Charles River Laboratories International Inc (CRL) 2011 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Charles River Laboratories' first-quarter 2011 earnings call. At this time, all phone participants are in a listen-only mode. Later, there will be an opportunity for your questions. Instructions will be given at that time. (Operator Instructions). As a reminder, this call is being recorded. I will now turn the call over to Corporate Vice President of Investor Relations, Susan Hardy. Please go ahead.

Thank you. Good morning and welcome to Charles River Laboratories' first-quarter 2011 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 first-quarter results and review guidance for 2011. 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. The access code in either case is 198048. The replay will be available through May 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 You may also access an archived version of the webcast on our Investor Relations website.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 23, 2011, as well as other filings we make with the Securities and Exchange Commission.

During this call, we will be primarily discussing results from continuing operations and 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 would like to begin by providing a summary of our first-quarter results and commentary on our business prospects. We reported sales of $285.8 million for the first quarter of 2011, a decline of 2.2% from the first quarter of 2010 and 3% when excluding the benefit of foreign exchange. The decline was due to preclinical services as demand from our large biopharmaceutical clients continued to trend towards shorter-term general toxicology studies as it has done for the past year. However, PCS sales were nearly flat sequentially, which we believe confirms our opinion that both demand and pricing have stabilized, particularly with regard to our large biopharmaceutical clients. We are pleased to note that, on a sequential basis, consolidated sales improved 1.5%. The increase was due to RMS, which gained 3% from the fourth quarter of 2010.

We made very good progress in the first quarter on our key initiative of operating margin improvement. Operating income for the quarter was $51.4 million compared to $44.2 million in the first quarter of 2010, a 16.4% increase. The operating margin gained 290 basis points year-over-year to 18%.

The sequential improvement was also impressive. Operating income rose 6.1% from the fourth quarter of 2010 and the operating margin improved by 80 basis points. Both the year-over-year and sequential improvements were driven by cost-savings actions undertaken throughout 2010.

We also made significant progress on our initiative of returning value to shareholders. Earnings per diluted share were $0.61 in the first quarter of 2011 compared to $0.45 in the first quarter of 2010, a 35.6% increase. In addition to improved operating income, share repurchases contributed to the increase. Between the two accelerated share repurchase programs, or ASRs, and open market purchases we made in February, we repurchased approximately 5.2 million shares in the first quarter of 2011. On a sequential basis, earnings per share increased 1.7%. We had anticipated a sequential decline, but higher-than-expected sales in the quarter, tight cost controls and fewer shares outstanding contributed to the $0.61 result.

Our focused sales efforts to develop broader relationships and gain marketshare with mid-tier biotechs and academic clients have and we believe will continue to generate sales growth. However, it would require significant growth from these two sectors in order to offset the impact from our large biopharmaceutical clients to whom we are highly leveraged. These companies continue their intense focus on reducing costs, which has led to rationalization of therapeutic areas, frequent reprioritization of drugs in development and delays in moving therapies through the pipeline.

Despite these challenges, based on discussions with senior leaders and decision-makers at our large clients, we continue to reaffirm our sales guidance for the year. Given the cost-savings actions we took to streamline our own operating efficiency, we remain confident that, based on flat sales, we can achieve an improved operating margin from the prior year, which will yield higher earnings per share and cash flow.

Therefore, we are reconfirming our 2011 guidance of year-over-year flat sales and earnings per share in a range of $2.20 to $2.40 and free cash flow in a range of $150 million to $170 million. Despite flat sales, we are driving EPS improvement through a combination of aggressive cost management and a lower share count as we focus on returning value to shareholders.

I would like to give you more detail on the segment results. First-quarter sales for our RMS segment decreased by 0.7% to $173.4 million from the first quarter of last year due principally to foreign exchange. The operating margin increased 80 basis points year-over-year to 31.2%, demonstrating the benefit of higher sales of in vitro products and genetically engineered models and services, or GEMS, as well as cost actions we implemented in 2010.

On a sequential basis, sales increased by 3% and the operating margin improved by 70 basis points. The sales increase was due primarily to new pricing, which went into effect on the first of the year. We were very pleased with the operating margin, which exceeded our expectations despite some softness in the research model business in North America. All research model production businesses, except Japan, reported increased sales on a sequential basis, which we would expect based on the seasonal softness we normally experience in the fourth quarter.

Compared to the first quarter of 2010, sales of research models declined in all geographies except Europe. As they did for most of 2010, sales in Europe increased. We believe the different sales trends between the US and Europe has to do primarily with the character of our client base. Where our US sales are leveraged to large pharma and the impact of mergers and acquisitions has been significant, European sales are a more diverse mix of large pharma, private companies and government-funded academic research. Sales in the US market were down in the quarter, which is not surprising considering its exposure to large pharma. Sales of outbred rats continue to be soft, consistent with demand for toxicology services.

Research model services sales increased year-over-year primarily due to the GEMS business. Gains were driven by a mix of large biopharmaceutical clients and academic accounts demonstrating research funds continue to be directed towards the development of disease models and that our clients rely on Charles River for the expertise required to develop and utilize these models in research.

In vitro business again delivered very strong results. There were two sales drivers in the first quarter -- the portable testing system, or PTS, and the Asian market. As I previously mentioned, demand for the PTS continues to grow because it offers a faster testing process. We place additional testing units in the field every quarter and are benefiting from increased cartridge use as well. As successful as the PTS has been to date, we believe we are still in the early stages of converting our clients from the older tests to the PTS. We believe this gives us the ability to continue to grow sales at a rate of 10% or better for the foreseeable future.

In addition to the PTS, we are also deriving growth from Asian markets as more contract manufacturing or GMP standards is being done in China, Korea and India for export to the West. There is greater demand for quality control testing. We have and will continue to meet that need through either our older testing process or the PTS, whichever suits the clients best.

I would like to take a moment to talk about the situation in Japan. Charles River has been working to support its employees and clients in Japan and our thoughts are with the people of that nation during this difficult time. We are fortunate that all of our employees in Japan are safe and that our five facilities are fully operational. We are working with our Japanese colleagues and clients to continuously monitor and evaluate the situation. We have experienced some moderate disruption in our Japanese operations as the country and our clients respond to the aftermath of the earthquake and tsunami. Tom will give you some additional details shortly, but from an EPS perspective, our current view is that the first-quarter outperformance will likely cover our estimated exposure to Japan.

The PCS segment reported sales of $112.5 million in the quarter, a decline of 6.3% versus the prior year and 7.2% when excluding the effect of foreign exchange. The decline was driven primarily by mix, which, as I said earlier, continues to include a greater proportion of shorter-term studies and general toxicology. Pricing remained relatively stable throughout 2010 and in the first quarter of '11 as clients continued to be resistant to price increases.

There was some sales impact from the renewal of two significant long-term contracts in the fourth quarter as work performed in the first quarter of '11 reflected the new pricing. We had expected first-quarter sales to be below the fourth-quarter level due to the customary slow start to the year by many of our biopharmaceutical clients as they finalized budgets and prioritized projects. However, the sales decline was less than 1% with improvement in volume at some of our sites and a few discrete events contributing.

Despite the first-quarter results, at this point, we have not seen a sustained increase in demand from our large pharmaceutical clients. Although there can be variability from month to month, inquiry levels, bookings, cancellations and the backlog have remained relatively stable over the last year. We have yet to see an improvement in demand for longer-term studies, which would increase the backlog and improve visibility. As long as the mix remains weighted to shorter-term studies, we expect visibility to remain limited.

We have invested significant effort over the last three years in developing more strategic relationships with our large pharmaceutical clients and have successfully advanced a number of these relationships. Meeting with senior leaders of our clients, we are mutually identifying opportunities to support a greater portion of their pipeline utilizing our broad portfolio of essential products and services. Although we are pleased to say that we are generating higher sales from some of these clients, we expect the efficiency initiatives of the larger client group will continue to restrain pricing and demand, which will be a factor in our results.

We were very pleased with the PCS operating margin improvement, which was driven by the cost-savings actions we implemented in 2010. Year-over-year, the operating margin improved 430 basis points to 14.1% and 210 basis points on a sequential basis. Although the margin may fluctuate over the course of the year, depending on sales and mix, we expect to maintain or slightly exceed the 14% level on a full-year basis.

I would like to provide an update of our strategic review process for our Phase I clinical business and our preclinical facility in China. On March 28, we finalized the sale of the Phase I business to comprehensive clinical development. As a focused clinical services provider, we believe that CCD will be able to leverage the strength of the Tacoma, Washington facility. We are pleased that CCD has retained the majority of our former employees and will continue to serve clients through a seamless transition. We considered several alternatives for the China operation and have chosen to shut down the business. We are proceeding with this plan and anticipate final closure by the end of the second quarter.

With the strategic review process now effectively completed, we have achieved our goal of eliminating the operating losses, which were approximately $10 million in 2010. This was one of the components of our first key initiative to improve operating margin, as well as the cost-savings actions and aggressive management of our infrastructure.

I would like to comment on another of our key initiatives -- investing in existing businesses with the greatest potential for growth. Our guidance for capital expenditures is $50 million in 2011, approximately half of which is expansion capital. We are investing in a new laboratory for our research animal diagnostics, or RADS business and a new facility for our discovery services business in Finland. We are expanding our in vitro facilities to accommodate the growing demand for PTS equipment and cartridges and we are investing in IT systems to provide clients with significantly improved access to study data. We believe that each of these investments is pivotal to our growth strategy, which encompasses providing clients with the scientific expertise and exceptional client service, which they expect from Charles River.

Our client base is undergoing significant change and we continue to believe that the outcome of their efforts to create a new more efficient drug development model will involve increased outsourcing. The ability to utilize our expertise and infrastructure instead of investing in their own will enable them to redeploy assets to more productive initiatives and to replenish their drug development pipelines with therapies to advance human health.

While our clients are involved in this challenging process, we will continue to identify opportunities to work with them more effectively both to advance their processes and at the same time drive our growth, earnings and cash flow and return value to shareholders.

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

Thank you, Jim and good morning. Before I recap our financial performance, let me remind you that I will be speaking primarily to non-GAAP results from continuing operations. A reconciliation of non-GAAP items can be found in our press release and on our website.

Our first-quarter results clearly demonstrate the collective benefit from our emphasis on enhancing shareholder value. In the first quarter, despite slightly lower sales, we were able to generate nearly 300 basis points of operating margin improvement year-over-year as a result of the significant cost-savings actions that we implemented. EPS grew by 35.6% year-over-year, or twice the rate of the robust operating income growth, as we returned value to shareholders in the form of share repurchases.

First-quarter sales and EPS were ahead of the expectations that we provided on our February call. On a sequential basis, sales improved by $4 million, or 1.5%. Sequential sales growth in RMS was driven by small models, which improved from seasonally weaker fourth-quarter volumes.

PCS sales were flat sequentially as additional studies booked and performed during the quarter helped to offset the normally slower start to the year. The consolidated operating margin increased by 80 basis points sequentially in the first quarter to 18% due to the benefit of our fourth-quarter cost-savings actions, as well as higher sequential sales of research models.

In addition to cost-savings, the PCS operating margin also benefited from discrete events that are not expected to continue in the second quarter. This could lead to a slight headwind in the PCS margin in the second quarter.

While EPS was up over 35% year-over-year, certain items limited the sequential growth. As expected, the first-quarter tax rate returned to a more normalized level of 26.3% from 21.6% in the fourth quarter. Other income was also less favorable. We commented in February that the tax rate and other income provided a $0.06 benefit to fourth-quarter EPS that we do not expect to recur.

I will now discuss some of the non-operating items that contributed to our first-quarter performance. Unallocated corporate costs declined by $1.4 million year-over-year to $18.6 million, reflecting the impact of the November cost-savings actions and a reduction in consulting costs related to last year's ERP implementation.

The $2.1 million sequential increase in unallocated corporate costs was largely driven by higher healthcare and fringe-related costs that are typically recorded in the first half of the year, as well as performance-based incentive compensation in the first quarter of 2011.

Net interest expense increased by $0.5 million sequentially to $6.4 million, primarily reflecting the $150 million term loan added in February to fund the new ASR program. Other income was negligible at $63,000 in the quarter compared to $1.4 million in the fourth quarter of 2010 related to investment gains associated with our deferred compensation program.

As I mentioned earlier, the non-GAAP tax rate of 26.3% returned to a more normalized level in the first quarter. You may recall that the 21.6% rate in the fourth quarter of 2010 was particularly low principally due to higher benefits from R&D tax credits in Canada.

During the first quarter, we concluded the strategic review process for our US Phase I clinic and China preclinical facility. We divested the Phase I business on March 28 and accomplished our stated goal of eliminating our operating losses from the facility. As a result of the disposition, the Phase I business has been reflected as a discontinued operation for which we recorded a $3.9 million loss in the first quarter.

We also booked an $11.1 million corporate tax benefit in continuing operations related to the disposition of the Phase I business. This tax benefit has been excluded from our non-GAAP results in the first quarter and we updated our GAAP guidance for 2011 accordingly. We are also completing the final accounting of a lease guarantee, which we will record at fair value in the second quarter.

Regarding our preclinical facility in China, after thoroughly evaluating a number of alternatives, we have implemented plans to close the facility during the second quarter. As a result of this decision, we have excluded operating losses from China from our non-GAAP results beginning in the first quarter. We also expect to incur limited severance and related costs predominately in the second quarter of 2011, which will also be excluded from non-GAAP results.

I would now like to talk about our emphasis on improving free cash flow generation and in turn returning value to our shareholders. Free cash flow in the first quarter was $14.6 million compared to $18.6 million last year. While the first quarter is typically the weakest for cash flow generation, two specific factors contributed to the reduction. First, DSOs were less favorable at 49 days, up from 46 days in the first quarter of last year and 45 days at the end of 2010, although within our range during 2010.

Also, we had a use of cash related to certain tax adjustments in the quarter, including a required cash tax payment in conjunction with the appeal of a German tax assessment, which was fully reserved for as an uncertain tax position. While these items negatively impacted first-quarter free cash flow, we do not expect the same impact in subsequent quarters. Therefore, we continue to expect free cash flow of $150 million to $170 million for the year, particularly given the strong operational performance in the first quarter.

CapEx remained low at $6.8 million compared to $9.3 million last year. CapEx guidance for the year remains at approximately $50 million as we continue to focus on disciplined capital management.

We continued to aggressively repurchase shares in the first quarter. We completed the $300 million ASR program on February 11 and received an additional 0.9 million shares for a total of 8.9 million shares repurchased under that program. We also initiated a new $150 million ASR program on February 24 and received an initial delivery of approximately 3.8 million shares at that time. We expect this program to be completed by the end of May at which time we would settle it based on the VWAP over the calculation period by either receiving additional shares or providing cash or shares if necessary. Prior to implementing the $150 million ASR, we repurchased approximately 0.6 million shares in the open market in February 2011 for $21.6 million.

Based on these repurchase activities, which we expect to result in a diluted share count to be approximately 52 million shares once the current ASR has been completed, we expect our average diluted shares for the full year to be in a range of 52 million to 53 million. This is slightly above the current level based on the higher first-quarter share count and movements in our stock price. Upon completion of the ASR, we expect to have approximately $225 million outstanding on our stock repurchase authorization.

We continuously evaluate our capital priorities and at this time expect to moderate our stock repurchase activity in the near term and allocate a greater proportion of free cash flow to debt repayment. To facilitate the $150 million ASR, we added a $150 million term loan to our existing credit agreement in February. The new term loan has the same interest rate as the existing $400 million term loan that we entered into last August. We had $857 million of debt outstanding at the end of the quarter and cash and marketable securities of $185 million.

As Jim discussed, we are reaffirming our 2011 guidance of approximately flat sales and non-GAAP EPS in a range of $2.20 to $2.40. We expect the first-quarter outperformance to be offset by the anticipated impact from the situation in Japan and due to limited visibility, we remain cautious on the outlook for our preclinical business, particularly with regard to our large pharmaceutical clients.

In addition, I remind you that we have a 53rd week this year. The extra week is periodically necessary to true up to a December 31 year-end. The 53rd week, which is the last week of the fourth quarter, creates some margin pressure because we have a full week of costs, but given the holidays, a light week of sales.

I would like to add a few details on our Japan operations, which represented 6.5% of total sales in 2010. We have five RMS facilities in Japan, three production sites and two for services, but none were near the affected area. Our closest facility in Tsukuba, which is northeast of Tokyo and over 100 miles away from the affected area, sustained only minor damage. However, client shipments were disrupted across Japan in the weeks that immediately followed the earthquake and while shipments have steadily increased as clients returned to work, sales volumes are not quite tracking to normal levels yet.

Although the situation in Japan remains uncertain, we currently believe that we can manage the anticipated financial impact from Japan within our guidance range. We expect to experience more of an impact in the second quarter as only two weeks were affected in the first quarter.

This leads me to our outlook for the second quarter. We expect sales to be approximately flat sequentially. This outlook incorporates relatively stable trends in both RMS and PCS, including steady inquiry and booking levels in the preclinical business. However, in the second quarter, we believe that both the top and bottom lines will be pressured by the anticipated impact of Japan and to a lesser extent the absence of the discrete PCS events that benefitted the first quarter. These factors are expected to be partially offset by a lower share count reflecting a full quarter impact of the February ASR and open-market repurchase activities and favorable movements in foreign exchange rates. We expect the cumulative impact of these items to result in second-quarter EPS that is flat to slightly below the first-quarter level.

To conclude, we are pleased with another strong quarterly performance and the progress we have already made to improve our operating efficiency and enhance shareholder value. We remain focused on our value creation initiatives and the responsibility to deliver on our financial and operational goals. Thank you.

That concludes our comments. Operator, would you please take questions now?

(Operator Instructions). Ricky Goldwasser, Morgan Stanley.

Good morning. Jim, I have one question for you and then one follow-up on the financials. I think you talked in the prepared remarks about the continued -- the ongoing continued weakness from the pharma side. Is this just in line with kind of past trends or is this -- are there any change that you have seen more recently in level of activity from the larger pharma companies?

I wouldn't say it is anything new. It is a continuation of really looking closely at price, continuously changing and re-changing their infrastructures and looking at their pipelines. And I think that will be a continuous process for these companies. Probably we have a little bit of the residue of the consolidations that occurred the prior year.

Having said that, I would say that, with some of the drug companies, large drug companies, we have seen them getting down to business and beginning to outsource work that was historically not available I think to us or anyone. I think that is a good sign. And we would anticipate that, over time, there will be more companies following suit in order to compete effectively, particularly the patent cliff descends upon them next year. But I would say that we are not really seeing anything new, but just sort of a sustained continuation of how they have been operating for the past few years.

So to your point, if we think about kind of like the inflection point that you have been waiting for, do you think that it is possible that we might need to wait for next year's patent expirations to see a bigger shift?

It is tough to try to predict or discern what a triggering factor will be. I think it is very subtle and continuous and it is a constant process of re-looking at their own infrastructure. I mean they know that the patent cliff is coming. Whether actually living through it instigates change faster I suppose is possible, but not necessarily predictable. I do think it will be a continual process of looking inward, determining what needs to be done internally and what can be done externally as we continue to see the virtualization of these big clients.

And given the clients that are beginning to outsource and the scale of them, one would predict that others will follow. And I am sorry, but the visibility and the timing of exactly when that happens is not clear. I think it is best to assume that it just continues to happen over time without any sort of dramatic momentary event that causes it, which is frankly what I think we are seeing now.

And then on the RMS side, I think you talked about the price increases coming through and having a positive impact on sales in the quarter. So based on your recent years' experience, do you think that those price increases will hold throughout the year?

We do. We do think that they have and will hold. We have been doing price increases at the beginning of the year for a long period of time with some advanced notification and yes, given the quality of product and sort of our [prominent field] from the scientific and service point of view, I think clients feel that those price increases are fully justified and they seem to be accepting them nicely.

Thank you.

Robert Jones, Goldman Sachs.

Thanks for the questions. Jim, can you maybe elaborate a little bit on the discrete items that you mentioned in PCS that contributed to the overall results? And then I know you mentioned the overall headwind in conjunction with Japan, but I was wondering if you could maybe just talk about the headwind from these discrete items specifically next quarter.

Well, it principally came from our biosafety testing business or we call it our bps business where we are testing predominately large molecules. So it is reported in our preclinical sector, it is not classic in-life toxicology studies and it was a situation that we don't expect to re-occur and not part of the main business.

Yes, one as an example, Bob, was a credit that we had received from the government for levels of work that we performed in the area locally. So we recorded that in the first quarter because of where we were in the agreement with them and obviously that is not something that is going to recur and then there were a couple of similar type items that are same type of magnitude.

Okay, that's helpful. And just on pricing on the PCS side, you mentioned in the slides and in the comments that clients are being resistant to price increases. Is there a sense that there might be a new norm here or is this just where we are in the cycle in your view?

We continue to believe that it is -- it is tied to two things. It is tied very much to the available capacity or put another way how much capacity is being used specifically in our system obviously, but in the whole tox system generally both with regard to external competitors and our clients.

It is also very much dependent on mix. So it really depends on specialty work and the length of studies, how much churn there is in the system. So mix has historically been better. It is not unlikely to expect that that will improve over time as drugs move through the drug development process. And certainly, we believe the capacity will continue to fill because capacity is filling now. We are obviously just talking about our system, but we would expect the capacity filling throughout the industry. It is quite masked by the price and the length of the studies. And so it would occur to the reader or our investor base that it wasn't filling as quickly just given sort of the nature of the revenue contribution. But it is and as it does, it is inevitable that there will be some pricing power and particularly as clients have drugs closer to finishing their clinical trials and they are pushing hard and they begin to do more sophisticated studies.

So it is a little bit complicated to talk about cycles because there have been so many changes in our fundamental core client base, but there is some cyclical activity in terms of the way they buy given where the drugs are in the pipeline.

And then, Jim, just lastly on capacity you mentioned, are you seeing pharma take more aggressive steps in taking captive toxicology capacity off-line?

You mean their own space?

Right.

We haven't seen them do anything dramatic except continue to talk about that and acknowledge the fact that that is something that they need to do, intend to do and that they probably are spending disproportionately higher by keeping it inside. I think there is obviously a lot of factors that contribute to the making of those decisions. But again, we think that those are inevitable, particularly as there is capacity externally in the system that can soak up that work.

Thanks for all the comments.

John Kreger, William Blair

Hi, thanks very much. Just to follow up on the mix question, Jim, you mentioned that mix has shifted more towards shorter-term studies. What about the mix between specialty and general tox within PCS? Where does that stand now versus your historical norms?

Less attractive than we have seen it historically, so we have less specialty work, which comes in tandem with our work in the later stage, later phases of clinical work, but that is, of course, not across the board. I am thinking some of our specialty activities are up, some are down and some are sort of flat. I would say that the market for specialty work is a little more competitive than we have seen it historically and probably a little more active on pricing than we have seen it historically as well.

So it is an area where we continue to be stronger and larger than the competition. I think that is a net positive, but again it is very much related to and connected to what phase they are in the drug development process. And there is a lot of churn right now with these short-term studies for drugs that apparently are not advancing. We have no control over that. Actually, neither does the client at the outset. So as those drugs advance, that obviously will be a good thing not only for capacity, but for additional specialty work.

Great, thanks. And a follow-up question, I believe you said, again within PCS, that you had a couple of longer-term large pharma contracts that renewed in the fourth quarter and that new pricing kicked in in Q1. Do you have any more situations like that as you look out across the rest of the year, which could cause some margin hit to the business?

That's it. Those were two large ones we have had for some time that have rolled off and there are no others like that.

Okay. So it is fair to say your business is pretty much priced at the spot market at this point?

I think that is a fair characterization.

Great, thank you.

Dave Windley, Jefferies & Co.

I wanted to follow up on John's last question. In the renegotiation of those agreements that have rolled over, are you rolling those over on shorter time intervals anticipating maybe the price might go back up and you could reset sooner?

We are just pausing to make sure we have the answer to that. The pricing has been temporary. I think we will actually have to get back to you on the length of them. They were fairly lengthy agreements, so I suspect not quite as long, but let us return to you on that.

Sure, fine. Moving on then, Jim, we have heard others talking about a little bit of an uptick in demand from small, mid-biotech or biopharma and you commented in your prepared remarks that maybe you are seeing a little bit of that too. But you also said that the move in that client base and academia would have to be quite large to make up for the large pharma softness. So I wanted to I guess come back and get a sense for how small has small biotech become in the backlog or in the revenue mix and just any other color that you can provide about the movement of that client group from a demand standpoint?

So the mid-sized biotech clients continue to be an important source of revenue for us. We do well with them and we have lots of clients there and they are a significant part of the whole. So obviously we have a very large part of it that is big pharma. And so if you are comparing our activities to smaller players who have a preponderance of work with small biotech companies, it would have a more dramatic impact on their results.

I would also say though along with that where we have seen aggressive pricing, much of that has been with regard to smaller competitors of ours with regards to very small clients or potential clients. So the question is always at what price point (technical difficulty) is that rational.

But I would say, by and large, we are doing well with that client segment. We are spending much more time on it than we have historically both from a sales point of view and senior management point of view and we are not just selling better, but we are developing very senior relationships with those clients.

I think the operative point though is that, since we have a larger business than a lot of the competitors and pharma is so important to us, some of the shifts or slowness to act or outsource, for instance, by the large drug companies will offset a lot of biotech work or the inverse as you stated. So we're working harder on both fronts. We are also working harder on the academic front because there is a lot of money coming directly from big pharma to the small biotechs, as well as the academic market and we continue to see an uptick there.

Okay, thank you. On the academic side, on the federal budget and thinking about it, NIH funding, wondered what your thoughts were there about exposure or potential impact if that becomes a source of savings in the federal budget debate.

It is always a frustrating potential when the government is moving in that direction. Yes, I mean we have some adverse impact on us. Having said that, a lot of our government contracts are long-term contracts, which are locked in for a number of years. A lot of our government work -- we report 16% of our revenue is in the not-for-profit sector. Obviously, some of that is in Europe, which would be unaffected and a lot of that is with the academic market. So I suppose in time we would see some of that, but at 16% relatively small percentage of our total sales.

Okay, great. Thank you.

Douglas Tsao, Barclays Capital.

Hi, good morning. Thanks for taking the questions. Jim, in terms of what you are seeing in the RMS business, in terms of volumes for standard outbred rats, would you say the results are consistent with what you're seeing in the PCS business and the toxicology business?

I would. I would say that we are seeing very stable purchases of outbred rats sort of week to week and month to month consistent with essentially no major or significant uptick in the demand for tox. We've just talked about it for a while. It ebbs and flows. It is a little bit different by business sector or client segment, but be that as it may, we have stability on the demand side certainly in terms of inquiries and cancellations and bookings and even prices. So we would expect to see some consistency of purchasing on the outbred rat side as well.

Okay, and then in terms of margin and profitability of different tox studies, do you find that -- short-term studies obviously have a lower price point. Are they also lower margin because they are sort of more resource-intensive from a human resources standpoint?

I mean the very short ones do have lower margins, so the mid-price ones tend to have -- the mid-length ones tend to have the best prices. So yes, there is a lot of churn. There is sort of an inherent inefficiency in putting those studies up and taking them down so often. That is probably the primary thing that hurts the profitability of them.

Okay. And then just to get some -- just some color in terms of describing mid and small biotechs, obviously with a lot of M&A that has been ongoing for the last few years, there has probably been some changing in terms of the composition of these different categories. If you could just provide some metrics in terms of how you're defining those respective customer groups, that would be very helpful. Thanks.

Well, we sort of use the term mid-tier as a kind of catchall for classic biotech. That would be pretty much very small and medium and even sort of first-tier biotechs. So only the very, very big biotech clients would be lumped in with pharma. The rest we would include in that characterization and of course, the preponderance from a sort of second tier, and by that I mean public, have several drugs that they are working on, often have no revenues at the current time, but are on the verge of having some. So we look at that whole segment together.

We probably do much better in the very large biotech and in the mid-term biotech. Although we have a lot of activity in the smaller ones because I think a lot of the smaller ones are purchasing primarily on price because they are burning through their funds relatively quickly.

Okay, great. Thank you very much.

Todd Van Fleet, First Analysis.

Hi, good morning, guys. I wanted to ask about what you are seeing from a wage inflation aspect and maybe you want to speak to this -- maybe it is more to do with the research models business as opposed to PCS. I imagine that RMS is more internationally oriented than PCS at this point, but you can correct me if I'm wrong on that. But just curious about -- there is a lot of talk about pricing in the marketplace in general. I am just thinking about the potential margin pressures that you would see from a cost perspective, that is mainly what I assume would be salaries and wages.

We really haven't seen too much. This year, we morphed into focal reviews for all of our businesses where previously we had a lot of businesses doing reviews at one point in time and some others doing them through the calendar year. So we did those all in the beginning part of the year. Our compensation was between a 2% and 3% increase. That is actually better than it has been for the last couple of years. I think generally speaking, our employee base was fairly happy with that. And I don't believe that we have any areas geographically as an example where we have had some compensation issues centered around something like that. So I think overall, I would say that we have not had any type concerns from wage push or type cost increases.

If you look at our other areas, the only commodities that we are really tied to would be feed in our research model business. We do have multiyear agreements that provide price protection to us. So we are not feeling anything there. And we are seeing a little bit on the fuel side where we have had some surcharges from our delivery providers and we are reviewing what we will do internally with regard to what we might pass on to our clients.

And Tom, those salary reviews and so forth, you said those were done at the beginning of this year and so were those -- I imagine those were not baked into the March quarter, so should we see those have more of an impact maybe in the June quarter or September?

No, no. I mean the beauty of the focal review is even though we put them in place during the first quarter that really allowed us the ability to manage the process, but we had targeted increases that we were able to meet and because we do it all at one time, it is pretty clear whether you can meet them or not because everybody is getting their review at the same time and we roll it all up and calculate it. So what we put in place you would see a little bit of an increase, but not from a forecast or a budget standpoint.

Okay. And then on the balance sheet, I guess as it relates to the stock purchases, Tom, I don't know if you can give us the cash and debt balances as of maybe the end of April, or a more recent cash and debt balance.

Well, we don't typically do that, so I can reiterate what we had said about the first quarter. The only other comments that, of course, I made with respect to those two items is that we will put a little bit more energy into delevering throughout the year as opposed to share repurchases, which I had mentioned. And first quarter free cash flow is typically a little bit light, and it was even a little bit more so this quarter based on the two items I mentioned.

But we still have a lot of confidence in our free cash flow guidance for the year. So I think what you will see is cash to some extent probably building a little bit because of some pockets where we do have trapped cash, and I think you will see our debt balances come down as we move through the year.

Okay, thanks, guys.

At year-end, I think our leverage was 2.8 times roughly and, of course, with the $150 million credit facility we would push beyond that at the end of the first quarter. So the delevering will allow us to start to move back to a target or a low target level of say 3 times.

Right. All right, thank you.

Derik De Bruin, UBS.

Hi, good morning. How much was the China business a drag on the overall operating margin? And now that you have put it in discontinued, I am just curious to what the impact was and what we'll see on a year-over-year basis?

Right. Well, last year it was in the mid-single digits, somewhere around $5 million, $6 million operating loss. A little bit less than that probably on a cash basis, given depreciation and whatnot. On a run rate basis I would say was a little bit less than that in the first quarter because of reductions that we had been making.

So if you look at it year-over-year, it is a decent sized improvement. And if you remember we talked about that in the preclinical, the Phase 1 business being a drag of about $10 million in operating losses between the two of them.

Okay, that's helpful. Thanks for the reminder on that. And I guess what is your interest rate on the total debt, just for --?

LIBOR plus 2.5.

Great.

So it is 3% plus, basically.

Okay, great. And I guess, you know, could you just talk a little bit about how big a portion the in vitro business is in RMS these days?

Well, we haven't answered that directly in the past. Susan is probably our in-house expert on answering this because we generally respond by grouping a few of the nonresearch model businesses together. Susan, I am not sure if you have that off the top of your head.

Off the top of my head. If you look in the K or the Qs that we file, you will see a new segmentation of the RMS business which shows production which is all the production businesses, services and other. And what is in other is our in vitro and avian businesses. And in that group which has been running about 20% of total revenue, in vitro is the larger portion, but we haven't split out which is which.

20% of RMS rev, though.

RMS revenue, yes.

So it is 20% RMS revenue is in other and that is the largest and fastest-growing piece of other. That's the best we can do for you.

That's fine. That's great. Thanks, I'll get back in the queue.

Doug Schenkel, Cowen and Company.

Hi, good morning. So I think you guys referenced some softness in the Americas. I thought it was specific to RMS. Assuming I caught this correctly, is any of that attributable to the budget situation in Washington, the uncertainty that existed during the quarter? And if so, was there any signs of improvement in Q2 as we move past that?

Not really connected to the budgetary situation. I think we were drawing a distinction between our US rodent business and our European one and our European one has been performing exceptionally well actually for a while, including this year. Just has a different client base. It is not as heavily dependent on large pharma. It is a fair number of private companies and a large amount of government-supported academic institutions, which we do quite well with. So we are having really nice top-line growth and good margins in that sector. Whereas, in the US, there is still the sort of impact of the churn from multiple consolidations, some price sensitivity and a bigger impact from softness in outbred rat sales tied to tox than we are seeing elsewhere in the world. So that was the basis for the distinction.

Okay, that is helpful. You mentioned consolidations, which has obviously been an ongoing theme for quite some time, specifically the Sanofi Genzyme. Anything new that you have heard from them that is incorporated into guidance or at least to this point, basically does it look like it is business as usual with both of those parties even though they are now merged?

We try not to talk about specific clients. I guess I would say that we wouldn't have as dramatic impact from the deal of that scale obviously as two big pharmas to begin with. We anticipate in every operating plan that we put together that we will have some churn from consolidations because I think they will continue. It is always -- each one is unique and we have to wait and see what happens. I think sort of the early indications that I think are generally out there that those companies will run relatively independently as we have seen with a lot of big pharma and biotechs historically. In fact, I think that may be the model for the future. If that is the case, that is obviously or often will be good for us.

Okay. And if maybe I could sneak in one more. If I remember correctly, I believe last quarter, you highlighted discovery services as one area that was doing well, maybe doing a little bit better. Did that continue this quarter? And I guess as part of that, is that embedded in some of the rationale behind the new Finland facility?

Yes, we didn't call that out. I would say that the pure discovery business in the first quarter was a little slower than we would like. There seem to be a lot of sorting out of compounds. That is a business, of course, where we are taking a first look at the efficacy of compounds. We would anticipate that that would improve as the year moves forward. And yes, the Finnish facility where we have our CNS operation, there is -- a lot of companies are investing and emphasizing CNS diseases and we do have to significantly improve the quality and scale of our facilities there.

All right, that's great. Thanks for taking the questions, guys.

Tycho Peterson, JPMorgan.

Hey, good morning. Just want to dig a little bit more into the study mix and obviously you've talked about the bias remaining toward short-term contracts. Do we live in a world where that doesn't change over the next year or what are the leading indicators I guess that can get us more comfortable that there will ultimately be a shift back toward longer-term studies for you guys?

They have been imponderable. I mean one would hope and believe that a certain proportion of compounds look to be beneficial and look to have really good therapeutic characteristics and efficacy and safety and we will continue to move through the clinical trial process. I don't think there is any reason to believe that that isn't the case. Certainly have reason to believe that it could be better going forward, hopefully, given the intense focus and investment in and with biotech companies, first and foremost and secondarily with certain academic institutions who do the basic discovery work. So we would hope that the molecules, albeit a lot of them large molecules, will fare well over time and will move through the process.

So I don't think there is any reason to believe or that it is logical to assume that we are just going to have a series of try the drug, not be happy with it and try something else, continue to churn like that. Some proportion of them I think will stick. Leading indicators of that -- I mean I think the best indicator you can get is dialogue from a client as to what they are seeing with the drug in the clinic. Often that is something they share with us and sometimes it is not. So we will just have to continue to work closely with them and garner enough of the work so that that improves the value proposition for us.

And then can you talk to the Pfizer deal that you announced during the quarter for animal models? Is this something we may see more of from you in terms of partnering with pharma for that business?

Yes, we are certainly happy to do that. That is a model deal and if you develop proprietary models, whomever you are, but in this case you are talking about the pharma companies and you want to enhance, get the best possible distribution on a global basis, you are going to want to work with us. So I do think that the opportunity will likely continue to make themselves available.

We need to be careful to pick situations where we think that the drugs -- the animals have a decent market opportunity, but directionally, disease models are the most important discovery tool and a lot of the drug companies have invested heavily in them. The extent to which we can help commercialize them I think will be beneficial for all of us.

And then as we think about utilization and capacity, obviously that is continuing to come out of the system. Can you just take a stab at where you think we end up a year from now from a utilization perspective? And I also assume that there is probably no chance that we will see discussions of dedicated space coming back in the next year or two or are we wrong in thinking about that too?

It's hard to imagine that we are going to have a lot of that given the sensitivity to expending large amounts of money and committing over long periods of time. Having said that, as the space fills and as they shut down their own space, I do think there will be some clients who are forward thinking enough and financially strong enough that they will want to consider locking up some space, particularly if they don't expect the CROs to be building any new space and they have already taken the space off-line.

So I think directionally it is possible. I don't think the market dynamics right now would support that sort of activity. We don't disclose what our capacity utilization is nor has there been any articulation of it in the public domain in a while. Suffice it to say, if we can use our own activities as any sort of gauge, that space is filling I think for everyone. While we all have some excess space, we are certainly not going to build new space.

We said some time ago that we thought probably sometime in '12 we would be approaching a period where space was becoming well-utilized in let's say many or most of our facilities where we would have to consider what we would do with that. But also the clients would have to consider how comfortable they were just taking their chances because once they are ready to commit, once they are ready to commit to a study, there is a great deal of impatience. So I think all of those things could conspire to having dedicated space agreements in the future, which obviously would be positive for both us and our clients.

And then just one last quick one, are you still comfortable with the op margin target for PCS of 20% within the next three to five years? I think you kind of laid that out at the beginning of the year.

We are.

Hello?

I said we are comfortable with that. Sorry.

Okay. Great, thank you very much.

That was your final question. I will turn it back for any closing comments.

Thank you for joining us this morning. This concludes the conference call.

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