Charles River Laboratories International Inc (CRL) 2014 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Charles River Laboratories second-quarter 2014 earnings 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'd now like to turn the conference over to your host, Miss Susan Hardy, Corporate Vice President of Investor Relations.

Please go ahead.

Thank you.

Good morning and welcome to Charles River Laboratories' second-quarter 2014 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 update guidance for 2014.

Following the presentation we will respond to questions.

There's a slide presentation associated with today's remarks which is posted on the investor relations section of our website at ir.criver.com.

A 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 324004.

The replay will be available through August 22nd.

You may also access an archived version of the webcast on our investor relations website.

I'd like to remind you of our Safe Harbor.

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

Actual results may differ materially from those indicated by any forward-looking statements as a result of various important factors including but not limited to those discussed in our annual report on form 10-K, which was filed on February 25, 2014, 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 a 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 information link.

Before turning the call over to Jim Foster, I'd like to mention our upcoming Investor Day on August 12 in New York.

If you would like to attend, please call or send an email.

My contact information is in the press release.

Jim, please go ahead.

Good morning.

I'd like to begin by providing a summary of our second-quarter results before commenting on our business prospects.

My comments address the new business segment on which Tom will give you more detail shortly.

We reported sales of $341.2 million in the second quarter of 2014, a 15.9% increase over the prior year.

The acquisition of Argenta and BioFocus contributed 8% to second-quarter revenue, and foreign exchange 1.4%.

All three business segments reported sales increases.

In constant currency RMS gained 30 basis points, DSA gained 31.4%, and manufacturing gained 15.2%.

In addition to the benefit of the acquisition we saw improved sales to many of our global accounts, and as they did in the first quarter mid-tier clients again generated a double-digit sales increase.

Sales to academic and government clients also increased primarily due to research model sales in China.

I'm very pleased to tell you that year-over-year the consolidated operating margin improvement improved by 170 basis points to 19%.

Margins increased in all three segments due primarily to a combination of leverage from higher sales and benefits from our efficiency initiative.

Earnings per share were $0.97 in the second quarter, an increase of 32.9% from $0.73 in the second quarter of 2013.

Our limited partnership investments contributed $0.04 in the quarter.

Once again we are increasing our non-GAAP earnings per share guidance by $0.10 to a range of $3.25 to $3.35.

This increase reflects both the outstanding second quarter performance as well as the gain from our limited partnership investments.

We remain confident that successful execution of our sales strategies and integration of Argenta and BioFocus will enable us to achieve this guidance.

Like the first quarter, the second quarter results continue to demonstrate three overarching strategies that are fundamental to positioning Charles River as the partner of choice for outsourced drug research services: productivity and efficiency initiatives, portfolio expansion, and sales strategies.

The productivity and efficiency initiatives have enabled us to maintain and enhance Charles River's leading market position as a premier provider of essential drug discovery and early stage development solution.

We can provide cost-effective solutions tailored to meet each client's specific need.

And because we operate more efficiently, we have been able to meet our clients' needs without compromising scientific expertise or client service.

This in turn has provided clients with the resources they require in lieu of in-house capabilities and supported their goal to increase their use of outsource services with a reliable scientific partner.

The acquisition of Argenta and BioFocus is a prime example of growth through our portfolio expansion strategy.

We are extremely pleased with the progress we have made to date.

The 90-day integration plan was completed successfully and second-quarter revenue was slightly ahead of our acquisition plan.

We've also made significant progress on our outreach to heads of R&D and other decision makers at the leading pharmaceutical and biotechnology companies as well as many of the larger mid-tier companies.

We are meeting with these companies to discuss our ability to provide early discovery services including target discovery, medicinal chemistry, and complex in vitro biology, and to continue to support research programs as they move downstream through in vivo discovery and safety assessment.

Clients are evaluating the placement of additional work streams with us, which will enable them to outsource integrated drug discovery and early stage development programs to a single provider.

We believe our value proposition is resonating with many clients, which we believe will result in the expected sales synergies in 2015 and beyond.

The second quarter results also demonstrate the effectiveness of our third strategy, targeted sales efforts.

We have developed specific plans for each of our client segments: global biopharma, mid-tier biotech, and academic and government.

Our strategic relationships with global clients are continuing to evolve, and the introduction of early discovery capabilities is enabling these clients to work more closely with us.

After a slow start in the first quarter, several of these clients significantly increased their spending with us in the second quarter.

However, the high teen sales growth of the mid-tier clients outpaced the other segment.

We have increased our focus on mid-tier not only because these clients are benefiting from robust funding, but also because they are the ideal clients for our new early discovery capabilities.

Many of the mid-tier clients did not maintain infrastructure and in some cases they are virtual.

Outsourcing to a partner like Charles River who can work with them at the earliest stages of their molecule and stay with them throughout medicinal development, preclinical development, meets their needs for scientific expertise and continuity of service.

I'd like to provide you with details on the second quarter segment performance.

I'll begin with the RMS segment, which now includes both small and large research models as well as GEMS, RADS, and outsourcing solution.

Sales were $133.1 million, a 30 basis point gain in constant currency.

Consolidation of the biopharmaceutical industry, closure of biopharmaceutical facilities, and the evolution of drug development to eliminate molecules earlier in the process are resulting in continuing soft demand for research models.

Sales of models declined by 70 basis points in constant currency year-over-year.

The impact is now most evident in Europe and Japan, which tend to lag the North American market.

Sales in North America increased as did sales in China.

This marks the second consecutive quarter that we have seen improvement in commercial sales in North America, and we are optimistic that market share gains, particularly in the mid-tier and academia, will enable us to continue to drive growth.

Our service businesses reported higher sales in the second quarter, primarily due to our GEMS business.

Because of the importance of translational medicine, researchers are developing more complex models of human disease.

Producing these models is quite complicated, requiring expertise which most organizations do not have in-house.

As a result, they are turning to us for the scientific knowledge required to manage their model colonies.

We expect GEMS, RADS, and IS to benefit as global biopharmaceutical companies increase the use of outsourcing at the earliest stages and mid-tier biotechnology companies utilize higher funding to invest in their pipeline.

I want to take this opportunity to discuss the recent news that the National Cancer Institute canceled the contract with Charles River.

Initiated in 2006, this was a 10-year, $112 million contract for our insourcing solutions business which had only two years remaining.

Under the contract we produced NCI research models for academic and government researches.

Because we will continue to produce the same models, there will be very little change to Charles River's business and the transition will be seamless for researchers.

We launched an outreach program to inform researches that they could continue to obtain the NCI models from us with no change in initial pricing or logistics.

From a revenue standpoint we receive between $10 million and $11 million annually to produce the model.

Expect that we will retain only half of that amount from sales to researchers.

That would mean a revenue shortfall in the fourth quarter of only about $1.5 million.

Primarily as a result of our efficiency initiatives, the RMS operating margin increased by 150 basis points to 29% in the second quarter.

I want to point out that we achieved this improvement independent of the profitable EMD business, which was formally included in the RMS segment.

As you know our efficiency initiatives are focused on various areas including capacity utilization, inventory management, and automation to improve data access and reduce manual workload.

We are continuing to identify opportunities to streamline our RMS operation, and we believe that an annual operating margin in the high 20% range is achievable.

DSA sales were $142.6 million, a 31.4% increase in constant currency.

This segment is comprised of all of our discovery businesses, including Argenta and BioFocus, and the safety assessment business.

Argenta and BioFocus, which are now referred to as early discovery, contributed $23.5 million in the second quarter, slightly ahead of our expectations.

The safety assessment business was the other significant driver of sales growth.

For the first time since 2008, sales growth exceeded 10%.

We were extremely pleased with this performance which resulted from our intense focus on scientific expertise and client service and market share gain.

However, demand is variable on a quarterly basis, and you should not expect to see this level of growth consistency.

I remind you that our annual guidance for DSA sales growth in 2014, excluding Argenta and BioFocus, is mid-single digits.

It's likely that we will see quarters of higher and lower growth, but on a year-over-year basis we expect to achieve our targeted growth rate.

As a result of leverage from higher safety assessment sales, the UK tax law change, and foreign exchange, the DSA operating margin increased by 360 basis points to 17.1% in the second quarter.

I remind you that operating margins for Argenta and BioFocus are below the segment average, but we expect to improve them.

Efficiency gains resulting from initiatives we put in place over the last few years are enabling us to accommodate the increasing volume of studies and a relatively stable infrastructure and generate an improved operating margin.

We have focused on standardization and harmonization of processes, on creating centers of excellence rather than recreating expertise in every location, on utilizing technology to provide clients with access to the data in real time, and on efforts to ensure that the client experience is the same high quality no matter at which of our facilities they place work.

As a result we have improved our ability to manage the workload while using fewer study rooms and fewer personnel.

This outcome has enabled us to provide scientific expertise efficiently and at a reasonable price, which appeals to all clients.

I previously mentioned that we opened additional space in Edinburgh last year to absorb the volume from new strategic relationships.

And we recently opened a few study rooms at our Ohio facility.

As clients increasingly choose to place work with Charles River, we will continue to add the required space with little or no impact on margin.

We are careful about adding space because despite the fact that our capacity is nearing full utilization, pricing will not improve significantly until industry capacity has filled as well.

That said, we want proposals where we are not the lowest bidder.

When scientific expertise is a critical criterion Charles River is often the preferred provider.

The manufacturing support segment delivered sales growth of 15.2%, with each of the three businesses EMD, biologics, and Avian contributing.

The EMD business was the largest driver of the segment sales increase, reporting exceptional sales growth of nearly 20% in constant currency.

The PTS franchise continued to exhibit strength as we sold additional instruments and cartridges and continued to take share in the conventional testing market.

As I've noted previously, the ease of use, accuracy of results, and processing speed make the PTS an ideal instrument for endotoxin detection.

Because of these capabilities, we are converting clients who use our traditional LAL testing methods to the PTS and take market share as new clients make the change from other providers.

Accugenix has been and excellent addition to the portfolio, not only because it is a leader in the field of microbial identification, but also because it allows clients to test for and identify contaminants with a single provider.

We expect that EMD will continue to deliver at least low double-digit organic sales growth for the foreseeable future as new products are introduced and as we continue our efforts to convert large biopharmaceutical manufacturers central laboratories to the PTS cartridge technology.

I want to describe our biologics business for you because this business has become more important to our portfolio as large molecules increasingly represent a more significant proportion of drugs in development.

Biologics provides all testing services required to bring large molecules to market, including cell line characterization and banking, assay development and testing, and viral clearance.

Recognizing that large molecule drugs were becoming more important, we undertook an initiative to become the leader in biologics testing.

We've expanded our portfolio with the acquisition of new labs and through internal development.

We strengthened our organization by deepening our management team and adding scientific expertise.

We've built a state-of-the-art facility to provide capacity for new business.

And throughout we maintained our focus on efficiency so that we could drive margin expansion.

As a result of our efforts, we believe we are well positioned as one of the two market leaders in the large molecule testing space, and we intend to pursue our goal of becoming the clear market leader.

In manufacturing segments, second quarter operating margin was 33.4%, a gain of 230 basis points year-over-year.

The improvement was due to the biologics business, the result of both leverage from higher sales and increased capacity utilization of the new building.

We believe that a margin in the low 30% range is sustainable and are working on improving efficiency in these businesses as well.

All the actions we have taken in recent years have been focused on differentiating Charles River as the preferred provider for early stage drug development and positioning us to compete effectively when new opportunities become available.

You are familiar with many of these actions.

Expanding our broad early stage portfolio through international development and selective strategic acquisition, maintaining and enhancing our extensive scientific expertise, improving our operating efficiency, providing best in class client service, developing state-of-the-art data systems and portals which offer clients realtime access to data, and structuring flexible creative solution that support each client's drug development goals.

We'll continue to pursue strategies to enhance our position as a leading early stage CRO.

Perhaps the most important initiative now underway is to identify additions to our portfolio.

Acquisitions have always been a critical component of our growth strategy because they enable us to enhance the support we can provide to clients.

With the acquisition of the early discovery assets, we believe our portfolio is the strongest it has ever been.

We can support clients at the earlier stages of their research with our integrated drug discovery capabilities, and stay with them through the entire early stage process, a capability that no other CRO can fully match.

We believe the value of a single provider for the complex challenges of early stage research resonates with clients and reinforces our strategic relationships.

The importance of strong client relationships is fundamental to our ability to drive sales, cash flow, and earnings growth in the coming years.

In conclusion I'd like to thank our employees for their exceptional work and commitment and our shareholders for the support.

Now I'd like Tom Ackerman to give you additional details on our second quarter results.

Thank you, Jim.

And good morning.

Before I recap our financial performance, let me remind you that I'll be speaking primarily to non-GAAP results from continuing operations.

Before discussing the business segment revisions, I will provide a brief summary of the financial results of our former RMS and PCS segments so that you are able to compare your models.

Going forward we will no provide financial results for our former segments.

On a constant currency basis legacy RMS segment revenue increased 3.5% in the second quarter, while the former PCS segment gained a robust 11.2%.

This performance was driven by a particularly strong quarter for our safety assessment business on which Jim has already commented.

The non-GAAP operating margin also expanded in both of our former segments as the legacy RMS margin increased 90 basis points to 30.9%, and PCS gained 600 basis points to 18.2%.

Following the acquisition of Argenta and BioFocus on April 1, we reviewed our financial reporting segments to insure alignment with our view of the Company.

As a result of this thorough review, we determined that we should report three business segments: research models and services, discovery and safety assessment, and manufacturing support.

We believe that in aggregate, the business and financial profiles and customers, and go-to-market strategies are now more closely aligned for the businesses within each segment.

The RMS segment now consists of the research models and research model service businesses including GEMS, RADS, and insourcing solutions.

All our discovery service businesses, including Argenta and BioFocus, are now being reported in the discovery and safety assessment segment, or DSA.

The segment also includes our safety assessment business, which Wall Street commonly refers to as toxicology or preclinical services.

The third segment, manufacturing support, is made up of endotoxin and microbial detection business, or EMD, as well as our biologics testing solutions and avian vaccine services businesses.

The biologics testing solutions business was previously known as biopharmaceutical services, or BPS, prior to its rebranding initiative.

By revenue the DSA and RMS segments are the two largest segments, representing 42% and 39% of second quarter revenue and 29% and 45% of second quarter non-GAAP operating income respectively.

Manufacturing support represents 19% of revenue and is expected to be our fastest growing segment due primarily to the strength of the EMD business.

Also due to EMD, it will likely be our highest operating margin segment.

At 33.4% for the second quarter, the manufacturing segment represented approximately 26% of total non-GAAP operating income.

In addition to our reportable of those segments we will continue to provide sales of research models, research model services, and EMD in our quarterly filings.

For the full year 2014, our outlook for the new segments is as follows.

We expect approximately flat sales in the RMS segment as price increases are expected to largely offset the ongoing impact from biopharmaceutical consolidation.

The DSA segment is expected to increase more than 20% in 2014 driven by the acquisition of Argenta and BioFocus which will contribute more than 15% to DSA revenue growth.

This equates to mid-single digit growth for our legacy discovery and safety assessment operations.

Manufacturing revenues are expected to increase more than 10% in 2014 as a result of continued double-digit growth in the EMD business and improving trends for our biologics business.

We expect the operating margin in each segment to improve in 2014 due to a combination of our productivity and efficiency initiatives and higher sales volumes.

Margin improvement will be partially offset by higher corporate cost, which is expected to result in a consolidated margin that will be similar to or slightly higher than last year's level of 17.3%.

I will also remind you that Argenta and BioFocus's operating margin is below the corporate average.

So it is slightly dilutive to the consolidated operating margin.

The business currently has a low to mid-teens margin which we expect to improve over time.

With regard to the DSA segment, the UK tax law change in 2013 and foreign exchange benefited the DSA operating margin by a combined 222 basis points in the second quarter of 2014 when compared to the prior year.

These items will benefit the full year DSA operating margin, but are expected to provide less of the year-over-year benefit in the second half as we anniversary the adoption of the UK tax law change in the third quarter.

I will now discuss the nonoperating items that affected the second quarter performance.

Unallocated corporate costs increased $3 million year-over-year to $20.1 million in the second quarter of 2014, but declined by $2.3 million on a sequential basis.

We expect allocated corporate cost for the year to be at or slightly below 6.5% of total sales.

Net interest expense was $3.2 million in the second quarter, an increase of $0.6 million from the first quarter 2014.

This was driven by higher debt balances principally associated with the completion of the Argenta and BioFocus acquisition.

For the year we expect net interest expense to be in a range of $12 million to $14 million, which is below our prior outlook of $14 million to $16 million because libel rates remain essentially flat and favorable to our forecast.

We reported $2.7 million in other income in the second quarter, or a $0.04 gain related to our investment in a large life sciences venture capital fund.

Our 2014 EPS guidance has been adjusted for the $0.12 year-to-date gain, but not prospectively for any gains and losses which might occur in the second half of the year.

As I have previously mentioned, we do not forecast other income since gains and losses are primarily derived from market based returns on investments.

In the second quarter the non-GAAP tax rate of 27.2% declined slightly on a sequential basis and was in line with our guidance range for the year.

We continue to expect our non-GAAP tax rate for 2014 to be in a range of 27% to 28%.

We previously updated our tax guidance in May to reflect the Argenta and BioFocus acquisition and associated legal entity restructuring initiatives.

As a result of the strong operating performance, free cash flow increased by $8.5 million to $47.7 million in the second quarter.

CapEx was slightly lower at $9.3 million.

We continue to expect free cash flow in a range of $180 million to $190 million in 2014 and CapEx of $55 million to $65 million.

Our top priority with the capital deployment is disciplined M&A activity as we continue to strengthen our early stage portfolio and drive profitable growth.

Major uses of capital in the second quarter with the completion of the Argenta and BioFocus acquisition on April 1 and the repurchase of approximately 1.5 million shears of common stock for $80.5 million.

We accelerated a meaningful portion of our planned 2014 stock repurchase activity into the second quarter due to our belief that there was an attractive entry point for our stock.

We anticipate a more modest level of repurchases for the remainder of the year, in line with our stated goal to offset dilution from option exercises.

As a result of the timing of the stock repurchases, we now expect an average diluted share count for 2014 of slightly higher than 47.5 million shares.

At the end of the quarter we had $48.8 million remaining on our stock repurchase authorization.

At the end of the second quarter our total debt was $803 million, an increase of approximately $163 million from the end of the first quarter.

In the second quarter we borrowed approximately $116 million to finance the acquisition through our euro denominated revolver.

At the end of the quarter our pro forma leverage ratio was within our near-term targeted range of 2.5 and 2.75 times.

Debt repayment for remainder of the year will be primarily related to the scheduled installments on the term loan.

I would like to provide some additional details with regard to our updated guidance.

Our sales guidance of 9% to 11% is the same for both reported and constant currency because we continue to expect foreign exchange to provide only a small benefit in 2014.

In addition, we lowered our GAAP EPS guidance by $0.04 to a range of $260 million to $270 million primarily as a result of additional restructuring charges that we expect to incur as a result of our global efficiency initiatives.

In addition to earlier actions in North America and Europe that we previously discussed, we also implemented a plan in the second quarter to consolidate the number of facilities in our Japanese research model operations in 2015.

This project coupled with our other global initiatives, is expected to further enhance the efficiency and operating margin in our RMS segment.

Following the extremely robust second quarter performance, our second half outlook assumes more normalized results due to a combination of factors.

Normal seasonality affects the RMS segment in the second half of the year, the result of lighter order activity during summer vacation and winter holiday periods.

Because of the volume sensitivity of research model production and the importance of production to the RMS segment results, we expect the new RMS segments operating margin to decline sequentially in the second half of the year similar to last year.

In addition, we anticipate a modest sequential decline in safety assessment revenue in the third quarter reflecting normal fluctuations in client demand.

As Jim said, safety assessment sales growth is not linear quarter-by-quarter, but we do expect annual increases.

We recorded a gain of $0.12 in the first half of 2014 related to our limited partnership investments, and have not forecast any gains in the second half of the year.

Based on these factors we believe the third quarter revenue growth will be in the low double digits on a year-over-year basis including the acquisition of Argenta and BioFocus.

We expect non-GAAP EPS to be similar to last year's third quarter level of $0.79, which equates to EPS growth of approximately 10% when excluding $0.07 of investment gains and tax-related items in the third quarter of 2013.

We are pleased with the robust second quarter financial performance and successful completion of the Argenta and BioFocus acquisition.

Revenue and earnings may vary quarter by quarter based on client demand.

We're confident that our financial performance for the year will show signs of sustained improvement in our business resulting in 2014 EPS growth above 10%.

We also remain focused on driving continuous improvement in our business to further enhance shareholder returns.

Thank you.

That concludes our comments.

The operator will take your questions now.

Thank you.

(Operator Instructions)

Dave Windley with Jefferies.

I want to focus around DSA and the safety assessment business.

I'm first of all curious if your views on the second half and comments on the third quarter are based on kind of a level of caution after a really strong second quarter?

Or are they driven by kind of actual bookings in hand and level of backlog?

Are you seeing some moderation in the bookings activity for safety assessment headed in to the second half?

Hi, Dave.

We're seeing pretty much all of that.

So second quarter was obviously a terrific quarter.

It was particularly strong.

So kind of all things hitting on multiple cylinders.

Lots of studies with larger animals, a fair amount of specialty work, and a fair amount of long-term work.

Some work which happens often, but you never know when.

Some large studies that were originally contemplated for the first quarter ended up moving into the second quarter.

So we had a big bolus of work.

The margin obviously is driven by having a great quarter, having a great mix of work like that, and that's driving efficiency.

So the margin is a combination of all of the above.

We're expecting a really good third quarter and fourth quarter.

Where as we step back from the second quarter and kind of look at the industry and the demand and the competition and particularly the pricing, we're very cognizant of the fact that this is feeling at least at the moment very much because of the price, like kind of a mid-single digit growing business for us.

And maybe it'll get to high single, but that's not what we're guiding to.

So we're expecting a strong quarter that will appear to moderate off of the second only because it was unusually strong.

We're trying to get others besides us to look at the safety system business on an annual basis because, as you know pretty well since you're familiar with the space, studies don't start and conclude commensurate with our corporate reporting quarters.

They have different durations.

And so taking a holistic view of it, not withstanding the quarterly conversations like this one, we just think this is a much better view.

So we don't feel, just to get to the essence of your question, we don't feel like we are being inappropriately or overly conservative.

The back half of the year for all of our businesses tends to be somewhat adversely impacted by holidays and summer slowdowns and sometimes running out of budget.

It's not some overly cautious response, it's just cognizant of the -- while demand is very good, and obviously we had a really strong quarter, and so have others in the industry, and all systems point positively, given the fact that they're still a bit too much capacity in the system, we still don't have the level of pricing that should be commensurate with the volume and demand.

And if and as we do, both the top and the bottom line will begin to move much more quickly.

So I guess in a lot of ways we continue to be cautious about pricing and while we're delighted with the quarter, I would say that studies are still quite competitively bid.

And yes, we talked about the fact that we win some studies where we're not the lowest price point, but price is still an important part of the evaluation process.

Thank you.

My follow-up is kind of on the same topic and on capacity that you just touched on.

The demand does seem to be rising around the industry.

It seems that all the major competitors' capacity is filling at least, if not full, and there is some discussion of trying to move price up a little bit.

So I'm curious about your comments about efficiency initiatives to stretch your existing capacity and openings, and just your thoughts around how much additional work can you take on by squeezing work in to your existing footprint versus your thoughts about further additions to capacity?

Thank you.

First off, we don't think that the dialogue that you're hearing in any way jives with day-to-day, week-to-week, month-to-month pricing negotiations that we have with clients when other competitors are at the table bidding.

And trust me, as soon as that changes, you'll be one of the first to know.

Because we still don't feel that we're getting paid well for the quality of our services, although we're trying to make up for that by being as efficient as possible.

But clearly it will have some, pricing obviously will have some significant relationship to capacity being very utilized.

So I suspect there's more capacity in the system than people are letting on.

In our case we are getting full.

We said that now several calls in a row.

We have, depending on the quarter you speak to us, a facility or maybe a couple of facilities that are functionally full.

For us that means 85%-ish.

We have a little bit of space at several sites that we have and will continue to open, and by that I mean a run that's built and not caged, a run that's shelved but not totally finished.

Not major happenings to get it done at multiple sites.

We'll be able to subtly bring those online.

And what I mean subtly without adversely impacting our operating margin but providing additional capacity for our clients, which of course is our job.

So I think we can do that for a year or two.

Could be a year, but year or two.

We're concluding a five-year strategic plan.

We're talking a lot about capacity.

We have several buildings, like one in Canada in Sherbrooke, which was built for the express purpose of continuing to add on to it.

It was built in a modular fashion, sort of break out a wall and add on to it and the HVAC is large enough to support the additional space.

So we can do that whenever we want.

You obviously know that both Reno and Shrewsbury have [phalo] space probably in the aggregate over 300,000 feet that's just shelves; that would take a significant amount of time and money to finish.

But we own them and they're part of our facilities, so even those will give us a leg up.

And of course we want to open Shrewsbury as soon as rationally possible.

It's a big facility, it's close to the major research center in the world.

And we are going to wait for some significant client commitments, but we're starting to hear a lot of noise about some clients that would like to see Shrewsbury open, and there are probably ways to open it and do multiple things in it.

Like you could do safety assessment, in vivo pharmacology, and some sort of vivarium management program and variations on those themes.

Without going out and adding additional capacity through M&A or [greens] building, we have a really good portfolio.

Some literally immediately available.

Some is available over the next two to three years if we want to push out walls and do some construction.

And of course we aspire to get Shrewsbury done.

Obviously, if demand increases in a really significant way that we have many more large pharma companies for whatever reason begin to close down their own facilities, then we'll do things more quickly.

John Kreger, William Blair.

Thanks very much.

Jim, can you talk about the historical correlation if any that you've seen between your core model business and the tox business?

The real question here is as the tox business begins to gradually get better, do you think that will eventually be enough to sort of cause the model business to flatten out and start to grow again on a unit basis?

Really good question.

The answer is we would have thought so, historically, for sure.

So here's the facts.

I was thinking about this kind of the last 24 hours in preparation for this call.

Demand is definitely better for everyone in the CRO safety assessment space, particularly for us, but it's just better.

Our North American research model business has had two good quarters in a row.

Not increasing sales, but flat sales as opposed to declining sales, and escalating operating margins.

So two really good metrics.

And we used to talk a lot about the correlation that you're asking about, and so on the one hand there obviously is a correlation.

Outbred rats have the model of principal, small animal model of choice, and the Charles River CD rat is the principal model of choice within the outbred rats.

So yes, we should see it.

I think we're actually not seeing it yet.

I think what's happening is the following.

One is that you have a focused reduction in the number of drugs in the pipeline, so that drug companies can spend more money getting the ones with the highest probability of getting to market to market.

So that's definitely a significant issue.

The other is that a lot of the work that we're doing, and I suspect that our competitors are doing, used to be done by our clients in their facilities.

So they're not doing the work.

We used to sell them the animals.

Now we sell them to ourselves or we sell them to our competitor.

So you don't have a net increase in work.

I would just say anecdotally, and then we should watch it and you can ask me again in a year, a lot of people at Charles River are spending a lot of time with clients, and I've been spending a lot myself including a couple last week.

And I do ask every client, they're all senior R&D people and often the head of R&D, is your discovery spending beginning -- are you beginning to shift more of your spending back towards discovery and as opposed to disproportionately feeding the clinic?

Many of the them are saying yes.

So if that's true, I would say that there is the real potential in a year or two or three, depending on what the hit rates are, that we'll see more compound with more promise beginning to come through the development process without this imbalance that we've had.

Of course, the imbalance, if it persists too long, is going to have a really negative impact on drugs getting to market in the future.

I hope that answers your question.

Not seeing it now for some very good reason, but it's better.

Even when our competitors win the studies, they often use our RADS so we get a little piece of their work.

But on the margin it's really a trade-off between the work being done formally internally and now externally using the same animals.

Eric Coldwell with Robert W. Baird.

Good morning.

Two questions.

I have many, actually.

But first with research models, you kind of hit on this with John, but North America flattish for two quarters, trying to up, Europe and Japan tend to lag.

You've lagged for a couple of quarters now.

Are you getting any signs in Europe and Japan that perhaps demand could pick up?

And I guess there's a corollary to that.

You're consolidating some sites in Japan.

That might be your signal that you really haven't.

But I'm curious on the reasoning for the consolidation of facilities there now.

Great question.

Historically for whatever reason, and you're a student of the pharmaceutical industry as well, geographically Europe and Japan have always lagged the US pretty much with regard to everything.

All the ways that we've interfaced with them we seen this.

So we're not surprised.

Europe tends to come right after the US and then Japan typically follows.

It tends to be a more insular environment, obviously.

So it looks like the US, at least for the moment, has kind of stabilized from their capacity reduction.

And of course we have reduced our capacity both in California and currently in our Michigan facility.

So we feel really good about utilization of capacity and the resulting margins that will be derived from there in the States.

And we're trying to manage the same process overseas.

So we will continue to look carefully at the capacity that we have and refine it as necessary, commensurate with the demand.

And we're in the process of doing some of that refinement a little bit in Japan right now.

So now I wouldn't say that we've seen it stabilize, but we expect that it will.

Probably going to be another year, maybe another year or two.

But I would continue to point you and everyone else listening to the fact that while sales have not been increasing in that business, we have some very creative, very aggressive initiatives in process right now to drive efficiency through capacity utilization, automation, and doing things much less manually.

And we, like we just showed this quarter, believe we can and intend to continue to drive operating margins up in that business.

And we will continue definitely to take share in the US in the mid-tier and academics.

We do think that China will obviously grow indefinitely given how nascent that market is.

Thank you very much.

And I'm going to ask a follow-up or shift gears a little bit.

You've talked about seasonality for the firm in total and the major themes, which is a recurring theme, no surprise there.

But with the new reporting structure the three segments and some of the mix shift, could you speak specifically to the segments in terms of whether manufacturing services perhaps has a different seasonal pattern now than we might see in safety assessment or research models?

Just trying to get a better sense of the revenue and any bit of flow by new reporting segment based on the changes and mix.

Well, that's a good question.

I would say that manufacturing is probably slightly less seasonally impacted; so it's got three pieces.

It's got the EMD business, the avian business and biologics.

I would say that the EMD business is pretty much not impacted by the season.

I would say that the egg business where we have -- I'm knocking wood, historically been sold out of eggs year after year after year, it's pretty much not seasonably impacted.

I would say biologics could be.

That's a really tough business for us because it's very short-term work and you don't have much of a backlog.

You don't have much predictability, although the business is doing much better.

Very much tied to large -- entirely tied to large molecules.

So I'd say that will probably follow some of the ebbs and flows of just the pharma and biotech industry spendings.

So somewhat in manufacturing support, but less impacted by the seasonality that we're seeing in kind of classic RMS or in the safety assessment business.

I would add to that one comment because we don't think about it in those seasonal terms, but in the vaccine business we have several clients who peak production around the vaccine periods, which tend to be oriented at different times of the year.

So we actually do see a little fall-off in the second half of the year because vaccine production in a couple of key accounts is actually lower.

And given overall demand, we do try to place those eggs at many other customers and sometimes we're successful and sometimes we're not.

So it's a little different from other seasonal trends that we talk about that are more related to summer vacations and things like that.

This relates to some of our clients' productivity cycles.

Greg Bolan, Sterne Agee.

Tom, going to the -- I know we're not going to be talking about this on a go-forward basis, but given kind of the very exceptional results this quarter for legacy PCS, I think you had mentioned a 600-basis point rise in legacy PCS operating margin to around 18.2%.

Can you give us a sense as to how much of that was driven by the tax credit as well as FX and then just what the underlining pull-through margin was from the general improvement in volume?

Yes, we did say in DSA I believe that it was about 200-plus basis points for those couple of items.

So it would probably be a little bit more than that in the legacy PCS business because it's a smaller size versus adding the discovery services to it.

So clearly a good percentage of it, probably around one-half or better, really driven by volume and the flow through of operating margin, contributed margin, however you'd like to state it, that you guys have been asking about.

So we did see a nice flow-through of incremental margin on the pick up in volume.

That's great.

Thanks.

Jim, thinking about your comments on the North American model outbred rat market -- outbred model business, I guess as you think about the spot pricing market for that particular model, your CD rat, I guess one of your primary competitors has gone through some changes.

I guess one of the things that I was wondering is, is there any indication that the pricing for that particular model is starting to get somewhat of a lift after, say, 9 to 12 months of maybe some irrational behavior by some of your competition?

Is there any indication of that at all?

No.

This is not a model where price is variable and changing from time to time, anyway.

We have an annual price increase that affects different clients in different ways.

Sometimes our competition follows us.

Sometimes they don't.

Sometimes they're higher.

It's a bit unpredictable.

Not withstanding whatever your conclusions are about the volumes, the volumes are still very significant for this animal model.

I suspect they're still the highest of anything we do just in terms of share units.

The margins are very, very good just because we produce so many and we're so efficient.

We do get a meaningful price increase throughout the world, and I think we'll be able to continue to do so just because of the fundamental importance of the animal model.

We're not seeing anything particularly unusual from a competitor point of view.

And even if we did, even if competition were to be aggressive in a positive way, in other words raising their prices, we would do what made the most sense for our clients given the relationships that we have with them.

But that's a product line that we're still really happy with.

Tycho Peterson, JPMorgan.

Thanks for taking my question.

Want to understand some of the gives and takes in the margin line, in particular the sustainability of the tox margins.

You obviously had a one-time benefit here from the UK tax law change and then some from FX, and I know tox margins are going to be down a bit sequentially.

What do you think the underlying run rate is on tox margins over the next couple quarters?

And then similarly, where do you see Argenta and BioFocus margins going from here?

We did say that Argenta and BioFocus to work backwards, Tycho, we're sort of in the mid-teens.

We don't necessarily see that changing a lot this year.

We are working through the integration, efficiencies, and what not but really we're looking to leverage that as we exit 2014 and into 2015 and beyond.

Whether we can get there or not, our target would be to really try to get that up in line with our corporate targets, somewhere up in the 20% range.

So that would be our objective.

We have reasons to think that's possible, but obviously that's not a commitment that we would make at this particular point in time.

I think we basically want to raise them as much as we can without impacting the business negatively from a quality of service standpoint.

And with regard to sort of the legacy PCS, I think the overall DSA we'll continue to see it move sideways I think in the mid-teens to maybe a little bit better than that, which is sort of where the legacy PCS business has been and it's kind of where AB is.

So I think mid-teens to slightly better is probably a good number to be looking at for DSA.

Okay.

And then just to follow up on Jim's comment earlier about capacity, I'm just trying to put the comments on Shrewsbury in context.

Have you had discussions with clients about potentially opening that in the coming year?

How do we think about how you would potentially do that?

Would it be in pieces?

I'm just trying to understand how actively you're thinking about taking that step.

I wouldn't say we're having any serious conversations.

What I did say is I've had a whole range of Cambridge, Boston-based biotechs large and small ask me recently about what our plans are for Shrewsbury.

So they're starting to think about how they could benefit from that being open.

And as I said earlier, that was built as a very sophisticated toxicology facility and could be reopened as one.

But I think it's more likely to be reopened with several different services going on at the same time.

Perhaps regulated safety assessment, some sort of in vivo pharmacology, DMPK activity, and then some vivarium utilization by clients where either we manage or they manage, some combination of those.

But in any event we would want some commitments by clients in advance.

And I think typically at least the last half dozen years or so people are reluctant to give those commitments.

But as they run out of their own space or get out of their own space or fail to want to increase it, we're likely to be able to negotiate some deals like that.

And when we do we'll be happy to open it.

Is there any discussion of dedicated space?

This was a top 10 years ago, but we haven't heard about it a lot recently.

That would be exactly the sort of conversation we would want.

The perfect scenario that we always thought is that we'd have three kind of big biotech companies take one-third, one-third, one-third or small pharma take one-third, one-third, one-third.

Kind of own the corridors, own the space, get to know the people and have them be dedicated to them.

I don't think that's an impossibility, either.

We have a team working on this right now in terms of what do we need financially, what are the best combinations, what are the most likely clients.

And we're working this because Cambridge continues to expand.

Big pharma's adding buildings all the time, there's more biotech companies to Broad, et cetera, et cetera.

It continues to flourish and we put that site there for a reason.

We wanted to be proximate to where all the work is done.

So we're really desirous of getting it open, but the clients will have to drive that.

Jeff Bailin, Credit Suisse.

Thanks for taking the question.

Jim, you mentioned earlier that you're not quite yet satisfied with the prices you're getting on the safety assessment side.

But can you give us any color on how you'd characterize the spot pricing environment right now?

Are you seeing any increases?

Are there any geographic differences worth calling out?

I know one of your primary competitors just discussed the trends in Europe being a little softer.

So curious if that's similar to your experience.

I would say the geography is not particularly relevant.

It's very client-dependant.

We have clients, who we have big enterprise deals.

We have clients that are one-offs.

We have clients that are very price sensitive and some that will pay up for great science.

So it's all over the place.

We don't think we're even close to being paid for the quality of work or the level of investment that we're making.

Having said that, because capacity is filling, because the mix of work is being enhanced, the margins are improving and we're proud and pleased with that trend.

But we're pretty full, and we're running pretty lean.

And doing really great quality work.

And the clients are experiencing a 30% to 50% reduction in what they would be spending internally at least.

And so there's definitely -- and if you consider the fact that we're still probably 25% or 30% below 2008, which was sort of the industry high, there's a lot of room for pricing improvement where the client still feels good about the value that they're getting and that we feel a lot better, the work that we're doing.

The other thing that's going to invariably happen here is that clients have gone from literally waiting six months, in other words calling us up and they say: how fast can you start this study?

And we tell them six months and they say, okay, and they plan for that.

They get their molecule in the queue, literally for the last four or five years clients could start a study in less than a month or sometimes in a couple of weeks.

They've grown accustomed to doing that, which I think is not good for any of us.

I don't think they plan well.

It's really difficult for us to plan.

And trust me, they plan better when they did all the work internally.

So what's going to happen, putting the price conversation aside just for a moment and then I'll come back to it, is that relatively soon if you believe the anecdotal input from our private competitors, clients are going to have to start to wait.

We're all going to say even as we bring our new space, sorry, we can't start your study in two weeks.

It's going to be two months or three months or five months.

They will get accustomed to that.

They will wait in line.

That will be fine.

And depending on their sense of urgency, they may very well be happy or insistent on paying more.

We used to experience that in 2007 and 2008.

I do think that this allocation of capacity, particularly where the client deems that to be really high quality and they really want it, and they want it and they don't want another client to get it, that people will begin to pay up for that.

There's a lot of reluctance.

And I would say the thing that puts the pall over the whole pricing thing, is that you have, particularly in big pharma, you have very strong purchasing organizations that have mandates to save billions of dollars and they pretty much try to do that across the board.

So there is a culture in big pharma of trying to get the lowest prices possible.

So I get that, I guess that's good business.

But there has to be some balance between that goal and buying really high quality science.

In some cases we have that and in others we don't.

Sandy Draper, SunTrust.

Thanks very much.

A lot of my questions have been asked.

Maybe a general observation, and Jim I'd love to get your comment on this.

When I listen to your commentary about where you are, talking about where you'd be to your portfolio, the way the market is, if I rewind 12 months ago, I would look at it and say your tone it sounds more positive, you feel better about where Charles River is sitting today than 12, certainly 18, 24 months ago.

But when I look at the full-year guidance this year in the three segments versus last year, if you exclude the acquisitions, there's not a whole lot of difference from the growth rate.

And I'm just trying to see if I'm misreading anything about your overall positive tone.

As you said, we need to focus on this stuff annually and not quarterly, which I can appreciate.

But just trying to see if you really do feel better but you're just trying to keep a conservative outlook.

You said not overly conservative but just generally due to the lumpiness you want to make sure that you're not getting ahead of yourselves.

Just I'd love some comments on that, thanks.

Tom and I can both take a shot at this, I guess.

Again, we don't feel that we're being conservative.

We're really trying hard to be realistic.

Yes, obviously some of the history is in our present, of course.

And there's some unpredictability in this marketplace and availability of funds and the competitive scenario continues to be challenging.

And it's okay that it's challenging.

It's more challenging than it was many, many years ago.

Having said that, we're quite pleased with the growth rate in the preclinical business versus the last few years.

We're very pleased with the engagement with many more clients.

We're very pleased with our facilities filling and the mix of business.

The only thing that we're not pleased with is the price point, and it sure feels like we ought to be getting some level of relief in the not too distant future, although that continues to be elusive from our ability to call that.

With regard to growth rates elsewhere besides our most frequent acquisition, the research model business has flattened, but operating margins are growing.

Our discovery businesses are growing.

Our EMD business is growing very rapidly, as we reported for I don't know how many quarters in a row, and we just finished to almost a 20% growth quarter.

Last two quarters were almost 20%.

And we've kind of showcased biologics as a business, which we've been growing and investing in for several years now.

It's beginning to break out and make a difference.

We're generally pleased with the overall demand for our businesses.

It's becoming a big complex portfolio.

The acquisition that we just did should grow faster than many of our other segments and should continue to enhance our top line growth.

And we think with some modest amount of M&A going forward we can get the Company back to double-digit growth which is our goal.

Just to add to that, if you think about our guidance this year excluding the acquisition of Argenta and BioFocus, we're essentially in the mid-single digits.

Last year, we grew low-single digits.

So clearly, the top line numbers on a quote-unquote pro forma basis will be better.

That's really being driven principally by the safety assessment activity, what we're now calling manufacturing support which includes EMD, continues to grow quite nicely.

I think the in-life/safety assessment is actually going to be up year-over-year in terms of the growth rate, which we've talked about.

And the new or old RMS segment, principally the models area itself, continues to be challenged as we talked by in large part the consolidations that we continue to see in the industry.

Overall, I do think we're in a better environment, particularly in the in-life.

I think the businesses that have been doing pretty well will continue to do well, like EMD and life's doing better.

And we're continuing to work through challenges in the models business.

Douglas Tsao, Barclays.

Stacy, why don't you take the next call.

Robert Jones, Goldman Sachs.

I guess just on the RMS side, Jim, the efficiency efforts there obviously continue to pay dividends on the margins side of that business.

And yet on the top line, and you guys have touched on some of the challenges here, it looks like on a constant currency basis it's been relatively flat.

I guess two quick ones.

How much room is left on the efficiency side to improve operations?

Then on the top line, you've called out a few specific things.

I'm just wondering from a higher level, how much of this slowdown if you will in growth there do you characterize as structural versus more market-specific in the current environment?

I think it's early days on driving efficiency.

We've said on several calls this is an old business that we've been in for a long time.

We're the world's leader.

We're really good at it.

The margins are terrific, and things are way too manual and we're rethinking everything that we do.

We're driving efficiency all over the world in multiple aspects of this business.

So I'm quite confident that the operating margins will continue to expand in a meaningful way.

That's really good news.

I think that we can and will continue to grow our share in the academic and the mid-tier sectors in the US And I think we can continue to grow share once things stabilize overseas as well.

And certainly, China will continue to be a high growth vehicle for us.

So we've been saying for a couple of years that business will probably shake out as a low-single digit growth business.

We're saying that the products and the services piece now are high 20%s margin.

And we'll continue to drive that as hard as we can, try to get it as close to 30% as possible.

It's a very big business.

It provides an entree to literally almost every research enterprise in the world.

Helps us build the rest of our businesses.

It's an extraordinary source of free cash.

And we do also have some continuing opportunities to participate either by creating or licensing in or somehow getting access to specialty models, which has been our goal for a long time which should help enhance the value proposition even if units are relatively small.

That's helpful.

I guess one quick follow-up and don't want to be a spoiler here, but looking ahead to the analyst day next week, curious if you'll be providing an update on the long-term targets, particularly on the margins side in light of the change to the reporting structure that you guys gave today?

We'll take that under advisement.

Thanks so much.

Rafael Tejada, Bank of America.

Just a quick here on an earlier question.

Just for the full year guidance and operating margin, can you just comment on how much is really being driven just by the business improvement factors as opposed to the other charges that are being recognized?

Thanks.

That would be looking at the whole year or the rest of the year?

The whole year.

If we go back to our original guidance we obviously increased guidance for Argenta and BioFocus.

We increased it for a combination both venture capital money and performance of the business and then we've just increased it again.

If you think about the second quarter we outperformed by consensus to use that data point by $0.15, $0.16.

We had $0.04 from venture capital.

Everybody's got a different take on whether the shares were a little bit better or not.

They were marginally better, obviously not meaningfully.

Same with the tax rate.

We did mention a couple hundred basis points with foreign exchange and the tax pick up versus last year.

Although from a perspective basis we knew about the tax change so we had kind of put that into our forecast.

The currency worked to our favor.

The truth of the matter is without scratching it out on paper, there's a good portion of it that's clearly from operations.

Clearly some of it's from venture capital.

We talked about that being 12%.

And some of it's clearly from the acquisition.

Not much I would say really from one-time activity at this point in time.

Other (technical difficulty) time activity.

Just a quick follow-up to that, just thinking, and maybe this is something you'll discuss next week, but longer-term on the potential EPS growth, I'm just trying to get a better handle on the contribution from efficiency saving since these have been changing a bit on a quarterly basis.

What sort of non-GAAP EPS growth do you think is realistic on a year-over-year basis, once you're still factoring in all these charges?

I mean can we -- is it something in the high single digits, low double digits?

And that will be it for me.

Thank you.

Thanks for the clarification to your question.

What I would say is as Jim just mentioned in reference to a question a few moments ago, we are planning to give a little bit more color on our longer-term growth rates next week at the investor day.

But in terms of your question now we still think there's room to improve relative to efficiencies.

We do have a robust program working on that.

We're a number of businesses historically, particularly probably the in-life safety assessment business.

As we talk about earlier in the call, we did take some charges relative to our business in Japan.

We hope to yield results from that starting next year.

As Jim said, I think there's a lot of room still to make improvements in efficiency in a number of our businesses.

We continue to do that.

We do think that we can continue to grow earnings as well as the top line going forward.

We have time for one final question and we'll go to Doug Schenkel with Cowen and Company.

Thanks for taking my question.

This is Chris on for Doug today.

So maybe a longer term strategy question.

Drug development in China continues to grow at a rapid pace, but I think your presence there is largely limited to Vital River.

Can you talk about if expanding services and product to China is a priority for Charles River and what steps are being taken to drive growth?

Sure.

Good question.

Our goal is to do as much of our current portfolio -- provide as much of our current portfolio in China, probably for China as quickly as possible in the areas that make sense.

So for instance, we've already opened and closed a GLT tox facility that was a fabulous facility that we opened in Shanghai in 2006.

And there was insufficient business to warrant using it.

Also we opened at a time when there was too much space in the US and Europe at low price point.

At some point we want to be back in the safety assessment business, but I can't see that for awhile.

We have a small EMD business that we've had there for a long time.

We've sourced a fair amount of our larger animal models from that geographical account.

Obviously we have a robust growth engine with our animal business which will have a related diagnostic laboratory and probably GEMS business associated with it.

We're looking at that locale for possibly doing everything else we do.

That would be our avian business.

That would be in vivo pharmacology.

That would be in vitro pharmacology.

That could always be chemistry.

We want to be able to participate in that market, which is growing disproportionately fast from a funding point of view, to the rest of the world.

And we think we have a lot to offer.

But we're going to do that cautiously and we're continuing to assemble a strong management team in China and as we do that.

So we're looking at several acquisition opportunities and several organic growth opportunities.

And depending on priorities around here and what deserves the most funding and where we think we'll get the best returns, we'll continue to proceed on those.

China remains an important part of our growth strategy.

I know there were a few more people in queue today.

We'll follow up with you.

For the time being this concludes the conference call.

Thank you for joining us this morning.

Thank you, ladies and gentlemen.

That does conclude your conference.

You may now disconnect.