage of the preclinical business and it's operated by the same people which is why we have included it in that segment. But I think that's about all the detail we'll give on it.

Could we interpret it as something that contributed positively to the operating margin in the quarter?

I think, Doug, given the size of it in the quarter relative to the preclinical, I would say that it did not have a significant impact one way or another.

Okay, that's helpful. And then on CapEx, it was significantly lower than I would have expected, sort of down from Q1. And also given that you're maintaining your CapEx guidance for the remainder of the year, I was wondering if you could provide a little color as to what explains that?

Sure. Nothing really untoward doing that. We've actually begun work at Reno, but I would not say that we're in full, full swing right now. Where conversely at Shrewsbury, if you were to go out there you'd see that it's a full-blown construction site. And generally invoicing will lag construction work and we don't generally accrue invoice in progress for capital. It's more of a cash basis on capital expenditures. So I think as Jim said, all work is on progress and where we expect it to be and I really think it's just the timing of the magnitude of that work and the billing.

Okay. And then finally, on the preclinical segment you talked about favorable study mix obviously off at Montreal. I was wondering if you sort of had any outlook on the sustainability of those trends. I know when it a separate company at Inveresk there was a lot of fluctuation there. And do you sort of see signs that maybe you're going to -- that their ability will remain or some of it's been smoothed out?

Given the demand -- concerted and consistent and increasing demand for outsourced services generally, and given that our clients are reluctant to make significant investments internally in the high-end specialty tox given the fact that many of our major competitors are less focused on specialty tox, we're fairly confident that we'll continue to garner consistent business and the demand for those high-end services should continue. It's a distinguishing feature of our business and we will continue to invest in facilities to expand space to provide those services.

Okay, great. Thanks a lot, guys.

Derik De Bruin, UBS.

Great. Thank you. Did I hear you correctly in that you were talking about the gross margin for the RMS business being in the 30% level for the rest of the year or was that operating margin?

Operating margin. I'm not sure exactly what was said, Derik, but we think the operating margin will continue to be around 30%.

Typically gross margins in that business tend to be lower in the second half of the year anyway, a trend likely to continue as you see it now?

The trend meaning the first half (multiple speakers)?

Yes, the fact that the second-quarter gross margin was lower, do you expect the 3Q and 4Q progress to be sequentially lower from the second quarter?

Well, I think that they potentially would be a skosh low, but I don't think that there would be any dramatic differences. Typically we're down slightly in the second half and we're actually a little bit ahead of 30% year-to-date if I'm not mistaken.

Okay. I guess the -- going back to the demand for the RMS. Certainly some of the other life sciences companies that have been reporting results haven't seen I would say big Pharma pulling back as much. Certainly it's some of the instrument companies that are more exposed to big Pharma. Waters in particular have had some issues. I'm just trying to understand why mice are being singled out as something that's being cut as opposed to other disposables?

Difficult question to answer, Derik. All we can tell you is that it's a small sampling of clients. We don't really think it's a trend. As I've said, we have a lot more clients whose discovery business is up both in the U.S. and Europe than we're seeing those down. But the ones that are down are our larger clients whose total spend is more significant. And so pull backs will be disproportionately significant for us.

So they can still be spending competitively large sums of money in discovery with other companies and still be cutting back and that would have some adverse impact on us, as I said in my remarks. But our business has always been primarily been big Pharma oriented, that's the good news. It can also be difficult and challenging news when they pull back.

So our hope is that it's a transitional process. We don't really see it clearing out before the end of the year, but we're guardedly optimistic that going forward that this would moderate somewhat, but we'll have to watch it. There's no real specific discernible answer we can give you as to why they would be pulling back on discovery except the obvious reason, to emphasize moving drugs through development and of course we're seeing a significant enhancement in our preclinical business which would seem to dovetail those activities and also some increasing in our lab animal services as well.

So I'd say in the companies with whom we are feeling these pressures there appears to be a greater emphasis at the current time in development in probably getting drugs through the clinic and into the market. And obviously that's something that could change in the not too distant future if and as they reemphasize discovery. It's difficult to get any clarity or predictability on that at the current time although we ask constantly.

Well, I guess what about sales of animals to Pharma that you know are being used in their own internal preclinical studies? Were those also affected by some of these customers? And I guess the corollary to that is have you seen a pickup in sales to some of the clinical people that you felt (multiple speakers)

Yes. Our sales in the development side and the preclinical side both to competitors and to our large Pharma clients appears to be stronger than sales into the discovery sector, again, to a handful of customers, but still significant ones.

Okay, thank you very much.

David Windley, Jefferies & Co.

Congrats on the quarter. Thanks for taking the questions. A couple of questions in toxicology that are related. Could you remind me the plans and the timeframe around collapsing Worcestershire and the existing Reno facility into your new facilities from an operational standpoint? Is that still your plan and over what time period?

I don't know whether we've articulated that specifically, but it is indeed our plan to collapse those and transition over time. Remember, we're building sort of first phases of both Shrewsbury and Nevada -- significant phases, but they will be both replacement space and incremental space. And as we move the current space over we'll take down space in our current facilities.

So they won't necessarily be in lock-step obviously, particularly since the Reno facility is coming on line six months later. But it's going to be a few year process. And I think that that's about as specific as I'd like to get. But it will be a gradual and focused effort to transition as soon as it makes sense.

Okay. So that sheds a little bit of light -- the other interest I had was you've been capacity constrained and I think certainly I was looking toward those bigger facility openings as kind of the milestone to ease up on that capacity constraint. But you opened some new capacity in old buildings in the quarter and I've wondered, the strategy behind that given their short life span -- or their seemingly short lifespan and then how difficult was that and what type of space is that?

The strategy was that there's significant market demand and we did have some relatively small spaces that were relatively low-cost to bring online and we were able to get the staffing and we've been able to fill it, as you can see from the 14% growth rate in the second quarter and the exceptional margin. So it was responding to the demands of the marketplace rather than simply waiting, so we felt it was a responsible thing to do.

As I said, we'll keep that space for a relatively short period of time, but we'll keep it as long as it's beneficial to keep it both from a customer support point of view and from an economic efficiency point of view. So obviously duplication of the space for too long a period of time is not optimal. By the same token, having incremental space and not just replacement space is extremely beneficial to us. So over time we do intend to be out of the old space and into the new space, it's just it's not going to happen in the next year or so.

Okay. And then that obviously provides some framework or context around the need to expand your management team rather than just transition the current management of the existing facility into the new facility. I'm curious, Jim, whether the manager-- as you mentioned, you hired a new person to run the new Nevada facility. What does that old chart look like at this point overall, not just Nevada but for your major facilities? How are you bringing those people in? Will they report directly up to Nancy or will they report through the local manager at the older facility or how does that work?

If I got your question, we have a new GM in the last 12 months in our Worcestershire facility who reports directly to Nancy. And we have a new GM, actually not on site yet, but hired with a large reputation from a major Pharma company who will start sometime soon. Both of these folks will report to Nancy as do the GMs of Montreal and Edinburgh. So four major sites report directly up to her.

The Massachusetts and Nevada sites are going to be significantly larger than they are now and more on the scale of what we have in Edinburgh and Montreal. So the need to have very strong GMs and to strengthen the teams dramatically is paramount for us and something that we're doing. The team in Massachusetts, as I said, has been essentially totally retooled with a much more sophisticated more in-depth team. The team in Nevada I would say is scientifically extraordinarily strong, we're just going to have to bulk it up to accommodate a much larger top line and a more complex business.

Okay, thank you very much.

Tycho Peterson, JPMorgan.

A question on the vaccine business. If I look back through my notes, you had kind of guided to that business being flat and you talked about the facility closings. I know you got the avian flu contract, but how do we think about some of the dynamics there in that business going forward in particular?

It's a relatively small and finite market where we have a very large share -- a 65% share, maybe larger depending on what our competition is doing. I guess what we've said is we don't see any sort of dramatic technological moves for that business. We were hoping to see something for instance in human flu or in oncology therapies and we haven't seen that.

Having said that, it's a solid business with good operating margins and single digit growth rates which I think are sustainable for the long-term. We continue to be more efficient, taking out a couple of facilities that we thought we didn't really need and focusing down on a smaller number of facilities obviously helps the efficiency and the margins as well. So we'll continue to be a solid contributor and we'll continue to look for technological outlets for this operation to grow more rapidly.

Okay. On transgenics, I know less quarter you talked about some modest improvements in Europe and France and Germany is there any additional color -- I know Europe was weak this quarter, but any additional color you can give us? And then Second of all, strategically are you looking to reevaluate any part of that business or how do you look to improve it going forward?

The transgenics business is interesting. When we talk about it's been flat for the last three quarters we're really talking about the U.S. and that's a true statement. And compared to the way it's been, I guess we'd have to say that's a positive statement. So we think that the reconciliation of the animal models that have been outsourced to us and the characterization of them, most of that with our major clients appears to have taken place -- at least that's what they've told us. They told us that previously and there were some declines following those conversations, but it really has slowed. So that's good news and we absolutely anticipate that the fourth quarter this year will be totally flat. And while we're not going to talk about '07 yet, we don't have any indications of further decline.

Europe -- I guess we didn't specifically comment on that. Europe is up this year and continues to be. Again, there's a handful of small customers that drive the trajectory of the business in Europe and Japan as long as those customers are doing more work than transgenics that will continue to do well. So we don't really see any strong indications that Europe is weakening. Japan, which I didn't comment on either, which is the smallest of the three locations is a bit sluggish but that's sort of commentary on the size and scale of the market.

So just to summarize -- U.S. flat, Europe continuing to be up and Japan continuing to be up slightly. No sort of overarching indications or overriding indications that we're going to see some dramatic up turn in demand for transgenics animals. We get some anecdotal input every once in a while from specific companies that indicate that they're investing more aggressively in transgenics, but we're sort of happy for the current time to see a leveling off of the decline.

Okay. And then finally, can you just remind us how you'll be selling PTS now that that's approved? And any color to the extent you feel comfortable on pricing?

So we've always sold PTS directly -- primarily directly. We do have some distributors, but primarily we sell directly. We'll continue to do so. We'll continue to manufacture that ourselves and retain essentially all of the margin. And comparatively the PTS has better pricing for us and clients are willing to pay that because of the ease of use, the efficiency and the fact that it speeds up their entire process of being able to clear their drugs.

Thank you very much.

Eric Coldwell, Baird.

Jim, this is the first quarter in a long time I can remember you kind of not walking through research models in terms of inbred, outbred disease models, guinea pigs, etc., kind of down the list. I was hoping you could do that, number one. Number two, if you could just talk briefly about pricing. You did mention volumes were down, but if we could kind of get a mix between pricing and volumes which you have given in the past.

Sure. Price continues to be part of the conversations of -- part of many of our conversations with our Pharma clients. Certainly is a bigger part of the conversations with the clients who are off year-over-year than the ones that are up. So we do raise our prices and we do get them in our various geographic locals. There is some limited pushback and I would say it's more of the conversation and it's a major conversation with some of the (multiple speakers) that are off.

So for those folks it's a combination of sort of buying less and being very, very sensitive to price across the board but still wanting to buy from us. With regard to major pockets, obviously sales of outbred rats and immunocompromised mice, which are productlines that we typically comment on, are slower than we've talked about historically, particularly or principally as a result of the pressure that is being put on those sales from these half-dozen or so customers.

Okay, great. And if I could just have one quick follow-up. In the past I think a couple of years ago you told me that RMS pricing was basically a premium to your largest competitors in the range of 10 to 25%. And I'm curious if you could give us an update. I know one of your competitors has taken a couple of price hikes here. Where do you see pricing dynamics between CRL and the largest competitors and research models?

The pricing dynamics have changed over the last few years. It's a combination of the fact that we have been less aggressive and our major competitors, particularly our second-largest competitor, has been more aggressive. We have indications that those more aggressive price moves by competition will persist. The premium has shrunk. On a priceless basis I'd say it's probably 10, maybe 15%. What one never knows is what the level of discounting is off of the price list.

But I would say on a price list basis it's getting tighter and tighter. We think that gives us even a greater competitive advantage since we are much larger, much closer to the clients we think the clients are getting more for the value received in the scientific oversight and input and lack of disruption of supply. So the pricing dynamics actually should be beneficial for us, particularly as and if clients become more sensitive to price.

Okay, thanks very much.

John Sullivan, Leerink Swann.

Good morning; thanks for taking the question. Do you consider yourselves still in the market for additional Phase I testing capacity? And do you still think that it's important to be able to offer to clients both the preclinical testing and the Phase I human testing?

We do indeed, John. So we are still in the market for Phase I; we think it's an integral part of the strategy to be in the preclinical business. We think it is really part of the preclinical service, particularly with our biotech clients both large and small. So we are still in the midst of the hunt. We can see the benefit and the power of it in Europe and we want to similarly enjoy that sort of leverage in the U.S.

Thanks very much.

And for any final or closing remarks I'd like to turn the call back over to Ms. Susan Hardy. Please go ahead.

Thank you for joining us today. We'll look forward to seeing you in the near future and this concludes the conference call. Have a nice day.

A replay of today's conference will be made available beginning today at 11:30 AM Eastern and ending on August 23rd at 1 AM Eastern Time. You may access the replay by dialing 888-203-1112 or 719-457-0820 and entering replay pass code 842-3456. This does conclude today's conference call. Thank you for your participation.