Charles River Laboratories International Inc (CRL) 2013 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Charles River Laboratories second-quarter 2013 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 first speaker, Miss Susan Hardy, Corporate Vice President of Investor Relations.

Please go ahead.

Thank you.

Good morning and welcome to Charles River Laboratories second-quarter 2013 conference call and webcast.

This morning, Jim Foster, Chairman, President and Chief Executive Officer, and Tom Ackerman, Executive Vice President and Chief Financial Officer, will comment on our second-quarter results and review guidance for 2013.

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 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, and the access code in either case is 297653.

The replay will be available through August 15.

You may also access an archived version of the webcast on our Investor Relations website.

I would like to remind you of our Safe Harbor.

Any remarks that we may make about future expectations, plans and prospects for the Company constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by any forward-looking statements as a result of various important factors, including but not limited to those discussed in our annual report on Form 10-K which was filed on February 27, 2013, 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 second-quarter results before commenting on our business prospects.

We reported sales of $294 million in the second quarter of 2013.

This was 3.4% above the previous year and excluding the negative impact of foreign exchange a 4.6% increase in constant currency.

Growth was driven primarily by the RMS segment which reported a 5.5% increase in constant currency, having benefited from the acquisitions of Accugenix and Vital River, as well as growth for the Avian and legacy EMD businesses.

The PCS segment also had a very strong quarter.

We were very pleased with the year-over-year growth of 3.1% in constant currency, as well as the sequential growth of 4.8%.

As a result of our market share gains, sales to large biopharmaceutical and mid-tier clients are increasing.

The consolidated operating margin declined 210 basis points year-over-year, to 17.3% from 19.4% in the second quarter of 2012.

However, it increased 50 basis points from the first quarter of this year.

Both RMS and PCS contributed to the year-over-year decline.

Lower legacy sales of research models fall straight to the bottom line, and as our global biopharmaceutical clients continue to take large facilities offline, they reduce the volume of research models that they purchase.

However, as they decrease their internal capacity, these companies increase the amount of work that they outsource.

This benefits our service sales in both RMS and PCS, and is the primary force behind the PCS segment's return to moderate growth and the sequential margin improvement.

Because we intend to maintain the RMS margin at or above 30% on an annual basis, and increase the PCS margin to 15% over the next few years, we are intently focused on improving operating efficiency.

As we have discussed previously, we have a number of initiatives identified through our performance improvement plan which were implemented in 2012, or are currently in process.

In 2013, these efforts are primarily focused on projects in the areas of procurement, energy, discretionary spending, preclinical study management, and sales productivity.

As we stated when we provided guidance last December, we expect all of these projects to generate approximately $20 million in annualized operating income in 2013.

Earnings per diluted share were $0.73 in the second quarter of 2013, compared to $0.75 in the second quarter of 2012.

We generated less operating income than in the prior period, principally as a result of lower legacy sales of research models, and also due to the fact that we received an insurance settlement for the tsunami in Japan in the second quarter of 2012.

Sequentially, we improved operating income by approximately 4%, due primarily to higher capacity utilization of our preclinical facilities and operating efficiency initiative.

And we continued to return value to shareholders in the second quarter through our share repurchase plan, with the purchase of approximately 389,000 shares for $16.6 million.

At its recent meeting, the board of directors increased the size of the repurchase authorization to $850 million.

We are reiterating our constant currency sales growth guidance for 2013, which we continue to expect will be in the range between 4% and 6%, with both the RMS and PCS segments in that range.

Sales growth is expected to be driven by successful targeted sales efforts which continue to enable us to gain market share, as well as the acquisitions of Accugenix and Vital River, both of which are performing ahead of plan.

Our non-GAAP EPS guidance remains in a range of $2.80 to $2.90, or about 4% at the midpoint.

As we discussed when we gave guidance in December, earnings growth in 2013 is being moderated by compensation costs and inflation, as well as costs incurred in relation to new strategic relationships.

I would like to provide you with details on the second-quarter segment results.

RMS segment sales were $180.5 million or a 5.5% gain in constant currency, due primarily to the acquisitions of Accugenix and Vital River.

We are very pleased with both of these acquisitions which are performing extremely well and contributing more to total sales growth than our original estimates of approximately 1% for Accugenix and slightly more than 1% for Vital River.

In addition to the acquisitions, both our Avian and legacy EMD businesses contributed to sales growth, but were offset primarily by continued soft sales of research models to large biopharmaceutical clients.

We believe that our acquisition of Vital River was a timely addition to our portfolio.

Demand for high-quality research models in China is expanding as researchers appreciate more and more of the difference that high-quality models can make in research.

With both government stimulus and academic and private investment driving pharmaceutical research, our China operation has the potential to grow significantly in the coming year.

Charles River is recognized and trusted for the high-quality products and services we provide, and we intend to play a leading role in this emerging opportunity.

The RMS operating margin was 30%, a decline of 280 basis points from the second quarter of 2012.

Last year's margin benefited by approximately 100 basis points as a result of the insurance settlement we received for Japan.

Otherwise, the margin decline was primarily a function of lower legacy sales of research models which, as I said, were affected by our global biopharmaceutical clients' buying patterns.

These clients continue to reduce their purchases of research models as they rationalize capacity which is no longer needed due to industry consolidation, elimination of therapeutic areas, rationalization of pipelines, or a combination of all three.

A positive outcome for our clients' action is that they are increasing their reliance on outsourcing.

As we have seen over the last two years, many of them have chosen to outsource larger tranches of early Discovery Services and Preclinical safety assessment.

Historically, Discovery has been considered a core capability which couldn't be outsourced.

But as large biopharmaceutical companies have assessed the costs of maintaining in-house capabilities and we have expanded our Discovery expertise, outsourcing has become a more logical choice.

To maintain the RMS segment operating margin at or above the 30% level, in addition to our performance improvement initiatives, we intend to rationalize some of the production capacity at our California research model facility.

We will be closing three barrier rooms which is equivalent to slightly less than 2% of our worldwide capacity.

At the same time, we will increase production of certain isolated isolator-bred models for which demand is increasing.

These actions will enable us to enhance the product and support we provide to our clients on a more cost-effective basis.

We did see a moderate impact on spending by our government and academic clients in the second quarter, which we believe may be due to sequestration.

As we noted when we reported our first-quarter results, one government contract was canceled and there were restrictions on filling open positions in some of our insourcing solutions contracts.

Several of our academic clients have told us that they are concerned with the availability of funding, but this has not resulted in a noticeable decline in spending to date.

Therefore, we are maintaining our estimate that the impact of sequestration in 2013 should be approximately $3 million.

Sales of Research Model Services declined in the second quarter, due primarily to the expiration of two long-term contracts for certain services in Europe at the end of 2012.

As we previously noted in our first-quarter results, these contracts represented approximately $5.5 million in annual revenue.

The decline was offset in part by modestly higher GEMS and RADS sales, as both commercial and academic researchers utilized our services in lieu of their own internal resources.

In addition, sales for our Insourcing Solutions business increased slightly in the US despite sequestration, and significantly in Europe as clients increased the number of staff positions we were contracted to fill.

Sales to Discovery Research Services or DRS were effectively unchanged from the second quarter of last year.

The first and second quarters of 2012 were extremely strong due to the ramp of services under the strategic relationship we entered into in the fourth quarter of 2011.

Sales increased significantly on a sequential basis, as both our oncology and CNS franchises performed very well.

Our expertise in these two therapeutic areas is well known and respected.

So as biopharmaceutical companies increasingly choose to outsource, they are relying on Charles River for the expertise that they no longer are maintaining in-house.

Given the emerging importance of outsourced Discovery Services, the area is an acquisition focus for us.

Our goal is to expand our ability to support additional therapeutic areas as well as our geographic footprint.

The EMD business again delivered an outstanding performance with year-over-year sales growth in excess of 20%, including the addition of Accugenix.

Both our core testing products and the PTS performed exceptionally well, primarily as a result of exposure through the larger Charles River salesforce and our broader access to clients, Accugenix is reaching a bigger audience than it was able to do on its own.

To support the demand for access to Accugenix microbial identification capabilities, we are in the process of strategically expanding our testing facilities so that clients and countries either than the US can have their testing performed in one of our labs situated closer to them.

Our new facility in France opened in June, and we have already seen significant growth there.

We expect that the strong growth metrics will continue as we open laboratories in Korea in September and India in November.

We intend to continue investing in both product extensions and acquisitions like Accugenix in order to drive EMD growth.

We were extremely pleased with the performance of the PCS segment.

Sales were $114 million, a 3.1% year-over-year increase in constant currency, and 4.8% on a sequential basis.

This was the highest sales level since 2010, with volumes increasing for both non-GLP and GLP services.

Higher sales was a direct result of successful targeted sales strategies, which have enabled us to gain market share.

These strategies highlighted our competitive differentiators, our broad portfolio of early-stage drug discovery and development products and services, which is unique in the industry, our scientific expertise, our geographic footprint, our best-in-class client data portals, our operating efficiency which we continuously strive to improve, and our flexibility in structuring working relationships with our clients in the arrangement which is best suited to their individual needs.

These differentiating factors enable us to offer clients a value proposition that few CROs can match.

Furthermore, the value proposition is a compelling choice for all types of clients as evidenced by increased PCS sales to both our large biopharmaceutical and mid-tier biotechnology clients.

Regardless of size, we build each working relationship and embed ourselves in our clients' processes, becoming an integral part of the team.

We believe that one size does not fit all and that a deep understanding of our clients is essential to a successful working relationship.

With approximately 25% of our total sales derived from strategic relationships, we do have improved visibility.

However, the PCS operating margin exhibits some unevenness from quarter to quarter due to variables including volume, study mix and pricing.

The second-quarter PCS operating margin declined by 90 basis points to 12.2% when compared to the second quarter of 2012, but increased 160 basis points on a sequential basis.

Higher study volumes improved our capacity utilization in the quarter, but a less advantageous study mix and pricing offset some of the improvement.

On a year-over-year basis, the increase in sales from new strategic relationships did exert pressure on the PCS margin.

This was expected because as we have said previously, pricing for these agreements was competitive and there would also be associated startup costs.

However, we expected that as we became more integral to our clients' processes and they became more familiar with our capabilities, they would increase the amount of work they place with us, and the higher volume would improve the margin.

This is occurring, and startup costs for some clients are behind us.

Both factors are responsible in part for the 160 basis point sequential margin improvement.

Spot pricing remained relatively stable at approximately 1% in the second quarter.

There have been certain cases in which some competitors are offering significant discounts, particularly to some of the smaller clients.

In general, we have declined to match these prices.

With our capacity filling, we are able to be more selective with regard to accepting lower-margin work.

We have been very successful in winning new business based on our deep scientific expertise, our ability to provide clients with flexible early-stage solutions that are unmatched by other CROs.

Our global biopharmaceutical and larger mid-tier clients continue to reduce the number of providers with whom they do business, in favor of a smaller, more select group of partners.

Based on current discussions, we believe that this process is accelerating.

We have been told by some of our clients that they are reducing from hundreds and in some cases thousands of suppliers to a select few, and we have also been told that Charles River is considered a first-tier supplier.

This is evidenced by the fact that in most of the selection processes, we have been designated as a partner or preferred provider.

So while pricing remains a factor, scientific expertise and flexibility are critical elements in the choice of an outsourcing partner.

Pricing and study mix will continue to affect results, but we expect that directionally both the PCS sales and operating margin will continue to improve over the next few years.

We believe this improvement will occur not only because of our focus on sales growth and operating efficiency, but also because outsourcing has become essential to our clients' successful navigation of the drug discovery and development process.

Discussions concerning additional strategic relationships are continuing as our clients tackle the logistics of how and what to outsource.

We believe it's critical to participate in that process now.

So our strategy is focused on positioning Charles River as the preferred partner for outsourced early-stage discovery and development products and services.

I previously described the approach we are employing to achieve this strategy, so I will simply remind you that our efforts include targeted acquisitions both upstream and geographic, which are a sound financial and strategic fit; investments to add new or upgrade some of our facilities in order to provide more capabilities and space to take on additional work; increasing collaboration across our business units in order to leverage capabilities of our unique portfolio; and improving our operating efficiency to allow us to deliver the essential products and services for which we are so well and in most cases cost-effective manner.

We have worked to achieve this strategy through a series of actions over the last five years and believe our success is enabling us to present clients with a superior value proposition that allows them to outsource services which they've formerly maintained in-house, without compromising science and with improved time frames.

This value proposition is the basis of our belief that over the next few years, sales growth will continue to improve, which will in turn drive operating margin expansion, earnings-per-share growth, and free cash flow generation.

Today, we differentiate ourselves by our broad early-stage portfolio which is unique in the CRO universe, our extensive scientific expertise, our attention to client service, our best-in-class data systems and portals, and our ability to structure creative, flexible solutions that support our clients' goals of reducing the costs and improving the productivity of drug development.

We are dedicating ourselves to executing our strategy and continuing to 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'd like Tom Ackerman to give you the second-quarter financial details.

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.

In the second quarter, we excluded $1.5 million from non-GAAP RMS sales and $1.9 million from non-GAAP earnings related to our US government billing practices in prior periods.

There is additional detail on this matter in our Form 10-Q which was filed last night.

Second-quarter operating results were in line with our expectations, with constant currency sales growth of 4.6% and an operating margin of 17.3%, both on a non-GAAP basis.

The consolidated operating margin improved 50 basis points sequentially, driven primarily by the continued improvement in demand and capacity utilization in our Preclinical Services segment, partially offset by study mix and competitive pricing.

However, the consolidated operating margin declined year-over-year, principally due to lower sales volume of the legacy small models business, as well as last year's receipt of an insurance settlement related to the 2011 tsunami in Japan.

As Jim said, our goal is to maintain the annual RMS operating margin above 30%.

We intend to achieve this through our continued focus on operating efficiency, including such actions as the closure of the smaller German and French facilities that we announced in the first quarter and the reduction of production capacity in California that we discussed today.

Unallocated corporate cost increased by $850,000 year-over-year to $17.1 million, but declined approximately $3 million sequentially.

We continue to expect unallocated corporate costs to be approximately 6% of sales for the full year.

This would suggest a reduction in these costs in the second half of 2013, which is consistent with the historical trend.

Net interest expense was $3.8 million in the second quarter, which was $600,000 lower sequentially compared to the first quarter.

We now expect 2013 net interest expense to be in a range of $15 million to $17 million, below our prior outlook of $17 million to $19 million, as a result of an amendment to our credit agreement in late May and the subsequent refinancing of our convertible debt.

The amended credit agreement lowers the interest rate on our bank debt by approximately 25 basis points to LIBOR plus 125 basis points for drawn amounts based on our current leverage ratio.

This is expected to result in a slight reduction in interest expense in the second half of the year.

Other income was favorable at $1 million in the second quarter due to gains on certain investments, although slightly lower than the $1.1 million of income in the first quarter.

The non-GAAP tax rate declined 130 basis points year-over-year to 24.8% in the second quarter, driven primarily by the geographic earnings mix.

Earnings mix was also a factor in the 190 basis point sequential decline.

In addition, the rate was higher in the first quarter because of discrete costs related to a French tax law change that was retroactive to 2012.

As a result of the lower second-quarter rate and our outlook for the remainder of the year, we now expect our non-GAAP tax rate to be 25.5% to 26.5% for 2013, or 100 basis points lower than our previous range.

Second-quarter EPS of $0.73 was slightly ahead of our prior outlook, due in part to other income which we do not forecast, and the favorable tax rate.

Year to date, we have generated $62.7 million of free cash flow, an increase of nearly $4 million from last year.

We remain on track to generate free cash flow of $165 million to $175 million in 2013, because we typically generate greater free cash flow in the second half of the year.

DSOs increased by 3 days sequentially to 54 days at the end of the second quarter, but we did not see any additional credit risk.

We intend to improve DSOs by year end.

CapEx was $9.8 million for the second quarter, which was similar to the prior-year-level, and $16.2 million year to date.

Lower spending in the first half is primarily the result of the timing of projects, and we continue to expect CapEx of approximately $50 million in 2013.

Our capital priorities remain focused on debt repayment and stock repurchases, as well as targeted acquisitions which we continue to rigorously evaluate.

We amended and expanded our credit facility in late May to provide additional liquidity to refinance the $350 million of convertible notes which matured in mid-June.

The expanded credit facility includes a term loan of $420 million and a multicurrency revolver of up to $550 million.

With $215 million drawn and $335 million undrawn on revolver, we had approximately $635 million of outstanding debt at the end of the second quarter, or a reduction of nearly $16 million from the end of the first quarter.

Year to date, we repurchased approximately 547,000 shares for $23 million.

As of June 29, we had $31.8 million outstanding under our stock repurchase authorization, which the board of directors increased by $100 million at its meeting this week.

Taking option exercises into consideration, which have totaled approximately 1.1 million shares year to date, we now expect to repurchase more than our previous range of 1 million to 1.5 million shares in 2013.

It is our goal for stock repurchases to offset the dilution from option exercises.

We expect our diluted share count to be between 47.5 million and 48 million shares at the end of 2013, for a full-year average of approximately 48.5 million shares.

As Jim discussed, we are reaffirming our 2013 guidance of constant currency sales growth in a range of 4% to 6%, and non-GAAP EPS in a range of $2.80 to $2.90.

Foreign exchange rates are somewhat less favorable than our last update in May, principally due to the weakening Japanese yen.

So we expect FX to reduce reported sales by slightly more than 1% in 2013.

As noted in our press release, we reduced our GAAP EPS guidance range to $2.40 to $2.50, principally to reflect second-quarter charges related to a government billing adjustment and debt refinancing costs, all of which are excluded from non-GAAP results.

However, we have not yet included any potential charges related to our planned consolidation of RMS production capacity in California in our GAAP guidance range, since the analysis of the financial impact has not been finalized.

This action could result in a non-cash accelerated depreciation charge of approximately $15 million, which would be excluded from our non-GAAP results.

We anticipate that this planned action will be completed in late 2013 or early 2014, at which time we expect to generate cost savings of approximately $1.5 million on an annualized basis.

We expect third-quarter sales and EPS to be modestly below the second-quarter levels, primarily due to seasonal trends in the RMS segment.

As you know, demand for small models in the third and fourth quarters normally declines from first-half levels due to lighter summer and holiday ordering patterns.

In the PCS segment, we anticipate relatively stable trends on a sequential basis.

Other nonoperating items in aggregate are not expected to have a meaningful impact on EPS in the third quarter.

For example, lower interest expense should be offset by a more normalized tax rate in the third quarter.

We are pleased with our second-quarter performance and remain on track to achieve our original earnings-per-share guidance of $2.80 to $2.90 for 2013.

We continue to be intently focused on achieving these results through our targeted sales efforts, continued actions to improve operating efficiency, and our disciplined capital allocation strategy.

Thank you.

That concludes our comments, and the operator will take your questions now.

Stacey, please go ahead.

(Operator Instructions).

Tycho Peterson, JPMorgan.

Just want to start off with I guess a question on margins.

You saw the sequential improvement in PCS margins this quarter.

Maybe just as we think about back half of the year, if you could think about how or comment on how you think about margins may trend sequentially in PCS.

And then RMS, was the margin decline a little bit more than you had been anticipating?

You'd obviously talked about some of the European issues last quarter.

So just curious as your thoughts there.

I can answer the first part, Tycho.

I didn't quite hear the latter part; maybe Jim did.

But in any event, I don't think we will see a dramatic change in margins throughout the year.

As I said, the sales sequentially should be somewhat stable and, therefore, similar.

And so I think the margins will be similar, maybe up a little bit directionally.

We have talked overall about margins in total being stable year-over-year, segment growth being consistent with the overall guidance growth rate of 4% to 6%, and I think the margins in the segments will be somewhat similar.

But with the cost efficiencies that we are building in, I do think there is a little bit of an opportunity for us to see some modest depreciation in Preclinical margins out through the back half of the year, but nothing dramatic.

Tycho, could you repeat the second half, please?

We're having a little trouble hearing you.

Yes, I guess similar question for RMS, and can you maybe just talk about -- you talked about that being a function of lower legacy sales of models.

And just maybe talk about how that tracked relative to your expectations.

Obviously, there was some softness in the first quarter there as well.

So just wondering what your visibility is on RMS margins in the back half of the year.

What I would say is obviously the margins are down a little bit.

They were down in the first quarter, down in the second quarter.

We have taken some actions, notwithstanding what we mentioned about California which will give us a bigger benefit in the latter half of the year, but we have been very active in a number of areas for cost savings.

So typically, we would see a little bit less model sales in the second half of the year which will put some pressure on the margin, but I think the cost actions that we will take will ameliorate that to some degree.

So I think as you look to RMS margins, they will probably be a little bit more stable through the year than they have normally been because we will be benefiting the OI with some cost actions that will help mitigate the seasonal trends in the top line.

Okay, and then just one last quick one for Jim.

Can you maybe just comment on delays and cancellations?

There was a competitor that said they had come down in the quarter.

Are you seeing a similar trend?

Come down in the quarter?

You mean there were less of them?

Yes.

Delays and cancellations haven't been an unusual factor for us for a while.

So I don't know whether they have come down, but they've certainly haven't worsened and, of course, where we've been taking share and filling capacity.

So our experience is likely different than other people you are speaking with.

Okay, fair enough.

Thank you.

Eric Coldwell, Robert W Baird.

Thanks.

Sorry, we are balancing a lot of calls this morning.

I'm sorry if I missed it.

Did you say anything additional on the government billing adjustment, number one?

And number two, Covance yesterday was talking about some tax law changes, R&D tax credit changes in the UK.

And I'm curious if you have had a chance to analyze that and if that's part of the forward-looking guidance.

Thanks.

So, Eric, I will work backwards through your questions.

So we, with the UK facility, are also looking at the same thing.

I don't know if Covance went into specific details of election periods, but you don't actually have to elect into that and don't have to make that decision for a while.

So we have done a lot of analysis on it.

As Covance had said, it will impact their tax rate negatively, but it will benefit the operating margin -- I don't remember if they said by a similar amount.

So it's not necessarily a negative overall to the Company, other than to the tax rate it's a negative and to operating income it's a positive.

So we are still working through that.

I expect that on our third-quarter call we will update you.

It would be similar to us, although the differential because of the size of our operation could be different.

But if we do elect in, it would be a negative impact on our tax rate and we would see a corresponding type increase in our operating income to the point where it would be relatively neutral on net income and EPS.

So we will make that decision a little bit later in the year.

We have done a lot of analysis to date and just want to make sure that electing in early is the right thing to do for us.

Your first part of your question was about the government.

The only thing that we said on the call that wasn't in the Q — or it was in the Q and the release -- was that we excluded it from our non-GAAP results because of the nature of it and the fact that it related to prior periods.

I wasn't sure exactly what the billing adjustment was, what it related to.

It related to some work that we were doing for the government on a couple of contracts, well, several contracts in our Raleigh and Kingston facility where hours that had been substituted for employees were not always involved in those particular contracts.

So it became a billing that needed to be corrected.

Got it.

Okay, thank you.

Greg Bolan, Sterne, Agee.

Thanks for taking the questions.

A little all over the place this morning.

So sorry if I missed this as well.

Going back to the closure of the two barrier rooms I think at Hollister, what percentage of the barrier rooms in that facility is that?

I know you mentioned I think 2% of total global capacity, but what percentage of that facility is that?

That is three rooms out of nine.

Okay.

Okay, great.

And then kind of going to go out on a limb here, Jim.

I know you haven't really talked about this, and looking at your slides and your comments around more efficient processes at larger pharma customers, and maybe a reduced need for as many research models.

But some of my checks have indicated that maybe last year there might have been some over-ordering of models.

And so with the idea, I guess, procurement thinking that -- or was being told that early-development studies were going to be stronger than they were actually.

So maybe we are in kind of a destocking cycle, and then that will be followed by potentially a restocking cycle as R&D budgets are finalized beginning of next year.

So can you maybe comment on that, or is that just completely off and not something you are seeing?

That is a great theory and wonderful supposition, and I wish were true.

Nobody stocks up on lab animals in advance.

They grow out of spec and they get too heavy and they get too old, and they actually are not appropriate for certain types of studies.

So pretty much it's become very much a just-in-time ordering business, and it's also one where I think everyone involved in this industry is very thoughtful and careful about how many animals are purchased and used.

No, I don't think it's an overstocking, destocking and restocking situation that we are going through to be with.

I mean it's quite simple.

We are getting price and we are taking share, and we are focusing heavily on the academic marketplace, doing really well there.

But we have very, very large research facilities, some of the most well-known ones in the entire industry for some of the biggest drug companies that are coming offline kind of one after another, and in a couple of instances almost simultaneously; all of whom -- they are all significant clients of ours.

Some buy only our animals.

So it has obviously an undue adverse impact on research model purchases for some period of time.

The flipside is it has, it is having, and will continue to have a positive uptick and influence on Research Model Services and Preclinical Services and Discovery Services for sure, because most of those facilities weren't empty.

They were sort of not well used, so there was still work going on there, a lot of safety assessment work and discovery work, and they need to still have that work done.

They just don't want to own the people or the bricks and mortar.

So that's one of the reasons we are seeing this, whatever it has been, four quarters in a row upward tick in our Preclinical business.

That's why we are getting and winning so many strategic deals, and that's why we are seeing us take disproportionate amounts of share.

That's fair.

Jim, on that point, were there any new strategic deals on the PCS side won this quarter?

And can you comment if the two larger strategic partnerships that you've talked about, are they ramping a little bit faster than you had originally expected or are they kind of in line with what you had thought?

So we have one additional one, and as we tried to clarify over the last couple of quarters, we have won many more than the two we reported on, which is why we now have 25% of our total revenue associated with those.

They are impossible to talk about because we don't get permission from our clients.

And it's really awkward to be referring back to pieces of work with no name associated with it.

So we thought it best to frame it in terms of how much of our revenue it takes.

In terms of ramping faster, I would say not.

The first one we announced ramped pretty much as anticipated.

There have been ebbs and flows there, but the client has done in the aggregate what they told us they would, and we anticipate they will continue to run at those levels.

The second one that we did announce actually started off a little slow, but is getting up to speed nicely.

There's a lot of these conversations going on now because there's so much space coming offline, and you can just -- you can see everybody sort of reaching the same conclusion.

It is unclear to us why it takes some people longer than others and, of course, some haven't reached a conclusion yet.

But certainly as the patent cliff has gotten more severe and the ability to fill it in has gotten harder and the value proposition has gotten more difficult, the necessity -- I won't even say opportunity -- the necessity to use outside resources to do development work, I don't think is optional.

We are quite optimistic that we are going to continue to see work continuing to come outside.

Our capacity utilization is filling up nicely.

We are becoming more selective on work that we take.

We are trying to get a better mix and trying to get a little bit of price here and there.

So we are seeing some solidity and some predictability in the market dynamics, and that's certainly a good thing.

And we are playing our critical role in this marketplace in a very strategic and I think beneficial way for our clients.

That's great.

Thanks, Jim.

Rafael Tejada, Bank of America-Merrill Lynch.

Good morning.

Thanks for taking the questions.

Just a quick question on the PCS.

Jim, can you just discuss the demand you are seeing by the different customer types perhaps, looking at larger biopharma customer versus those smaller biotech entities.

And just wondering if you are starting to see a pickup in smaller biotech customers.

Yes, sales for both -- safety assessment sales for both the very large drug companies and the biotech companies was up, continues to be strong.

Our biotech percentage is -- we don't break it out, but it's quite substantial.

And if you look at the client list at virtually all of our preclinical facilities, particularly even some of the larger ones, we are doing an increasing amount of work for the smaller players.

I wouldn't say necessarily the smallest players, but kind of mid-tier to first-tier biotechs who they tend to be very important clients.

Many of them have no internal capabilities at all.

The very, very big ones have modest internal capabilities, but outsource a lot.

They tend just to kind of lock on to us and stay with us, whereas pharma, of course, has been dismantling their own capability.

And you can tell that they are all trying to figure out how much work, if any, to keep inside.

And I think over the next 3 to 5 years, we are going to continue to see a reduction in space and work, and they are going to make some really tough decisions about why they have to do this work at all if they can depend on outside resources.

So it's more work to engage with the biotech companies, just because there's so many of them.

But we do quite well in our relationships with them, and they are an important part of our current revenue base and will continue to be in the future.

Right, and I guess the other factor around that trend is just trying to get a better handle of what the implications of better cash on hand for a lot of these biotech entities means for the PCS business.

So I'm just trying to get a better sense if there's sort of a thumb rule that Charles River may have in terms of looking at that growth in biotech funding, and how that flows through to PCS demand.

It's hard to say.

In the old days, we used to track the number of companies going public with what our volume was.

You could see that as the red herrings started to come out, revenue increased.

It's much more subtle today.

I would say a lot of the money is coming directly from big pharma, so spending is a lot about relationships that they ink with big drug companies.

And, of course, in any event, whether the money is coming from the capital markets or from big pharma, it really all depends on what the pipelines look like.

So if they have additional compounds to develop that they weren't developing because money was tight a little while ago, that's obviously very good for us.

I would say on the margin, obviously, additional funding sources for the mid-tier accounts will be beneficial for us going forward.

Great.

Thanks for the questions.

Dave Windley, Jeffries.

Thanks for taking the questions.

Jim, in comparing and contrasting a little bit what we heard from the competitor, it sounded like biotech and maybe particularly small biotech was on the rise and driving demand in RFPs and bookings in Preclinical for tox for them.

And while I'm sure large pharma is still a component, no kind of big strategic market share capture type deals were the driver of their comments, and kind of sounded like we were finishing June and end of July at pretty high levels of demand.

Contrasting, it sounds like the ramp of your strategic deals is maybe a bigger contributor to your increase in activity and you're expecting more flat sequential performance in PCS.

And so I just wanted to make sure I kind of understand what the background market demand environment looks like between pharma and biotech, and are you disproportionally participating on the large side and not the small side, notwithstanding what you just said to Rafael?

I would say that as I just said, that we are participating significantly in both client types.

We have one, as is our stated strategy, a positively disproportionate share of the large pharma deals that we have competed for, either pursuant to formal RFPs or informal conversations with clients.

So we have aggressively and decidedly gone after them with a view towards building market share and having a disproportionate amount of that work, hopefully for many years.

So I think we've been really clear about that.

We have had a similar strategy with regard to first and second-tier biotech companies who are well-funded, have drugs, many of whom have revenues and profits.

They don't have any internal capability, but we have a similar opportunity to bid on RFPs, and we have won many of those.

Two in particular, we are the exclusive provider to the client.

We are clearly seeing competitors, large and small, much more aggressive lately.

Some have been quite vocal about they are going to get aggressive and go after share.

I would say that in some of the smaller relationships, which is maybe how you started the question, some of the smaller clients where we have had extremely aggressive pricing by competitors, we have not gone to the mat.

And we've stopped at a point where we think any lower will be disadvantageous to our margins and we have let others have that.

And as I said earlier, since our space is filling, and you'd have to get your own data on our competitors, but I think their space is less full than ours, all of them.

We are being more selective and have to be more selective, and I think that's a really good opportunity for us.

So we don't want to turn our backs on any client segments and we're trying not to, but probably we have a disproportionate focus on very large pharma and first and second-tier biotech.

Okay, that is helpful.

If I can maybe just drill in and understand the sequential.

So if you have these two announced deals, you obviously, as you said, have more that you are not able to put a name to and are quantifying in the 25%.

And I think you have commented that you have had wins since the beginning of the year.

Help me to understand what about the progression causes the leveling in sequential PCS activity, revenue and margin expectations, when it would seem that you are in a position to continue to see that grow.

Is there just a pause here?

Are you being conservative about where those levels could go?

Obviously, I'm just digging for it seems like it ought to be sequential improvement, not flat.

Well, without commenting on the third quarter -- maybe Tom will want to do that -- our guidance is 4% to 6% for the Company and a similar range for both segments, which means that we are guiding towards 4% to 6% PCS which would be a very nice improvement over the prior year.

So we are pleased with the impact that the larger deals that we did last year are having on this year.

We are pleased with the additional ones we are getting.

Pricing, as I just said, it is competitive.

We are holding our own.

We are getting a little bit of spot price.

I would say some of the bigger deals that we are doing, we are actually really pleased with the price.

Some are tougher.

So the size of the strategic deals, the startup costs are definitely putting a little bit of pressure on the margin.

But we are very positive about our ability to grow that sector, both top line and bottom line.

Do you want to drill down that a little bit?

Dave, I do think that the sales in PCS will be up in the latter part of the year versus the first half.

Obviously, we improved sequentially in the second quarter as you mentioned and we mentioned, and I think sales will probably be a little bit better.

I think what's holding back our view a little bit more is that typically in the fourth quarter, especially as you get out through Thanksgiving and beyond that, we do see a little bit of a slowdown in preclinical activity; especially with a lot more of the studies being shorter-term where clients just don't start a lot of studies as you get closer and closer to year-end.

So that's also factored into our outlook for the remainder of the year.

So I think it will be a little bit better, especially when considering that.

And as I said, I think the second half will be up nicely over the first half, and as Jim said, overall up 4% to 6% in the segment which I think is a good number.

Okay.

Sounds great.

John Kreger, William Blair.

Good morning.

This is Ravi Fadah in for John today.

A longer-term question on RMS; it sounds like you are communicating that the traditional RMS orders from pharma are declining, but those clients are also outsourcing more.

So what would you think the long-term unit demand trend is going to look like?

As more space comes offline, that will put pressure on units for sure.

We've seen a lot of big facilities come offline already.

So difficult to predict what the future will bring or when that will happen.

While units are obviously impactful to us, the mix of units and the value of units is also critically important, as is pricing, as is our share gain opportunity.

So I don't know, it's very difficult for us to give sort of a long-term view of this, given the enormity of our share position, but we will do everything we can to continue to hold and gain share to the extent that the business is available.

Great.

And is it reasonable to assume that the pricing dynamics in there are such that you can still get 1% to 2% on an annual basis?

Yes, we would think so.

We get a little more in the US, and we get a little less in Europe and we get a little less in Japan, but the blended -- that is a blended number.

But yes, we've raised our prices always, so have the competition, as our cost of production continues -- goes up, cost of labor and things.

And yes, we have no indications that clients won't continue to pay more for these valuable research tools.

Great, thanks very much.

Tim Evans, Wells Fargo Securities.

Thank you.

Could you break apart the regulator GLP portion of the PCS business from the nonregulated portion?

And the reason I ask is one of your large competitors talked about some pressure more on the Discovery piece of the business, and I realize that the mix there is a little bit different.

But I was hoping if you could just kind of help us understand maybe if there's different trends in the GLP versus the non-GLP side.

We do not break those out specifically, except to say that we are seeing an increase in both.

It is share gain for the regulated safety assessment work.

It's also more work coming outside.

Of course, some of that could be share gains.

On the non-GLP work, we have a greater focus on that.

Clients are getting more comfortable outsourcing that work.

Historically, that has been work they have held much closer to the vest, so this is new.

But both in our in vivo pharmacology work and sort of classic non-GLP stuff, we have seen a continued uptick.

And I would believe that that would continue in both sectors.

Okay.

And if we just think about the regulated side, I realize that share gains are a big part of your growth there.

Do you think that the market overall is growing as well?

That's a very difficult question to answer because of the pricing dynamic.

So it's actually possible that the volume is increasing and it's tough to tell.

I guess the best answer to that is it doesn't matter to us.

By that, I mean that of the total pie, depending on whose numbers are accurate, let's say 45% to 50% is currently outsourced.

That means double the amount of work that's currently outsourced to all the CROs is still available for us to get.

And then you have to parse it and determine how much of that will be outsourced.

We've historically said we think the clients will get up to 75%.

I think it could be higher, by the way, but let's be conservative about that and say 75%.

There is a lot of market share opportunity for us to get, even if the whole pie doesn't grow.

So while I get your question, we are much more focused on the amount of work that will come outside and the rate at which it will come outside and, of course, the prices and the mix of the work that will come outside.

Okay, thank you.

Douglas Tsao, Barclays.

Good morning.

In terms of RMS, just curious in terms of your expectations for the Vital River acquisition and the contribution, because it sounds like it's going very well.

Do you expect that to grow sequentially through the rest of the year?

We would.

As you said, we are very pleased with it.

It is a totally different market than the rest of the world.

It is nascent.

We are almost going back in time.

We are going to re-educate this market from scratch.

There's obviously a very big investment in life sciences and not a very sophisticated understanding of the critical nature of high-quality research models.

So we are very pleased with the performance, both the revenue growth and the margin.

It's ahead of our acquisition plan.

As we continue to expand that business and don't see other commercial competitors in that space, yes, I think it will continue to sequentially grow.

Okay, and is that at a comparable margin -- is that an accretive margin to the RMS segment?

It's pretty close, Doug.

It's pretty close.

Okay, great.

Thank you very much.

Ricky Goldwasser, Morgan Stanley.

Good morning.

I think in response to one of the questions, you said that 25% of total revenue are associated with strategic deals.

Can you clarify further what percent of PCS revenues are associated with revenues that are coming from your strategic partners?

We haven't broken it out that way , Ricky, and don't really have any desire to do that at the current time.

That 25% number is important.

Most of these deals have started without a safety assessment or non-GLP work, as the conversation that we've had with the clients, they want to outsource that.

That is usually what the bidding process is about.

We have been highly successful in getting those deals.

Then we have kind of a large grid that we put across all of our products and services that allows them to get the benefit from a pricing point of view of additional volume.

So we actually think that the clients' utilization of the whole portfolio is really critical.

And as we've said in our prepared remarks, we have had several large drug companies just in the last quarter talk to us about the fact that they are reducing their research partners, in one case from several thousand and in another case from several hundred, down to 20 or less, with us being one of the 20 or less.

And, of course, that means that they are looking at their total spend and, of course, they buy a whole range of things from us.

So sorry for not breaking it out the way you asked the question, but safety assessment is a critical part of that 25% for sure; usually the catalyst that starts the conversation, but it allows us to have a bigger conversation with the client.

Okay.

And then on the pricing side, just curious.

Obviously, you mentioned in the prepared remarks that there's some small number of competitors that you are seeing some more aggressive pricing from.

So are you referring to larger competitors or is it more kind of like the smaller niche players?

I would say in the last quarter or so, it has been pretty much all of our competitors have been vocal in saying that they are going to aggressively go after business to take share.

Obviously, that's related to their capacity situations, which I suspect are not as full as ours.

As we also said earlier, depending on the client, depending on whether it's a current client of ours or one that we think is large and important to us going forward, or one that we just think we have to make a determination not to continue to join in that aggressive bidding, we have passed on several of those in the past quarter.

We just haven't played.

And in certain instances, as I said, in order to hold share or to get share -- with large clients we don't have it -- we have also responded in kind.

Having said that, I would say the whole pricing modality right now is reasonably rational, and it's pretty much on the edges and pretty much primarily related to smaller clients that they've gone after.

Okay.

Thank you very much.

Shaun Rodriguez, Cowen and Company.

Good morning.

Thanks for taking the question.

You called out the France, Korea and India facilities in your prepared remarks.

Can you just talk about the expectations there, how and really when those might impact incremental margins on the RMS side?

I'm really thinking more of the 12 to 18-month outlook and about whether -- anything about the expected mix of business in those facilities that would be notable with regard to margin contribution expectations.

These are really small laboratory facilities related to our Accugenix business.

So we want to have a local place to do the lab work before we send the results to our library to determine the species of microbial identification that they are focusing on.

So they should have no impact on margins.

They are very small.

And they should actually help the top line and the bottom line of the Accugenix business for us.

So you should look at those positively.

Okay, thank you.

And then lastly, just I guess sort of a higher level.

You continue to be open about your interest in M&A as part of the capital allocation strategy.

So I guess I'd just be interested in your views on the M&A opportunity funnel in terms of the quality of the available asset valuations.

And then maybe a bit more color on the areas in which you are particularly interested.

I think you noticed outsourced discovery in EMD, but any additional color on any particular areas within those that are of interest would be great.

Activity is really robust right now.

We are seeing a lot.

I would say we are seeing a lot of high-quality targets in terms of potential growth rates, quality of technology.

Most of these would give us additional technology capability.

Some of them are geographic, but most of them the focus is continuing to move us upstream, enhancing some of our current businesses, and adding additional capabilities which I'm not going to get too specific on.

A lot of these companies are venture owned, so I think the price expectations are high.

Haven't said that, we intend only to pay appropriate and rational price points for them.

I think a lot of these investors have been in these companies for a relatively long period of time, so I think we are optimistic about our opportunities to be successful to M&A.

Having said that, you never know until a deal is done and until we are deep in due diligence.

So we think that's a very important part of our growth strategy going forward, and we think it's critical for us to continue to expand the portfolio and have it be more unique, and hopefully provide some technology to our clients that not only no competitor has, but would like to provide technology to our clients that they've never heard of or seen before that will allow them to both accelerate and improve the drug development process.

Thanks for that.

Robert Jones, Goldman Sachs.

Thanks for the questions.

I actually just had at this point two housekeeping questions around RMS.

Tom, I know there were a few acquisitions in there that might affect the year-over-year comp.

Did you give the organic growth rate?

Sorry if I missed that.

And then just on margins within RMS, I know you guys have talked a lot about this with the sequential tick down there.

I was just wondering if you could provide any color just around how we should be thinking about the impact from pricing versus mix versus margin profile of recent acquisitions within RMS.

Thanks so much.

We didn't say anything specifically about Q2.

What we had said about the full year was the acquisitions which we had said would do 1% to 1% plus contribution to the top line, we are actually doing a little bit better than that, is what we said in that regard.

In terms of the margin on RMS, I would say that overall the margin is being impacted negatively by the trends in the legacy model sales, so the small animal models, which is still a key driver in margin there, still a good percentage of the overall RMS sales.

And more or less as those go, so goes the margin.

So really what has been putting some pressure on the margin has been the trend in the unit sales of the legacy models.

We did mention specifically in the second quarter that we did have an insurance reimbursement in the second quarter of 2012, because of the tsunami in Japan.

So that kind of creates a little bit of a year-over-year one-off when looking at the numbers.

But other than that, we didn't say anything else.

Great.

Thanks, Tom.

Ross Muken, ISI Group.

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

That does conclude our comments today.

We will be looking forward to speaking to you in the near future, and thank you very much.

Thank you, ladies and gentlemen.

That does conclude your conference for today.

Thank you for your participation and for using AT&T Executive Teleconference.

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