Charles River Laboratories International Inc (CRL) 2010 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Charles River Laboratories third-quarter 2010 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 your host, Corporate Vice President of Investor Relations, Susan Hardy.

Please go ahead.

Thank you.

Good morning, and welcome to Charles River Laboratories third-quarter 2010 earnings 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 third-quarter results and update guidance for 2010.

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 the 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.

The access code in either case is 173757.

The replay will be available through November 18.

You may also access an archived version of the webcast on our Investor Relations website.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 19, 2010, 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'd like to begin by providing a summary of our third-quarter results, before commenting on the actions we announced yesterday in our business prospects.

We reported sales of $276.1 million in the third quarter of 2010, a decline of 7.2% from the third quarter of 2009.

Foreign exchange reduced net sales by 1.6%.

Excluding the effects of foreign exchange, RMS segment sales were roughly flat, and the PCS segment declined 12%.

Operating income for the quarter was $43.6 million, and the operating margin was 15.8% compared to $57.9 million and 19.5% reported in the third quarter of 2009.

The decreases were primarily the result of lower sales and higher costs associated with our ERP initiative, partially offset by cost-savings actions undertaken throughout 2009 and early 2010.

Earnings per diluted share were $0.45 in the third quarter compared to $0.65 in the third quarter of last year.

Lower sales were the primary driver, because without higher sales to leverage the fixed cost base, operating income and EPS are reduced.

As a result of continued constrained development spending by our large pharma clients, we are reducing our 2010 guidance to reflect the third-quarter results and our expectation that fourth-quarter sales will approximate the third-quarter levels.

We currently expect net sales to decline approximately 5% in 2010 and earnings per share to be in the range of $1.85 to $1.90.

In the third quarter, sales of our RMS segment fell 2.5%, primarily due to foreign exchange, which accounted for 2.2% of the decline.

Service sales increased, as did our sales of in vitro products, but these gains were offset by lower sales of research models.

On a sequential basis, sales declined by 4.7%.

The decline was driven by research models, which are generally softer in the third and fourth quarters due to seasonality.

The RMS services businesses, in the aggregate, continued to perform well on an organic basis.

The anniversary of the Piedmont acquisition occurred in the second quarter, and there was only a marginal impact in the third quarter of Cerebricon, which was acquired on July 31 last year.

All of our services -- genetically engineered models and services, or GEMS, research animal diagnostics or RADS, discovery and imaging services, or DIS, and consulting and staffing services, or CSS -- are used primarily in the discovery process.

We believe the strength of our service businesses is evidence of our clients' ongoing discovering efforts and of their choice to outsource these complex services to us.

Sales to academic and government clients continued to show strength, as they have for the past few years.

We believe this is due to a combination of factors.

First, partner funding from large pharmaceutical companies; and second, to our realigned salesforce.

As you know, we have gradually shifted our sales presence in this market segment over time, most recently in the sales and marketing realignment last year.

The additional coverage has enabled us to meet with more clients more frequently, and the results have been very positive.

Just to give you two examples, our RADS business signed a one-year, $1 million contract with the NIH, which is renewable for a total of five years; and our CSS business signed a five-year, $12.5 million contract with the National Institute on Aging.

We expect the service businesses to continue to drive our future growth and profitability.

We have commented in the past that because services were less profitable than products, we expected margin degradation as the proportion of services in the sales mix increased.

Although services are generally less profitable than products, we have improved the margins so that in the aggregate, the margin for the GEMS, RADS and DIS businesses is in-line with the overall segment margin of approximately 30%.

The in vitro business again performed exceptionally well.

The PTS engine is propelling this business, both through sales of the handheld unit and increasingly through adoption of the multi-cartridge system, or MCS.

The MCS enables us to penetrate our clients' high-volume central testing laboratories, which in turn drives cartridge use.

We are also planning to accelerate the conversion from traditional LAL testing to the premium-priced cartridge technology through the introduction of a fully-automated MCS in late 2011.

By continuous investment in the PTS franchise, we expect it to maintain and expand its contribution to sales and margin growth.

The RMS operating margin was 28.1% in the third quarter, primarily as a result of lower sales of research models.

We are striving to maintain the operating margin near the 30% level, and we believe that the actions we are implementing in the fourth quarter will enable us to achieve that goal.

The PCS segment reported sales of $116.8 million in the third quarter, a decline of 12.9% versus the prior year, and 12% when excluding the effect of foreign exchange.

The operating margin was 11.3%, a decline of 250 basis points from the third quarter of '09.

The market factors remain relatively unchanged from the first half of the year.

In the absence of a rebound in spending by large pharma, our revenues are driven by smaller clients.

There is a greater preponderance of short-term studies in the mix.

There continues to be too much capacity in the global preclinical services industry, and the excess capacity keeps pressure on pricing.

The most significant change in the third quarter was a reduction in the number of specialty toxicology studies being placed by our largest clients, which primarily accounts for both the sales and margin weakness.

Our capacity utilization has improved due to the closure of PCS Massachusetts and new business awards, but the business is coming in at lower price points.

Although no worse than the third quarter, we estimate that pricing for general toxicology is approximately 30% below its peak in 2008.

We don't believe pricing will change until a meaningful amount of capacity in both the pharmaceutical and CRO industry is rationalized.

Let me talk about capacity for a moment.

Although there were short periods of weakness, demand for outsourced preclinical services intensified over the last decade, to a point where we and other competitors could not build enough space to satisfy the demand.

This was the case right through mid-2008, at which point, looming patent expirations, pharma consolidation, reduction in biotech funding, global economic turmoil and uncertainty about the Obama healthcare policy derailed spending on drug development and disrupted the outsourcing trend.

The actions the Pharma industry has taken to rationalize pipelines further exacerbated the issue, since they now had excess internal capacity as well.

Understanding the market dynamics, we recognize that we would have to reduce capacity in order to improve utilization.

We took action quickly through the closure of Arkansas in 2009 and temporary suspension of Massachusetts this year, and are continuing to refine our infrastructure through additional actions such as the closure of Laval, a satellite facility in Quebec.

A competitor has just announced capacity reduction, and we expect that the pharma industry will continue its efforts to sell and/or close preclinical space, now that the initial integration of the large mergers which occurred last year has essentially been completed.

Although we believe that more capacity remains to be rationalized, these actions will help to improve the pricing dynamic.

When the global pharmaceutical industry reinvigorates its preclinical drug development efforts and capacity tightens further, pricing leverage will improve.

You know from the press release that we have implemented a number of actions intended to preserve the operating margin until our clients reinvigorate their early development spending.

The first was the headcount reduction involving approximately 4% of our workforce.

The reductions occurred in RMS, PCS and in corporate, including finance, IT, facilities and sales and marketing.

Given the continuing softness of preclinical demand, the most significant actions occurred in PCS.

However, we do not expect these reductions to impact our ability to support our clients currently or to impede our ability to accommodate increased demand when it occurs.

In addition, we are consolidating our Michigan DIS facility into our Piedmont operation in North Carolina.

The combined DIS business is performing well, benefiting from our clients' discovery efforts and the desire to utilize our expertise.

However, we believe we can gain operational efficiencies by consolidating the Michigan capabilities into Piedmont, where we will be able to serve our clients more effectively, with a broader range of services.

Finally, we plan to implement additional reductions in discretionary spending.

We have tightly managed these costs through the duration of this downturn, but believe there are additional measures we can put in place.

In total, these actions are expected to generate annual savings of approximately $40 million beginning in 2011.

This in addition to the actions announced in 2009 and the first quarter of this year, which we expected to generate approximately $70 million of cost savings in 2010.

We have demonstrated over the past two years that we are aggressively managing our infrastructure in order to weather this period of immense change in the pharmaceutical industry.

We've pared down pipelines yielding little in the way of novel therapeutics and patent expirations weakening sales.

The largest Pharma companies are focusing on late-stage clinical trials in an effort to bring those drugs closer to approval to market.

As a result, they have been less focused on early development, and with the excess preclinical capacity available both in the CRO industry and internally, have retained much of the preclinical work in-house.

The rationalization of capacity is one driver for improvement in preclinical demand, and there are others.

Large pharma companies are continuing to invest in drug discoveries, which we know due to the purchases of our research models and services which support the use of models in early research.

They are doing so both internally and by investing billions of dollars in collaborations with academia and biotechnology companies.

The resulting increase in activity, especially at biotech companies, bodes well for us.

Biotech companies have always relied on preclinical service providers like Charles River, and in fact, we have strong and growing relationships with many of them.

We built state-of-the-art facilities on the east coast in Massachusetts and the West Coast in Nevada specifically to support the biotech corridors located there.

As these companies are increasing their spending, we expect to see increases in volume.

We can accommodate an increase in volume with our existing infrastructure, and intend to reopen Massachusetts as volume strengthens over time.

The capital markets have been improving slowly, which provides an additional source of funds for biotech companies.

Our realigned salesforce is focused intently on the mid-tier client base, which includes the biotech sector.

We intend to continue to enhance our relationships with these companies and capture additional share of this business.

Another driver towards improved demand is large pharma's efforts to reduce the number of partners with whom they work.

Managing numerous suppliers leads to delays in handoffs from one process to another, and our pharma clients are increasingly recognizing the value of working with fewer partners across broader portions of the drug development pipeline.

This is where our portfolio plays a significant role.

We are unique in the industry, the only player with a portfolio that spans the early development platform, from research models to first in human testing.

This gives us the ability to work with clients in the earliest stages, when critical decisions about which therapeutic agents will remain in development are made.

Because we offer such a broad range of essential products and services, we can improve the efficiency and cost-effectiveness of our clients' development process, reducing costs by up to 20% and saving our clients between three and six months' time.

On a $1 billion drug, that time savings represents sales of between $0.25 billion to $0.5 billion realized, because the drug came to market sooner.

The linkage between our RMS and PCS segments is important because it enables us to leverage our expertise in in-vivo biology to support our clients as they grapple with development challenges across the development spectrum.

Because we perform thousands of discovery and development studies for hundreds of clients across numerous therapeutic areas, our expertise often surpasses theirs.

Clients value that expertise because it enables them to accelerate their drug development efforts without maintaining an expensive in-house infrastructure.

And because we have a global footprint, with facilities located in close proximity to clients, they can access our expertise when and where they need it.

We continue to have extensive discussions with clients at the most senior levels regarding broader strategic relationships which leverage our entire portfolio.

Our portfolio and global footprint are unmatched by competitors and gives us the flexibility to engage in varying types of arrangements, which can be tailored to a client's individual needs.

Although clients remain price-sensitive, they recognize our unique attributes, and are working with us to identify opportunities to access our immense knowledge base.

They steadfastly maintain their intention to utilize outsourcing as a primary means to reduce the costs and improve the efficiency of their early development efforts.

As we look at the early-stage drug development market today, we see a market poised for recovery.

It appears to have reached a plateau, as evidenced by relatively stable volumes and pricing over the last year.

While the timing remains uncertain, we believe demand will accelerate for the reasons I mentioned -- completion of mergers, rationalization of capacity, improved biotech funding, and the fundamental necessity to drive therapies in late discovery through the development process.

We also believe that ultimately pharmaceutical companies will choose to outsource the majority of their preclinical development to improve the efficiency and effectiveness of the drug development process through partnerships with contract research providers like Charles River.

The cost reductions we announced today, in concert with those implemented in 2009 and early 2010, are intended to preserve margins and position us to improve profitability going forward.

We will give you more information about our 2011 prospects when we provide guidance in December of this year.

For now, I will say that the challenges of the current operating environment do not diminish our enthusiasm for our portfolio or our strategy to continue to expand our early development franchise and maintain our leadership position.

The breadth of our portfolio is unique, and our scientific expertise unparalleled.

We have a number of opportunities in emerging businesses, such as in vitro with the PTS; GEMS with access to new models, as the p53 and Bcrp Knockout Rat Models we recently licensed from Transposagen; our Biopharmaceutical Services Business, which is focused on large molecules; and Preclinical, with development of the new pathology software through our 2009 acquisition of SPC.

Although slightly behind on its timetable, we believe this software provides an objective tool to pathologists to greatly increase throughput in this highly technical field.

We are very enthusiastic about these opportunities and the value they bring to Charles River and our clients.

Over time and regardless of the market challenges, we have maintained our focus on our core competencies of in vivo biology and regulatory-compliant preclinical services.

That discipline has enabled us to build world-class capabilities across our businesses and enhanced our ability to fully support our clients as a strategic partner in the drug development process.

Today, we remain the global leader in RMS and one of two global leaders in the early development contract research industry.

Because we believe so strongly in Charles River's future prospects, I am pleased to note that our Board has increased our stock repurchase authorization to $750 million from the original $500 million.

We believe that the deployment of cash to repurchase stock is a means of enhancing per-share earnings growth and improving shareholder value in advance of the time when demand return and drives both sales and earnings growth.

We currently intend to execute the balance of the authorization aggressively, beginning in February, after we complete the ASR which is currently in process.

In conclusion, I would like to thank our employees for their exceptional work, commitment and resilience, and our shareholders, who have accommodated us with their time and consideration.

Now I will turn the call over to Tom Ackerman.

Thank you, Jim, and good morning.

Before I recap our third-quarter financial results, let me remind you that I will be speaking primarily to non-GAAP results, which exclude acquisition-related amortization, non-cash interest expense related to the convertible debt accounting rules, charges related to cost savings actions, the evaluation and termination of the WuXi acquisition and other items.

Please note that our GAAP EPS and cash flow were negatively impacted by the $30 million WuXi termination fee in the third quarter.

The charge was not benefited for tax purposes.

Overall, third-quarter sales declined 5.5% sequentially, reflecting lower sales in both segments, which translated into lower operating income and margins.

In particular, the sequential decline in PCS sales resulting from softer demand from large pharmaceutical clients led to lower than expected EPS of $0.45 in the third quarter.

Stock repurchases has a limited benefit in the quarter, which was primarily offset by the correlated increase in interest expense related to the new credit facility.

However, we expect more substantial accretion from stock repurchases going forward.

The sequential RMS margin decline was due principally to softer demand for research models, driven in part by normal seasonality.

We do expect a slight sequential sales uptick in the fourth quarter, and as a result of improved mix and cost actions, we also expect the RMS margins to improve.

Unallocated corporate costs increased by $4.5 million year-over-year, primarily driven by higher ERP costs.

Sequentially, ERP costs have continued to decline moderately throughout 2010 as we moved beyond the system implementation phase.

This contributed to the $2 million sequential decline in unallocated corporate costs from the second quarter, along with lower healthcare, fringe and other costs.

We expect fourth-quarter unallocated corporate costs to be moderately below the third-quarter level.

Net interest expense was $4.1 million, a moderate increase year-over-year and sequentially, reflecting the partial quarter impact of the new term loan.

Net interest expense is expected to total approximately $6 million in the fourth quarter to reflect a full quarter of interest expense on a new term loan.

In the third quarter, we were also required to write down deferred financing fees of $4.5 million in relation to the amended credit agreement, as well as a $0.5 million financing fee related to the proposed credit facility associated with the WuXi transaction, which have both been excluded from non-GAAP results.

The non-GAAP tax rate declined by 160 basis points sequentially to 25.9% in the third quarter.

This improvement was primarily driven by enhanced benefits from R&D tax credits in Canada, which we expect to moderate and lead to a modest increase in the fourth-quarter tax rate.

The Company has now completed a number of cash repatriation niches, which totaled $291.6 million in the third quarter.

This includes the repatriation of $121.6 million of cash from non-US subsidiaries, as well as $170 million of cash borrowed by our non-US subsidiaries in association with the new credit facility.

The latter is a result of placing the equivalent of $170 million of the term loan offshore denominated in euros.

Repatriated cash was used to partially fund the ASR and WuXi termination fee.

We incurred a one-time tax charge of $12.1 million related to the third-quarter repatriation that was excluded from non-GAAP results, as was $0.4 million in advisory fees.

As part of our emphasis to drive shareholder returns, we announced in our earnings release that our Board has increased the stock repurchase authorization by $250 million to a total of $750 million, reflecting our collective belief that our stock is presently undervalued.

Previously, we announced a $300 million accelerated stock repurchase program on August 27, which was implemented following the original $500 million authorization.

The ASR was implemented in order to facilitate the buyback of a substantial portion of the authorized shares in a timely and efficient manner.

We received an initial delivery of 6 million shares on August 27, and an additional 750,000 shares on September 23, which were excluded from our outstanding share count at the date of receipt.

Morgan Stanley is not required to deliver any additional shares until the completion of the ASR, which is expected to be in February 2011, or sooner, at their option.

Prior to the implementation of the ASR, we also repurchased 1.8 million shares for $52.9 million through open market trading in August.

Including these open-market repurchases, we expect to have between 54 and 55 million shares outstanding once the ASR has been completed, and have nearly $400 million remaining on our stock repurchase authorization.

We intend to reevaluate the timing and amount of any future repurchases at that time, but currently plan to continue repurchasing at an aggressive pace, once the ASR has been created in February.

To provide additional liquidity to finance the ASR, we amended our credit agreement at the end of August to provide up to $750 million, including the $400 million term loan and a $350 million revolving credit facility.

The revolver is currently undrawn and available for future borrowing needs.

Both facilities mature in August 2015, with an interest rate of LIBOR plus 250 basis points for the term loan and any drawn amounts on the revolver.

This translates into a borrowing rate at quarter-end of approximately 3% on the term loan, including the amortization of deferred financing fees.

We did use a portion of the proceeds to repay the $127.5 million balance on our existing credit facilities, so only the new $400 million term loan and $350 million in convertible notes are currently outstanding.

This leaves our total debt on the balance sheet at approximately $719 million at quarter-end, or less than three times the last 12 months non-GAAP EBITDA.

We used cash in the third quarter to partially fund the open-market stock repurchases and the WuXi termination fee.

As a result, our cash and marketable securities position declined to $163 million at the end of the third quarter, from nearly $250 million in June.

DSOs of 52 days this quarter were comparable to 51 days at the end of the second quarter, but continue to remain elevated as a result of an increase in receivables aging and a decrease in deferred revenue.

We do not believe we have a heightened credit risk as a result of the receivables agings, and are actively working on our collections to improve DSOs.

Free cash flow was $38.5 million in the third quarter and $105 million year to date, after adjusting to exclude the one-time $30 million WuXi termination fee.

For the year, we continue to expect free cash flow to be approximately $130 million, adjusting for the WuXi termination fee.

CapEx continues to track below anticipated levels at $9 million for the quarter and $27 million for the year-to-date period.

Thus, we expect CapEx to be approximately $45 million for the full year, which is mostly maintenance capital.

Now I will provide further information on our fourth-quarter actions.

We have undertaken additional measures to align our infrastructure with the current demand.

We plan to reduce our overall headcount by approximately 4% across PCS, RMS and corporate functions.

Also included in this reduction are the following actions - Closure of a leased PCS facility in Laval, Quebec, and a consolidation of our Michigan discovery operations with our larger facility in North Carolina.

In addition, we are further reducing discretionary spending levels, particularly with respect to consultants and travel.

The combined actions are expected to result in the annual cost savings of approximately $40 million, beginning in 2011, with the majority of the savings in PCS, followed by corporate and RMS.

We also expect to see a benefit in 2011 from an anticipated $4 million reduction in ERP costs, which is in addition to the $40 million of savings next year.

We expect to incur severance and other charges of approximately $15 million related to these actions, principally in the fourth quarter.

We have not completed the impairment analysis of intangibles related to the Michigan discovery operation at this time, but will update you with our fourth-quarter earnings call.

As Jim discussed, we are reducing our sales and EPS guidance for 2010.

The change is primarily driven by our third-quarter performance and our expectation that fourth-quarter sales will remain relatively flat in both segments on a sequential basis.

We are lowering our sales guidance to an approximate 5% decrease, with less than a 1% negative impact from foreign exchange for the year.

Non-GAAP EPS guidance is $1.85 to $1.90.

This assumes that we will not receive additional shares under the ASR program in the fourth quarter, resulting in an estimated diluted share count of approximately [57 million] (corrected by company after the call) shares in the fourth quarter.

Our third-quarter results reflect the continued challenges that we face in our markets.

We have continued to take vital actions to preserve margins and improve shareholder returns in the absence of revenue growth, including the elimination of a significant amount of costs, the reduction of over 300,000 square feet of preclinical capacity and the repurchase of a substantial number of shares, utilizing a combination of tax-effective cash repatriation initiatives and low-cost debt.

We believe through these actions that we have continued to work diligently to maximize shareholder value and better position the Company to capitalize on potential value creation opportunities as we move towards 2011.

That concludes our comments.

Operator, would you please take questions now?

(Operator Instructions) Ross Muken, Deutsche Bank.

In talking with a lot of executives across pharma, there continues to be this heavy focus on the commercialization end of the pipeline and getting things into the clinic.

I know you mentioned some of the M&A rationalizations that have gone on, and in general, you've seen kind of continued efforts for guys to kind of pare back on spend and sort of improve productivity.

In terms of like a lifecycle or in talking with the folks internally, how long of a period do you think these companies can go without sort of feeding the early parts of the pipeline before we actually -- they actually start to kind of run the risk of not having future innovation at the degree that they are going to need it, post all of the generic wave that is happening?

It is a great question.

It's obviously a departure of from the historical methods of running their business, where there was at least an equal spend, or often a preponderance or a disproportionate amount of spend in early development.

So there is some risk, and they are caught between the necessity to get drugs in the market to offset the impending patent issues.

One of the ways of dealing with it obviously is intensified spending with biotech, as opposed to doing it totally internally.

That is not a bad scenario for the CROs, because the biotech companies have no internal capacity and need to outsource pretty much all of their work.

And as we said in our prepared remarks, we have an intensified focus on what we call the mid-tier, which is biotech and smaller pharma companies, just to spend more time with them, to sell our entire portfolio and to let them avail themselves of our capabilities.

So it's an interesting paradigm that the drug companies are in.

What we've been hearing lately from most of them is that they are looking forward to sort of flat spend from most of them going into the next year.

I mean, some are down, some are flat for us.

It is even more important what the outsourcing rationale will be.

We keep hearing from clients that they intend to outsource more, that they understand the value proposition.

For many of them, they have just simply too much internal capacity, which they will still rationalize.

So we expect to see further closures of space and/or opportunities to buy space, not that we are necessarily looking for that.

So your question is the right one.

The answer, if you believe in the future of the pharma industry, has to be continued investment in discovery and being tougher on weeding out the products earlier in the process so that they actually run and spend money in development with the ones that they think have the highest probability of success.

We think some of the growth in our service areas and some of the growth in some of our products, some of our inbred and hybrid strains of mice in particular, give us some comfort that discovery spending is alive and well at many of the clients.

As we think about the cost actions that were taken, this is one of several restructurings we've seen.

I guess if the view is that we are -- if we are sort of at the bottom of the market, I mean, when you were thinking about the magnitude of the savings you needed to drive, did you kind of say, hey, I need to be at X percent profitability in this business at the trough, and sort of work from there?

I'm just trying to understand kind of the thought process in terms of deciding on the actual size and magnitude.

It is a combination of believing that this business can yield a minimum level of profitability, even at these sorts of sales levels and price pressures.

So we felt that was our responsibility to get back there, A.

B, we certainly feel that we also have an obligation to size our business, and that is both me the that operate the studies and make the animals, as well as our G&A costs, to be in line with the demand.

We were very, very cognizant to ensure, though, two things.

One is that we never cut so far as to in any way impair the quality and depth of our science, which we think is unparalleled.

And we are still getting compliments from most of our clients about the quality of our science.

And also that we don't impair in any way our ability to be responsive to our clients' needs, and they are always on very short time frames.

And also, to leave some capability to accommodate an upturn in demand when that comes.

So while it is not a pleasant task, but one that one has to do to keep the Company healthy, we think that we've done this to appropriate levels to preserve the quality of the work that we do.

(Operator Instructions) Greg Bolan, Wells Fargo.

Jim, I was very interested to hear that specialty tox volumes were somewhat weak during the quarter, especially given the well-noted strength in Phase IIb and III clinical activity.

Do you think this slowdown was due to market share loss or just a general slowdown?

And moving 10,000 feet higher -- and this somewhat chimes in with what Ross, I think, was asking for his first question -- looking back 10 years can you talk about the underlying cyclicality in drug development activities?

We don't think it is a market share situation at all.

Our footprint in specialty tox is larger and more complete than the competition, and indeed, in many areas, is much more complete that our client.

So we are the go-to company for lots of things, like inhalation and repro tox in particular.

So we don't think that is the situation.

We have seen clients increasingly over the last couple of years wait as long as they can stand to to do these specialty studies, sort of commensurate with the clinical trials.

And historically, when they would do something sort of at IIa or b, they are now waiting until Phase III to do it.

So they are pushing them out as long as possible, and of course there are probably less drugs coming through the pipeline.

The historical perspective is a complex and interesting one.

So the sort of peaks and valleys in the CRO industry are not particularly relevant from a historical point of view.

But I do think that the ebbs and flows of early development versus late-stage clinical and the time it simply takes to get drugs into the clinic and into the marketplace is inherent, and it's kind of the lifecycle of drugs which of course take longer now.

The fact that they take longer is probably hurting the process, as well.

So I suppose the positive spin on the fact that we were disappointed with the specialty tox numbers in the third quarter is that the initiation and the utilization of our specialty tox capabilities is inevitable as they get later in the clinical process.

So we look forward to seeing that in the not-too-distant future.

Thanks, Jim.

I'll jump back in the queue.

Douglas Tsao, Barclays Capital.

You referred to a falloff in terms of specialty tox demand.

I was just wondering if you could provide a little bit more detail in terms of which segment of specialty tox.

Because obviously, there are a lot of different buckets that can be characterized as specialty tox, although they are at different stages of development, as well as potentially different areas or different types of drugs.

So if we could just get a little bit more color in terms of what you are seeing there.

It was reasonably consistent across the board.

In places like reproductive tox, which are very expensive trials, we do a lot of it.

I think we do more of it than anyone.

We are seeing those sorts of studies wait longer.

As I said, some of the infusion and inhalation work, we are seeing that as well.

And we are seeing it in multiple geographic locales also.

So it is pretty much across the client base.

As I said earlier, we have no evidence or belief that it is share.

And unlike some of the general tox or some of the earlier studies, we don't see clients bringing this work back in-house, because their internal capabilities aren't as in-depth as ours.

So we've had a very good balance for a long time in specialty work, and in many quarters have been enriched by the specialty mix.

So again, from sort of a cycle point of view, this would appear to have us at a low ebb.

Having said that, the sort of pricing for specialty tox comparatively has held up better over time.

So I guess my question -- this is not isolated to inhalation or infusion, which are studies that don't necessarily have to be done for every drug.

It sounds like it is -- so it's not isolated; it sounds like from your comments that it is fairly broad-based right now.

Yes, and I would say it has sort of been an expanding trend over the last couple of years, where, as I said earlier, they definitely did those studies earlier, and are just waiting until they believe there is some certainty or a high probability that the drugs will actually get to market, with some evidence that Phase III are going well.

Great.

Then just one final question for either you or Tom.

If you could provide a little bit more color in terms of your expectation for the operating margins in the RMS segment as we move into next year.

I mean, obviously you stated the goal to stay at 30%.

Normally, the first half of the year, you have been above that, and often a couple hundred basis points above that.

Does that -- is that unreasonable to expect?

Is this a situation where it is going to take some time to implement all these cost-savings initiatives and realign the business, as well as see some catch-up in sales?

Or is that reading too much into your comments earlier?

As Jim and I both said, we do expect to see an improvement -- I was going to say reversal -- in the trends in RMS.

And I think there is a couple of things.

One, obviously, would be continued slowdown in toxicology type work; it has put pressure on our largest research models, which has been a little bit of a drag.

We saw some seasonality, which we typically do in the third quarter.

And we expect to see some of that reverse.

And in addition to that, we are obviously taking cost actions to mitigate the impact of some of those trends have had building up over time.

So I think the answer is, without putting any specific margin number down there, we do expect to see the margin trends improve and we are working hard to do that.

We are aware of it.

Okay, great.

Thank you very much.

I'll hop out for now.

Ricky Goldwasser, Morgan Stanley.

Can you talk a little bit about how much capacity do you think needs to come out in order for price to start improving?

Because obviously, we've seen pricing stabilize at 30%.

It seems like demand has gotten a little bit softer in the last quarter or so.

So from what you are seeing today, does capacity need to come up by 10%, 20% or more for pricing to start going up again?

It is difficult to put a number on it, but I would say that the trend is clearly going in the right direction.

We re-enumerated the space that we've taken out with Arkansas, Massachusetts, which was obviously a large space; and we've taken a lease facility off-line in Montreal, which was actually a large space as well.

We've read that a competitor has taken out some space also.

And we know that some of the private companies that don't report have taken space out as well over the last year or two.

We also know for sure that several of our clients have and continue to do so, and many have told us that there is additional space to come.

There are assets available on the market for sale right now.

And we anticipate that will continue.

So it is pretty clear that as space continues to come out, clients will begin to wait longer than they've grown accustomed to for the last, let's say, 18 months.

I think that they won't like that.

I think everything is about speed to market, and I think that will reduce the pressure on pricing and improve our ability to hold or increase price.

Obviously, we don't have any price increases in our mind for the foreseeable future.

I'd also say that pricing, while we have intermittent price cutting by some of our clients -- by some of our competitors -- sorry -- I would say that -- and while clients are of course interested in price, that we have seen it pretty much stabilize.

And it is all about available space.

So as space comes out of our clients' facilities and we all continue to take space out -- and I don't know how much more will take out -- but we for sure know that our clients will -- that will accelerate things.

What is the tipping point?

I think that is a bit of an imponderable, but clearly we are moving more closely towards that.

And I would say the sort of commentary and discussions with clients around pricing would tend to underscore the fact that -- I'm not sure they're concerned yet, but they are at least cognizant of the fact that capacity is being reduced.

Okay, and just one follow-up.

As we think about 2011, obviously, you are not giving guidance today, but do you think that we should just kind of like -- if we look at kind of like your 4Q guidance, is it fair to take that 4Q guidance and annualize it and extrapolate it to 2011?

From where do you stand today and kind of like the demand you are seeing, do you think that's a fair exercise?

Or is that -- would that be -- or is that a conservative approach, in your view?

I think it is premature for us to answer or for you to model.

You have to see how the year ends.

We have to see what the conversation and the commentary is with our clients about 2011.

I continue to meet with clients all the time, and some will tell me what 2011 looks like in terms of R&D spend and what they anticipate buying from us and what their pricing expectations are.

And as I say, we really don't think we will have our budgets done until the middle or maybe the end of the first quarter of 2011.

And we don't -- so we can't tell you yet.

And I'll just say, we don't know yet.

So rather than speculate, we need to do this for ourselves, and then we'll provide you folks the information on a bottoms-up basis, based upon info we get from our clients collectively.

And probably with greater emphasis this year on what we call the mid-tier, which is the biotech clients, in terms of their needs going forward.

Okay.

Thank you.

Dave Windley, Jefferies & Company.

Jim, you have touched on this mid-tier and biotechs.

I'm wondering, when you talk to clients, in particular those smaller ones, and they have raised a significant amount of capital, albeit most of that coming from pharma, what do they say they are doing with it?

Why -- I'm trying to get at the question that everybody is, is why aren't we seeing more studies?

Our work with the mid-tier has been increasing and improving, both by focusing on it and also by virtue of the fact that funds are flowing from pharma to them.

We've seen a mix change in a couple of facilities, one in particular, which has gone from predominantly pharma to more smaller companies.

We have several situations with sort of second-tier biotech, meaning ones that are well-capitalized and have good molecules, but aren't necessarily household names or (technical difficulty) profitability yet, where we are doing most, and in some cases all, of their tox work at reasonable price points.

So I do think it is improving and increasing.

It takes -- even if you have 100% of the work, it takes several good biotech clients to either offset declines to big pharma, or conversely, to give you the gains that you'd get from a major move in big pharma clients.

So it probably appears to be more subtle than it actually is, Dave.

Okay.

On the pricing front, I guess the peak to current pricing commentary that you made, 30%, I believe, does sound a little further down than -- I think we've been saying 20 -- maybe low 20%s decline when we started calling this environment stable.

I just want to make sure I understand.

And I guess I hear you saying stability, maybe things are getting incrementally better, but obviously the numbers -- that 30% price decline sounds a little worse, and obviously the revenue and margins look that way as well.

That's not particularly a new number, Dave from 2008.

It is only with respect to gen tox, general toxicology.

Obviously, lots of the work we do is specialty in nature or shorter-term studies, which are of higher value.

So it really has stabilized, except, as I said earlier, we do have periodic sort of aggressive low price points from some of our competitors that we typically choose to ignore, as it must be pricing at or below cost.

We are finding that clients seem pleased with the price point and have had some bad experience with some other suppliers in terms of quality and turnaround time, and so they think they've pushed the prices enough.

I think there is always a penchant for reduced price commensurate with volumes.

I think we are always going to see that.

But really -- it really has stabilized, and it is not a new number.

Okay.

I'm going to ask one real quick, make sure Tom is awake back there.

What would be the corporate overhead kind of base line number from which I should take these actions away?

What is that kind of annualized corporate overhead run rate number?

I would say it is a combination of the third and fourth quarter numbers, Dave.

Okay.

We do tend to see reductions, for whatever reason -- and it's the same every year.

Of course, the fringe, we kind of understand because of FICO and things like that.

But we do tend to see health costs lessen up as we get later or later in the year.

I don't really know why that is.

So we will step down a little bit in Q4 from Q3.

And Q3 is actually lower than Q2 and Q1.

So I think a rate around a Q3, Q4 kind of number.

And of course embedded in the $40 million is some level of corporate activity, as well as operational.

Right.

Thank you.

John Kreger, William Blair.

Jim, can you just clarify a little bit more what you were talking about in terms of what clients are telling you about what they are doing now and what they might be doing in 2011?

And specifically what I'm trying to get at, if you look at some of your key toxicology facilities and sort of set price aside, what are you really seeing change if you think about peak activity levels versus what you are seeing now?

Are you seeing your clients put fewer compounds through your facilities?

Are you seeing less work being done per compound or maybe fewer chemical analogues being brought through?

What does that analysis tell you?

We are actually seeing a slightly different mix.

So we are seeing more short-term work for smaller clients.

So -- and that causes a bit of churn in between studies, so you've got some inefficiency as a result of that.

Capacity is actually increasing -- I'm sorry -- capacity utilization is actually improving, not to where we want it, but it's improving gradually, so that is a good thing.

But we do have this sort of specialty tox waiting as long as possible and gen tox prices kind of languishing 30% below the peak.

So it is a bit more short-term-oriented, IND-enabling study work than we have encountered sort of generally in the past.

Obviously, they have to move through that once we file their IND.

So I would say directionally, it is not a bad scenario, nor is it a bad scenario at all that we have so much work with so many smaller clients.

And when do you think you will have more clarity on sort of the 2011 plans from your key clients?

We're in the midst of it now.

We are working to finalize our 2011 budget.

That is constant conversations with clients.

As I said earlier, pretty much zero base, so we sort of start all over with conversations about what is up with them, how much should we anticipate getting, what is staying in-house, do they anticipate closing space and what is the pricing paradigm and how much can we get them to buy across the whole portfolio.

We do that every year.

I think clients are actually more open to giving us some clarity as to what they will do with us, assuming they know it.

And there have been so many changes with the clients over the past year, particularly as a result of the mergers, that often what they tell us isn't the case.

So if we have a year of sort of modest consolidation in the industry, that would be also stabilizing in terms of the clients doing what they said they would.

Okay.

Thank you.

Robert Jones, Goldman Sachs.

Thanks for the questions.

Most of the specific ones I had have been answered, so just a big picture kind of theoretical question.

Clearly, the buyback would indicate you guys think the shares are undervalued here.

But I guess if you could maybe share with us -- what do you think it is that investors are missing or undervaluing?

Is it the future growth that you feel confident in the preclinical business or is it the RMS business?

And I guess the follow-up would be, is there a point that you would consider strategic alternatives to unlock the value, if investors don't start to appreciate what you perceive to be the value of the business?

I am not sure.

Well, I think two things.

I think that for some period of time, there has been an under-appreciation or a lack of focus on the research model business, which is an extraordinary business in terms of our operating margin and free cash flow generation.

And if we can get the top line moving faster, I think we will see a refocus on that.

But we've seen sort of a distraction from RMS as people sort of hover and wait for preclinical to turn.

So I'm not sure they are missing anything.

I think that people are simply waiting for the preclinical business demand quotient to change, both top line, and that will improvements to the bottom line.

So we continue to think that the uniqueness of the portfolio is a very powerful and strong one, and there is conductivity between the two segments, one that most of our clients buy across the continuum.

And so -- and I guess with regard to the last part of your question, our policy wouldn't be to comment on those types of issues.

That's totally fair.

Just one more on RMS, if I could, Jim.

I know last quarter you mentioned weak demand for the outbred rats.

But this was something that you were monitoring as an early indicator for the beginning of increasing demand.

I was just wondering as we sit here in November, if you could give us any signs of an uptick in demand around the outbred rats.

I would say that outbred rat sales have definitely stabilized.

We haven't seen any uptick, as we've said before.

You don't -- you only need a few weeks, maybe a month, in advance of studies beginning to accelerate.

So you don't get really an early warning.

You get some warning.

The fact that it has stabilized is a good thing, because outbred rat sales had been continuing to decline, I would say, since mid-2008, certainly through 2009 and the early part of this year.

So the fact that they've stabilized is a good thing.

They continue to be an exceptional profit generator for us.

Thanks for the questions.

Tycho Peterson, JPMorgan.

Just want to actually jump in with a question on the guidance for the fourth quarter.

You're kind of calling for flat sequential results here, and this is coming off a sequential decline in the third quarter.

Understanding that pricing is probably stable, how do we get comfortable that volume can't drop off a little bit more, given that pharma is still in the midst of a lot of integration restructuring and capacity transfer?

That is a good question, Tycho, obviously.

We clearly thought we were at the bottom earlier in the year, and seemed to be, as we bumped along for, I would say, three quarters sequentially in PCS at about 125.

I think we've looked at our numbers pretty closely.

I think plus or minus, we will be in line with Q3, based on our backlog increase and demand quotient.

The RMS business has been a little bit easier to predict.

There has been much less volatility.

So I think we are calling it as best we can.

We've taken a little bit of a leg down in looking at all the numbers.

It feels like we are at that spot right now in Q4.

I think the RMS will be up slightly.

We obviously talked about being flat, so I don't think that means it will be up dramatically.

But I do think it will be up a little bit from where we sit today.

And I think that will alleviate some of the pressure on the RMS margin, along with what we talked about earlier in terms of the cost reduction actions.

Okay.

And then question on the tox market overall, I guess.

As we think about -- there obviously, as you know, has been additional capacity that has come online in China.

If you can talk about how you think that factors into a potential recovery in the tox market.

And maybe, Jim, if you just want to touch on your kind of longer-term plans for China post the breakup of the WuXi deal, that would be helpful, too.

I'm sorry.

I missed the first part of the question.

(inaudible)

Oh, so what does China look like?

Yes, new capacity has come online.

It is in interesting market.

There is a fair amount of conversation and commentary on it.

I think it is of strategic interest to our clients.

It is developing much more slowly than any of us anticipated.

The amount of GLP work is relatively insignificant, and I think that is a combination of factors.

Compounds developed in China, discovered in China for development in China are few and far between.

So there just simply are not enough compounds right now.

The price points in China are not as compelling to some of our clients, because the price points have gotten so low at some of the facilities in the US.

And the investment in China by some of the big drug companies did not achieve the levels that we had originally anticipated.

So while I think long-term it is an important locale, for the longest -- for the foreseeable short-term, it is going to be sluggish, it is going to be a lot of non-GLP work.

And with the advent of additional competition, I think it will be -- could even be slower for a longer period of time.

Obviously, we had a different vision with the WuXi transaction, which I don't need to go into again, which wasn't about tox.

It was about doing more in China and having an earlier early development pipeline.

But China has suffered as a result of clients generally reducing their spend and generally being more judicious with not only how they spend their money, but how many compounds that they are producing.

And we don't see a lot of compounds, for instance, being sent from the US or Europe to China for development by the drug companies.

Nor do we see a lot of work being moved from overseas to China because of the price points.

So at least for the last couple years, it just has -- it has been a different market than I think we anticipated.

And I can't speak for the competition, but I suspect they are encountering the same issues.

Okay, that's helpful.

Thank you.

We are aware that there are other questions in the queue, but in order to the respectful of everyone's time this morning, we will follow up with those callers after the call.

Please feel free to call us as well.

Thank you for joining us this morning.

That concludes the conference call.

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