Charles River Laboratories International Inc (CRL) 2007 Q2 法說會逐字稿

Welcome to the Charles River Laboratories second-quarter 2007 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded. I would now like to turn the conference over to Vice President of Investor Relations, Ms. Susan Hardy. Please go ahead.

Thank you. Good morning and welcome to Charles River Laboratories second-quarter 2007 conference call and webcast. 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 review guidance for 2007. Following the presentation, we will respond to questions.

There is a slide presentation associated with today's remarks, which is posted on the investor relations section of our website at ir.criver.com. A taped replay of this call will be available beginning at noon today and can be accessed by calling 800-475-6701. The international access number is 320-365-3844. PIN number in either case is 880215. The replay will be available until August 22. You may also access an archived version of the webcast on our investor relations website.

I would 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 February 27, 2007, as well as other filings we make with the Securities and Exchange Commission.

During this call, we will be primarily discussing non-GAAP financial measures. We believe that these non-GAAP financial measures help 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 the investor relations section of our website through the financial reconciliations link. Now I will turn the call over to Jim Foster.

Good morning. I'm very pleased to talk with you today about our second-quarter results, which demonstrate robust demand on the part of pharmaceutical and biotechnology customers for the essential products and services we provide and their confidence in Charles River Laboratories.

For the second quarter, net sales increased 14.8% to $307 million as a result of strong growth in both the RMS and preclinical segment. The acquisition of Northwest Kinetics contributed 2.9 percentage points; and foreign exchange added 2.1% to the growth rate. Operating income for the quarter was $65.7 million compared to $62.5 million reported in the second quarter of '06.

The operating margin decreased to 21.4% compared to 23.3% in the same period last year. The primary drivers of the decline were higher corporate costs, resulting from the investments we are making in order to support our growing business, and the costs associated with the preclinical facility transition in Massachusetts. Although we reported improved capacity utilization across many of our facilities, both RMS and PCS, the benefit, as expected, was offset by the startup and transition costs assisted with operating the two facilities in Massachusetts.

I will discuss the transition in more detail shortly, but you should note that although we recorded a full quarter's cost for the two Massachusetts facilities in the second quarter, the overall margin declined only 40 basis points from the first quarter of '07, when we reported only partial costs.

At $43.8 million, net income from continuing operations was 5.3% higher than the $41.6 million reported in the second quarter of '06. However, earnings per share increased 10.3% to $0.64 due primarily to the lower number of shares outstanding.

Through August 1, we have repurchased a total of 6.7 million shares under our stock repurchase authorization and have just increased the authorization by $100 million.

These strong second-quarter results, combined with our expectation that the market trends will continue to support our growth, are the basis for our confidence in the outlook for the year. In recognition of that confidence, I am pleased to tell you that we are raising our 2007 sales guidance to a range of 12% to 14%, which is a combination of high single digit growth in RMS, and high teens growth in PCS. We are also raising the lower end of the EPS range to $2.47 from $2.43.

Now I will tell you more about our second-quarter segment results. The RMS segment's results. Sales grew 9.9% in the second quarter with foreign exchange contributing 1.8%. As was the case in the first quarter, the growth was quite broad-based, with significant contributions from the US and European Research Models, Transgenics services, and in vitro products. A wide spectrum of pharma and biotech customers, including many of our largest customers, increased their spending.

The second-quarter operating margin increased 80 basis points to 31.7% from 30.9% in the second quarter of '06 due primarily to higher sales and improved operating efficiencies. This was especially the case in Transgenics as we continued to benefit from the cost savings initiatives we implemented last year. The sequential decline was due primarily to the contribution from the additional sales of large models in the first quarter, following a quarantine delay in the fourth quarter of last year.

We were extremely pleased to see sales of Research Models in the United States, the bellwether for the industry, rise faster than the 10% we reported in the first quarter. Sales in immunodeficient mice were quite strong, which we attribute at least in part to increased focus on discovery of oncology drugs. Sales of both outbred and inbred rats were robust due to increased drug development efforts. These US sales trends were echoed in our European business.

Worldwide Transgenics services sales increased for the third consecutive quarter and again were better than anticipated. There is a continuing focus on the use of transgenic models as discovery tools, and the strength of our discovery services offerings -- which, in addition to housing and breeding, include genotyping, phenotyping, and other services which support development of these models -- make us the first choice for researchers in this field.

Creation and development of transgenic models are driving the current growth. However, cost pressures at pharmaceutical companies have offset the growth in the past and may do so again. We have conducted extensive discussions with customers to try to determine whether the growth will continue, but have not been able to identify a discernible trend. Based on current customer indications, we do expect sales in the second half of this year to be higher than in the same period last year, although the fourth quarter will mark the anniversary of improving Transgenics sales. We are guardedly optimistic for now and hope to have a better perspective on '08 by the time we provide guidance in December.

Our in vitro business performed extremely well in the quarter primarily as a result of sales of the PTS. Sales are continuing to ramp, with increasing sales not only to pharmaceutical manufacturers, but also to nuclear pharmacies who expect to be subject to endotoxin testing regulation as early as '08. The PTS is tailor-made for nuclear pharmacies, since the compounds they produce have a very short shelf life and fast test results are critical.

We have also just launched a multi-cartridge system, or MCS. The MCS will read multiple cartridges, an ability that our larger customers require.

I would like to update you on the status of our California and Maryland RMS expansions. As you know, two of the new barrier rooms in the California addition were put into service in early June. We are currently building production in these rooms and expect to begin shipping product by the end of the year. Given the strong demand in the Western region of the country, we expect to open a third production room in the first quarter of '08.

I am pleased to tell you that we broke ground two weeks ago for the new Maryland facility, from which we will support our dedicated space agreement with the National Cancer Institute. We are eager to begin operations in that facility, which is on schedule to open in the third quarter of '08.

We were very pleased with the RMS second-quarter results. Our sales reflect the strong demand from many customers for our high-quality products and the expert services we provide. Our operating margin reflects the leverage from higher sales, improved efficiency from last year's cost savings initiatives, and our ongoing efforts to effect continuous process improvement. With the new capacity provided by our expansion projects, we believe we will be extremely well positioned to support our customers' requirements for our high-quality, value-added Research Models and Services, and to promote our growth.

The Preclinical Services segment reported sales growth of 19.4% for the second quarter, benefiting from robust sales, favorable mix, improved capacity utilization, and stable pricing. Foreign exchange contributed 2.3%; and Northwest Kinetics added approximately 5.5%. We were pleased that Northwest Kinetics' growth was considerably better than our expectations, as the new capacity is filling quickly.

As expected, the PCS operating margin at 22% was lower than the 25.4% we reported in the second quarter of '06. The second quarter of this year was significantly affected by the transition and startup costs associated with the new facility in Shrewsbury, Massachusetts. The second quarter was the first full quarter of (inaudible) Shrewsbury; and as expected, its operating margin declined significantly. However, robust sales growth and the resulting improvement in capacity utilization at all of our other preclinical toxicology facilities helped to offset the decline in the Massachusetts operating margin.

Before I discuss Massachusetts in more detail, I would like to spend another moment on the performance of our other tox facilities. To say that their results improved doesn't do justice to the excellent performance they delivered. All of these facilities delivered double-digit sales growth in the second quarter, as clients continued to outsource services and to select Charles River as their provider of choice.

Each of these facilities also reported a higher operating margin, the result of a combination of greater capacity utilization, benefits derived from the cost savings initiatives we implemented last year, our fourth-generation Six Sigma process, and sales mix. In fact, the margin improvement was so significant that, on a sequential basis, the PCS operating margin improved 60 basis points from the first quarter.

Historically, the Worcester facility has been known for its expertise in early-stage discovery services. We are continuing to focus on those services at Shrewsbury. Clients are very pleased to place studies with a significantly enhanced and experienced scientific staff in our new state-of-the-art facility. I am pleased to tell you that Shrewsbury has been filling rapidly. Much of the early discovery work is short-term, so to improve the sales mix our plan for Shrewsbury involves expansion of our services to include a greater proportion of longer-term development work.

By doing so, we will better support our clients' drug discovery and development efforts, as well as increase the revenue-generation capability and profitability of the facility. Based on the growing backlog for toxicology studies, we believe we are making good progress on this plan.

The transition from our Worcester facility is also proceeding on schedule. We continue to move functions regularly and expect to finish our last in-life study in the third quarter. We estimate that by early September all new in-life studies will be placed exclusively in Shrewsbury. The remaining laboratory services will move during the fourth quarter; and we expect to exit Worcester on schedule no later than the end of December.

Our Nevada expansion continues to progress well and most of the first phase is nearly completed. We are on schedule to begin validation in September, complete construction in October, and initiate studies in the new facility in January of '08. Customers are regularly touring the facility, and we already have studies committed for next year. As is the case with Massachusetts, we are also discussing dedicated space arrangements for the Nevada facility, and we believe that such arrangements are likely in both locations.

Overall, we are extremely pleased with our preclinical performance in the second quarter. As I have said before, all of our preclinical tox facilities delivered strong net sales growth and operating efficiencies, which gives us confidence that, as we get the costs associated with transitioning to our new facilities in Massachusetts and Nevada behind us, we will make strides towards our longer-term goal of a 25% operating margin.

We see no diminution in the demand for high-quality Preclinical Services and, in fact, find that customers are increasingly choosing to outsource entire drug development programs. We are currently providing management for nearly 300 programs for approximately 90 customers who have chosen to use Charles River's scientific and technical expertise rather than to incur the cost to maintain in-house capabilities. And that number has risen significantly from '06 levels.

With intensifying demand, given our expertise in regulatory compliance, Preclinical Services, and our global footprint, including the expansions in Shrewsbury, Reno, and China, we believe we are positioned as a premier player in this field with significant opportunities for growth.

Execution of our strategy to be the premier provider of essential products and services to the drug development industry is dependent on investment on a number of fronts, and we are committed to making those investments. Our current capital expansion programs are the building blocks for the capacity we need to support our customers' requirements and our own growth into the next decade. Many other investments are equally important. Internal development and strategic bolt-on acquisitions will augment our portfolio. Our IT initiatives will enable us to build an infrastructure that will provide scientific and business information when and in whatever form we need it.

Our larger executive team and other personnel additions give us the bench strength to execute our initiatives. I will tell you that we have the strongest and most experienced senior staff in the history of the Company.

We also believe that success requires intense focus on core competencies in being the best of what you do and doing it flawlessly. While we strive for continuous improvement, we believe that we excel in our core areas of laboratory animal medicine and science, and regulatory compliant Preclinical Services. Our competencies are our greatest assets and we invest continuously to leverage them to our own and our customers' advantage.

We believe that the pharmaceutical industry is at an inflection point unprecedented in its history. With many drugs coming off test and new drugs increasingly complex and more costly to develop, pharma companies are recognizing the need for a new drug development model. Strategic outsourcing is a key component of this new model, evidenced by the number of pharma facility closures and staff reductions and by the intensifying demand for outsourced services.

In this environment, our goal is not only to be the supplier of choice but to be a partner. By partnering with us, our customers can focus on the early discoveries that they do best and rely on us to support their late discovery and development efforts, rather than incurring the cost of replicating our expertise in-house. Our customers can operate more efficiently and cost effectively when they partner with Charles River to achieve the ultimate objective of bringing drugs to market faster.

In closing, I would like to thank our employees for their exceptional work and commitment, and our shareholders for their continuing support. Now, I will turn the call over to Tom Ackerman.

Thank you, Jim, and good morning. Before I discuss our second-quarter financial performance, I would like to remind you that our discussion today focuses on results from continuing operations. As Jim did, I will also focus my comments on non-GAAP results, which exclude all acquisition-related amortization and other items such as charges associated with the accelerated exit from our Worcester preclinical facility and those related to our cost-saving actions in the second quarter of last year.

The only comment I will make on the GAAP results is to say that the GAAP operating margin increased 70 basis points year-over-year, primarily due to the fact that the nonrecurring charges related to the cost-savings initiatives depressed last year's second-quarter GAAP results. In addition, acquisition-related amortization expense declined this year.

As anticipated, the overall non-GAAP operating margin declined to 21.4% in the second quarter of 2007 from 23.3% last year, reflecting the expected decline in PCS margins due to the startup and transition costs in Massachusetts as well as higher unallocated corporate costs. An increase in the RMS margin partially offset the overall operating margin decline.

However, operating income did increased by 5.2% to $65.7 million, driven by higher sales and improved capacity utilization in both segments. As a result of higher operating income, lower net interest expense, and a lower share count due to the repurchases, second-quarter EPS increased 10.3% to $0.64 from $0.58 a year ago.

On a sequential basis, growth in sales and operating income was robust at 5.6% and 3.6% respectively. The contribution from the shipment of large research models in the first quarter of this year, and the second-quarter startup and transition costs in Massachusetts, caused the operating margin to decline by 40 basis points sequentially. EPS remained flat at $0.64, as the higher operating income was offset by increases in other expense and the diluted share count.

Unallocated corporate overhead increased by $3.2 million year-over-year to $16 million in the second quarter of 2007, driven by the expected increases in IT costs, stock-based compensation expense, and corporate spending on our Greater China initiative. On our first quarter conference call, we had stated that we expected unallocated corporate costs to decline from the $16 million we reported. That did happen; but higher than anticipated healthcare expenses offset the reduction. Assuming healthcare expenses return to normal levels, we expect the quarterly run rate for the second half of 2007 to be slightly below the first half.

Total equity compensation expense was $7.1 million in the second quarter. As expected, equity compensation expense increased nearly $1.7 million both year-over-year and sequentially, driven by the timing of our first quarter equity compensation awards. We continue to expect these costs to be approximately $27 million for the year.

Second quarter net interest expense of $2.6 million decreased $1.1 million year-over-year, reflecting increased interest income on higher cash balances. However, net interest expense increased by approximately $500,000 sequentially versus the first quarter, due to a reduction in the amount of capitalized interest expense. We expect full-year 2007 net interest expense to be approximately 10 to $12 million.

Other expense increased sequentially by $1.2 million related to foreign exchange losses, partially offset by gains on investments related to our deferred compensation plan.

The tax rate remained stable in the second quarter, decreasing slightly to 29.3% from 29.4% in the first quarter of this year. We expect the rate to remain stable in the second half of the year and as a result are maintaining our tax rate guidance of 29% to 29.5% for 2007. Year-over-year, the tax rate increased approximately 200 basis points from 27.3% in the second quarter of 2006.

Last year's second quarter benefited from a onetime revaluation of our Canadian deferred tax assets and liabilities following a reduction in the Canadian federal income tax rate.

Now, let's move to balance sheet and cash flow items. At the end of the second quarter we had cash and cash equivalents of $162.1 million plus $102.3 million in short- and long-term marketable securities, for a total of $264.4 million, compared to $255.5 million as of March 31, and $286.8 million at the end of 2006. The decrease versus the end of last year was due to the investments in our capital expansion program, payments made on term loans, purchase of the remaining interest in our Japanese business from a minority partner, completion of our Chinese joint venture, and share repurchases.

Accounts receivable were $228.6 million at the end of the second quarter, up from $202.7 million in the fourth quarter of 2006, primarily due to higher sales. Our DSO increased slightly to 40 days in the second quarter when compared to 39 days for the fourth quarter of 2006. We continue to work on improving DSOs in a few targeted areas and have not seen a deterioration in our receivables' aging as a result of the higher DSOs.

For the first half of 2007, free cash flow was $6 million, up from $3 million last year. However, capital expenditures were $87 million in the first half of this year versus $57 million in the prior-year period; so that is a net increase of $33 million in operating cash flow. Our full-year 2007 guidance for free cash flow remains in a range of 25 to $50 million with CapEx of 200 to $225 million.

Depreciation in the second quarter increased $1.9 million to $15.1 million, primarily as a result of the new Shrewsbury facility. Our full-year depreciation forecast remains at $54 million. Total amortization expense declined $1.2 million to $8.1 million in the second quarter, due to a reduction in (inaudible) related amortization expense. Our 2007 forecast for amortization expense increased slightly to $32 million as a result of foreign exchange rates.

As noted in our press release last night, our Board has authorized a $100 million increase to our current share repurchase program to bringing the program to $400 million with (technical difficulty) million remaining for repurchase as of August 1. We plan to buy back these shares over the next couple of years to help offset dilution.

As Jim mentioned, we remain on track to exit Worcester and fully transition to our Shrewsbury facility no later than the end of the year. We are incurring impairment and other charges of roughly $0.03 to $0.05 per share in 2007 to complete the accelerated exit; but as we have stated previously, we expect the early exit to reduce duplicative costs in Massachusetts by at least $1 million per quarter beginning in the first-quarter 2008.

We booked another $0.9 million of Worcester impairment charges in the second quarter for a total of $1.7 million year-to-date or approximately $0.02 per share. The $0.03 to $0.05 charges should be partially offset by a gain of approximately $0.02 on the anticipated sale of real estate in Scotland. The result will be a net charge of approximately $0.01 to $0.03 per share in 2007.

Looking ahead, I would now like to discuss some factors regarding our second-half performance. We expect robust sales growth to continue in the second half of the year, but at levels slightly below the first half due primarily to normal seasonality in the Research Model business, a smaller anticipated benefit from foreign exchange, and the anniversary of Northwest Kinetics' acquisition in the fourth quarter of 2006.

We also expect slightly lower operating margins and EPS in the second half of the year due to normal seasonality in our RMS business, particularly in the fourth quarter, and increased costs in Montreal due to the stronger Canadian dollar.

Finally, we expect our diluted share count will average slightly more than 69 million shares for the second half of the year, which is higher than the first half due to the dilutive effect of option exercises, our 2.25% convertible debt, and the increase in our share price. This dilution will be partially offset by repurchases under our 10b5-1 plan that covers the remaining 22 million under the buy back program prior to the new $100 million authorization.

In the second quarter, we included 0.2 million shares of dilution from the convert which occurred when the share price rose above $48.94. We should also note that the fourth quarter of 2006 includes $1.6 million of other income from gains on investments related to our deferred compensation plan and foreign exchange gains, which we do not expect to recur in the fourth quarter of this year.

Based on our exceptional performance in the first half of the year and expectation of robust sales growth in the second half, we are raising our 2007 sales guidance to 12% to 14% growth. We have also narrowed our EPS guidance to $2.15 to $2.21 on a GAAP basis and $2.47 to $2.53 on a non-GAAP basis.

We are extremely pleased to be well positioned after the first half to deliver 2007 results at the high end of the ranges that we originally provided in December. That concludes our remarks. We will now take your questions.

(OPERATOR INSTRUCTIONS) David Windley with Jefferies & Co.

Good morning. Thanks for taking the questions. Jim, in your prepared remarks you commented on program management or full programs in toxicology. I was hoping you could describe a little bit more the package of services that you are providing in full programs.

It is a range of services, which is always comprised of multiple studies per client, depending on the size of the client and the type of arrangement. Sometimes we take a client entirely through the whole early development and preclinical process, and sometimes we just do a portion of it.

But in all cases, particularly given our unusually robust expertise in specialty studies, we do a wide range for all 300 of those programs.

Okay. Are you seeing any of that pull-through to Phase I?

Yes, we still see some of that pull-through in our [Scotland] facility and always have since we did the Inveresk deal at the end of '04. Obviously, Northwest Kinetics' operation is relatively new and should work very nicely in tandem with our expanded Reno operation. We expect to get some West Coast pull-through there, but we'll really have to wait until that facility is more operational.

More specifically, do those full programs include Phase I or is that something that is coming along for you after the program management is complete?

Really it's at the end of the program management.

Moving on to, Tom, your comments around corporate overhead, I wanted to make sure I understood that. So it was about flat sequentially. You had thought it would be down a couple million dollars. Healthcare costs are accounting for that full difference?

Well, I wouldn't say the full difference, Dave. That was the primary driver. So we also saw in the second quarter expenses in our corporate area as a result of our initiatives into China, for example. But the healthcare would have accounted for the most of it, and I wouldn't say that those are increases either. We actually expected to see healthcare costs lighten up a little bit as occurred last year, and that didn't happen.

Didn't happen.

Yes. Although at this point, it does look like they'll moderate out a little bit, and I think we're still a little bit optimistic for the rest of the year. That's essentially what we saw last year too, where we had a little bit of a heavier load in the first half, and for whatever reason, things improved in the second half.

So you guys are working people too hard.

I'm not sure it's that.

In California in Hollister, two rooms open now. You mentioned a third room is to open. I wanted to make sure I understood the timing of that third barrier room opening.

Yes, we've got two rooms open now, Dave, which we have production coming up or we should before the end of the year; anticipate a third room coming online in the beginning of '08.

Beginning of '08. Then how many rooms would Hollister be able to support, or how many does it have in total by the time you're fully fitted out?

We built an incremental five.

Five, okay. Thank you very much, congratulations.

Douglas Tsao, Lehman Brothers.

Hi, good morning. I was just wondering if you could provide some kind of detail as far as the utilization of capacity outside of Montreal and Edinburgh and some of your other satellite facilities, just to get a feel for how much growth we might see beyond just the additions of Shrewsbury and Reno.

We have sufficient capacity collectively in operations, Doug, to accommodate the demands of the market. And as I think you know, we've been bringing it on as multiple locations in relatively rational increments each year. The two new locations are obviously replacement space and eventually some incremental space. But we've been adding and we'll continue to add to all of our operations in order to keep abreast of and ahead of the market.

Have you been utilizing additional -- I know there's a government run facility in Montreal that you tap into frequently. Did you expand your use of rooms at that Montreal facility this past quarter?

No. We did that last year, and we have a sizeable number of rooms there that we utilize consistently and have contracted for those exclusively, and we pretty much maxed out that operation.

Okay. Then final question, since the Reno facility will be a multi-species facility versus being primate only in the past, have you had to significantly -- or I guess the question is, how are you handling the recruitment of new study directors who have the appropriate experience for doing the studies that will be new for that region?

Well, it's a combination of utilizing our current staff from other locations to do some training of current study directors, and at the same time recruiting people expressly with background in species besides large animals.

The general manager of that operation has extensive experience with multiple species and has extensive contacts in the industry, and through his auspices and also sort of a very focused recruitment effort, we're broadening our expertise and we'll be training up employees prior to the launch.

So that recruiting/training effort has already begun?

Yes.

Okay, great. Thank you very much.

Eric Coldwell, Baird.

Thanks, good morning. I think Dave basically captured my big questions. Quickly, I was hoping you could go into a little more detail on Shrewsbury, in terms of where the study mix is today what kind of activity levels you're seeing, an update on staffing in Shrewsbury; just any additional color on that facility buildout.

Yes. So Shrewsbury is validated, open and staffed. So we're fully staffed for the ramp at this time, and obviously, we'll continue to staff up as we continue to build a facility. It has been filling up rapidly. We've had lots of clients come through, potentially new clients and clients that are repeat, clients who we've been utilizing in Worcester.

The mix of business tends to be predominantly sort of early discovery stage or acute studies, which would be primary expertise of our Worcester operation and its sort of reputational base. We now have the capability from a facility point of view and a staffing point of view to go well beyond that and to have more long-term, more sophisticated studies. And we are beginning to move in that direction.

Backlog is building nicely to support this notion. And as customers become more familiar with the site, as customers do short-term studies and then we'll progress to longer-term studies, we believe we'll be able to modify that mix in a more favorable fashion.

Jim, are you seeing any market mix shift in the type of toxicology studies being done today? Pfizer is talking about a three-fold increase in Phase III programs. Obviously long-term oncogenicity and other studies are run concurrent with Phase III. A lot of other manufacturers are making those same comments.

Is there a big shift here towards chronic studies or long-term work? And also, what kind of a mix shift are you seeing with specialty versus general?

We're seeing a continued mix, a continued shift towards longer-term studies, but still a combination of both, which allows us to be more responsive to the clients' needs. I think there is a continuing build in demand for specialty studies, given their complexity and cost, facility drop, and the necessity to train employees to be able to do that in a consistent fashion.

So we have always come from a background of specialty work, but I would say that that is increasing in our scope and focus, commensurate with the type of work that clients are performing and commensurate with the increased demand to do that externally and not make the investment in order to develop the expertise themselves.

My final question and then I will cede the floor here is preconditioning. I didn't hear a lot of commentary about the preconditioning initiative in the prepared remarks. I was hoping we could get an update on your status with that initiative.

Yes, our discovery services part of our business, which is really a broader umbrella which includes preconditioning and things like genotyping and pharmacokinetics and surgery, etc., a whole range of studies for our clients is progressing. It is progressing off of a very small base. Portions of it, like our surgery capabilities, continue to be quite strong; and we see a very rapid outsourcing move on our clients' part. We are beginning to make some inroads and some strides with clients in their understanding that the other services are available to them on a large-scale basis in multiple geographic locales. We're confident that we will see that business continue to build. But it is still a relatively small base at the moment.

Okay, thanks very much. Good results in the quarter.

Kerry Nelson with Skystone Capital Management.

Great quarter. A couple of follow-ups. Can you just comment on -- I think you mentioned you feel like the industry is at an unprecedented tipping point. Can you just talk about what that means in terms of pricing and backlog?

Yes, it means that price is not first item on the agenda with our clients. There have been times historically where it was a more important issue for them.

I think there is a recognition that we are making significant investments in facility and staff, in lieu of the clients doing it themselves. The pricing is part of our rational business practices in order to effectuate appropriate returns, in order to pay our folks well, and the clients are able to offload that business to us.

So price is always part of every discussion, but if you sort of rank-order the top four or five things it tends to be, in most cases, very much near the bottom. As long as we continue to make investments remotely at these levels, we are going to ask for and expect to get additional price from clients.

We have seen the backlogs build nicely. We commented that we are very pleased with the backlog building in Massachusetts, which is obviously important, given that it is a new locale for us.

Capacity -- there are some modest amounts of capacity left, but capacity is filling up well. There are other places where backlogs are building there also.

Again, you know, there is only a certain amount of time the clients will wait. So it's important for us -- it would be nice to have three, four months of backlog all the time, but we're going to have to keep our incremental facilities slightly ahead of the demand for the backlog. Doesn't build much longer than that or we will frustrate clients and they will be forced to look elsewhere. So we're pleased with the levels of backlog and we're pleased with the reaction of our clients to our pricing initiatives.

That's great. Then just one other follow-up. On the dedicated space as you work towards that in both the Reno and the Shrewsbury facility, can you just help us understand how you're thinking about the return on capital as you price out that space relative to the visibility that that dedicated space would provide? Are you going to require the same sort of return on capital that undedicated space would be?

That would be our goal. It is obviously important to the client who is not building new space -- or some clients who are not building new space -- to have the sleep factor associated with knowing that they have the space dedicated to them and can put studies in at any time.

I don't think it necessarily follows that there is a different margin contribution for that sort of business versus our normal business. So we're going to try to effectuate both having long-term partnership relationships with clients, where we sit on the same side of the table, and that they pay us well for our work.

Perfect, thanks very much.

Jonathan Palmer with Thomas Weisel Partners.

Good morning. Thank you for taking my questions. Jim, in your prepared remarks you spoke about the strong performance in toxicology. I was wondering if you could just break that out a little further for us, on the drivers behind that. Is it stronger outsourcing from pharma, or winning more contracts and business?

I'm not sure there is a distinction between the two. There is no question that one can feel the increase in intensity of strategic outsourcing being used as a lever by our clients, by large pharma, large biotech, and emerging biotech as well. There is no question that there is a reluctance on the part of clients to make the capital drop to build their own space.

If you look at our portfolio of preclinical locations, they're quite disbursed geographically, which is helpful from a proximity point of view, and our clients getting comfortable and getting to know the staff. We have different capabilities through our facilities from some classic general tox to very sophisticated specialty tox. So we're able to be quite responsive to the needs of myriad types of clients, clients that have no background in sophistication doing these regulated studies and clients that are quite aggressive and sophisticated.

So I think it is fair to say that we are experiencing a steady build in demand. Sort of unrelenting build in demand, and we don't see any indications that that is going to back off as long as we and other companies like us build the space, hire the people, and most importantly execute extremely well, preferably flawlessly. As long as we do that, we should see the demand remain consistent or perhaps even increase.

Thank you. Then just switching gears here, at the analyst day, you guys highlighted some of your IT initiatives. I was wondering if you could give us an update on where you stand with those and when you think you will be complete.

It's a multiyear process with various stages of it. It is everything from HR to finance to how we track customer information to how we schedule our capacity. Different portions of that initiative will come online at different times. But it is a couple-a-year initiative, anyway.

Great, thank you for taking my questions.

Derik De Bruin with UBS.

Good morning. So, could you just talk a little bit more about the pharma spending environment? I saw your comments or noticed the comments that you're still having -- I wouldn't say a difficult time, but you're still trying to feel out what they are looking for in terms of spending. Are you getting any sense that as pharma faces tougher comps in the second half of the year, because (technical difficulty) issues that they are looking at how they are going to do their R&D spend?

From our vantage point, if you were to compare the demand and increase in revenue from major pharma clients this year versus last, almost without exception -- and when I say exception, that would be clients who are closing facilities. Almost without exception we're seeing them up in a meaningful way across the board.

I think that is a combination of two things. I think it is a combination of pure increased spending in both R and D -- our activities are sort of the tail end of R and much of the D -- combined with an intensified effort to move the work out externally.

So where we meet the clients, it certainly feels very positive. There seems to be a real focus, intensified focus by the clients in really, obviously, stimulating their pipeline. In almost all cases, it is manifesting itself with increased research spending.

Okay. Most of my other questions have been answered. Thank you,

Tycho Peterson with JPMorgan.

Good morning. Jim, tying together I guess some of the themes you talked about earlier in the Q&A around backlog, it's been a couple quarters here since you have seen some pretty strong growth in Transgenics. Can you give us a sense of how much visibility you have in that business and to what extent we can think about trends there going forward?

I will do the best I can. It's a complicated story. I would say it is a service that we have with somewhat inconsistent visibility. But at the current time, this is where we are.

We have had three consecutive quarters of pretty substantial increase. I would say it has exceeded our expectations and continues to. We of course came off of a very rough kind of 18-month to two-year period.

We are also seeing an increase in Transgenics work on a worldwide basis, which is also something we didn't expect. When I say worldwide, that is predominantly US, but also substantially in Europe and in our operations in Japan.

So I would say from an underlying scientific point of view, two things have happened. One is that there has been a significant reduction or rationalization of the numbers of colonies by all of our clients, large and small, but mostly large, over the last couple of years. They have gotten it to a level where they think the models are important to retain. Coupled with increased investment in creating new models, because we are continuously setting up new isolateds or new holding environments for new models that are being created. So.

And of course, we are in touch with all of our clients all the time. So all we can say at the current time is that we are quite confident that the back half of this year will be at higher levels than the back half of '06. Subject to the caveat that we begin to sort of anniversary a time where we began to increase the fourth quarter of last year.

And it is a business that is quite sensitive to major swings by major pharma companies who decide to cut costs, something we have no control over. Sometimes there's overriding cost-cut initiatives that are put in place that affect everything and could affect Transgenics.

So in the prepared remarks, we tried to be very careful in saying that we are enjoying the increase; we expect it to continue; it is too early to call '08. We are talking to our clients constantly. There are some good signals in terms of basic investment in these models that look positive, at least for the foreseeable future. But we are reluctant to say we expect this to continue indefinitely until we have more credible information and more data points from our clients.

Okay, that's helpful. Switching gears a little bit, it sounds like the ramp in the Endosafe has been pretty good out of the gate. You have always talked about some of that being driven by the FDA Process Analytical initiatives. Can you give us a sense as to maybe how aggressive the FDA has been in pushing these initiatives? Whether you're seeing any pull from customers at this point?

And then to what extent you are thinking about pipeline in terms of environmental testing or diagnostics or some of these other opportunities you have talked about peripherally in the past?

Our short-term focus is on maximizing the potential of the PCS for endotoxin testing. We are doing that in large measure in the pharmaceutical companies; and increasingly it's the nuclear pharmacies who need information rapidly because of the shelf life of the drugs that are being created.

In terms of the FDA initiative, the PTA (sic) initiative is really testing as quickly as possible. It is sort of lurking there in the background. It is an issue that a lot of clients are recognizing. We are out ahead of the pack in terms of being able to offer a solution when those regs really take hold.

As I also said in my remarks, a major focus on our part (inaudible) having a multi-cartridge system which accelerates the throughput for our clients who want to do this on a more comprehensive basis.

Simultaneously, we are working diligently sort of on an R&D basis in developing these systems for other uses, particularly in areas like environmental testing, and that will naturally follow. But we don't want to do that to the detriment of focusing most of our time and attention in maximizing our returns in the endotoxin market.

Okay, fair enough. Then, finally just on the dedicated space, you made some comments earlier about potentially some of the economics around those agreements. But could you quantify the level to which you have signed any new dedicated space agreements? I know you talked about I think a $17 million agreement at your analyst day back in May.

That is the last one that we commented on. As we said we have several under discussion. As soon as we have something definitive to comment on, we certainly will let you folks know.

Okay, thank you very much, and congratulations.

John Sullivan with Leerink Swann.

Good morning. Quick question on Endosafe. Was Endosafe a significant contributor to RMS in the quarter? More to the point, I guess, are you seeing any traction in the additive applications for Endosafe that you have talked about in the past? Things associated with process analytical technology initiatives of your clients?

Endosafe is always a significant contributor. We have to define what we mean by significant, John, but it has extremely high growth rates and has margins that have always exceeded total Charles River margins. So as it grows it is a meaningful contributor.

As I said earlier, our focus on the technology side is primarily to continue to refine the device for endotoxin testing and to branch out to a multi-cartridge system, and continuing to work on environmental testing in some of the other applications simultaneously with that, but not in lieu of it.

Thanks very much.

Doug Schenkel with Cowen and Company.

Good morning and thanks for taking my questions. I just want to start off with a free cash flow question. Given that for the first half free cash flows were just about $6 million, what are the second-half drivers that are going to change and allow you to hit your full-year target of, I believe, 25 to $50 million in free cash flows?

Good morning, Doug. Generally, we see the first quarter as our weakest quarter. That is primarily attributable to a couple of factors. One of them is bonus payments as a result of the prior year that of course we pay in the first quarter of the following year. We also tend to see capital spending a little bit geared toward the latter part of the year and carrying over to the following year in terms of commitments being paid in the following year.

Beyond that, we think the business continues to be strong. We have improved our guidance, as we said, and the outlook continues to be good for the second half of the year.

Okay, thanks for that. That's helpful. You know, in terms of dedicated space agreements at competitors, if a competitor were to announce an acceleration of the number of DSAs they are entering into, would that in any way affect your thinking regarding the pace of DSAs that you would want to enter into?

Not sure (inaudible) the question, but just taking it at face value, not really. As long as our capacity continues to be substantially fully utilized and margins continue to improve at our location, I don't want to say we are agnostic to it, but I mean dedicated space agreements will be something our clients want or not. And we are happy to do them if the basis of the bargain is rational, given the amount of investment that we're making; and if it is in the best interests of the Company and responsive to their needs.

We're not really pursuing them just to pursue them, in order to put additional notches in our belt. It is about keeping the capacity full and satisfying as many customers as possible.

So we're happy with the conversations we're having. We're having them with the types of clients in the geographic locales that we would expect. We're happy with the nature of those arrangements. We do expect that we will get some of these and they will generate interest by others who may be concerned about availability of space. But it is really a difficult thing to titrate on its own, sort of its importance to us from a strategic point of view.

Okay, that's great. Then one, just one more thing. I just wanted to quickly touch base on the China facility. I just wanted to make sure -- and you may have mentioned this in your prepared remarks, so if you did, I apologize. But I just wanted to make sure that an initial opening of the 50,000 square foot facility is on track for, I believe, the second half of 2008. I didn't know if you were in a position at this point to comment on any of the CapEx that were needed -- CapEx needs for that facility.

We didn't mention it, so thank you for asking. We closed on our deal in June. We have got a great general manager for that facility. We have hired a controller and are continuing to put together staff, some of whom may come from our other locations.

We are undertaking plans to renovate a four-story 50,000 square foot building that is leased. That work well be initiated before the end of this year and should be completed by the third quarter of next year.

We are already in discussions with several major international pharmaceutical companies who are in that locale, that (inaudible) quite close by from a proximity point of view to our facility, about doing work for them. We are quite optimistic that we will be able to open the facility with that business in hand. So yes, it will -- scheduled to open in the third quarter of '08.

Okay, great. (multiple speakers)

Suffice to say that capital expenditures for this year would be not substantial, obviously, just given the time of the year that we are in right now and the startup of construction. I don't believe we said exactly what it would be in the total. But as Jim said, it is a 50,000 square foot facility and most of the cost will be next year from a capital standpoint.

Next year? Okay. All right, Jim, Tom. Thanks. I appreciate you guys taking the questions. Great quarter.

Speakers, I will turn it back to you for closing comments.

Thank you for joining us today. We look forward to be speaking with you soon and to seeing you at one of the three conferences at which we will be presenting in September. This concludes the conference call. Thank you.

Thank you. Ladies and gentlemen, that concludes your conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.