Charles River Laboratories International Inc (CRL) 2017 Q2 法說會逐字稿

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The replay will be available through August 23 and you may also access an archived version of the webcast on our Investor Relations website.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 the 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 14, 2017, 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 Information link.

I will now turn the call over to Jim Foster.

Good morning. I'm very pleased to say that the positive factors which contributed to the strong start to the year continued in the second quarter of 2017. Demand for our products and services remained robust as clients chose to partner with Charles River to take advantage of our strong portfolio and scientific expertise. We have the ability to support clients from target discovery through nonclinical development, a capability that we believe improves the effectiveness and efficiency of our clients' drug research process and one we believe is unmatched by other early-stage CROs. We believe clients recognize the advantages of working with us as evidenced by the fact that we worked on more than 70% of the drugs approved by the FDA in 2016.

In order to maintain and enhance our position as the premier early-stage research partner, we intend to continue to expand our unique portfolio, add to our management and scientific bench strength, enhance our already best-in-class client service and implement systems that provide critical data for both internal and client use. We are focused on the successful execution of our strategy, which is the basis of our performance year-to-date, our expectations for '17 and beyond and our ability to deliver value to shareholders.

Let me give you the highlights of our second quarter performance. We reported revenue of $469.1 million in the second quarter of 2017, an 8.1% increase over the prior year quarter. Our portfolio delivered strong organic growth of 7.1%, driven primarily by our Biotech and Other client segment. Sales to these clients increased in each of our business segments. The operating margin was 20%, an increase of 50 basis points year-over-year. We were very pleased with the margin improvement, which was driven primarily by the DSA segment. The RMS margin declined year-over-year due primarily to volume and to the investments we are making to expand capacity in China. The Manufacturing margin declined slightly year-over-year due in part to investments we are making to support growth in our Biologics business. However, both the RMS and Manufacturing margins were well within our targeted range.

Earnings per share were $1.29 in the second quarter, an increase of 7.5% from $1.20 in the second quarter of 2016. When normalizing both periods for gains on venture capital investments and the excess tax benefit associated with stock comp, the year-over-year increase was due to leverage from higher revenue. We remain enthusiastic about the outlook for 2017 and continue to invest in our growth, both through facility expansion and additional staffing. Demand for our products and services is robust, and we continue to gain market share, which supports our expectation for organic revenue growth in a range from 7% to 8.5% in 2017 and non-GAAP earnings per share in the range of $5 to $5.15.

I'd like to provide you with details on the second quarter segment performance, beginning with the DSA segment. DSA revenue in the second quarter was $252.1 million, a 9.3% increase on an organic basis. The legacy Discovery Services business continued to improve with revenue up slightly over the second quarter of 2016 and Agilux again performing better than our expectations. The Early Discovery business recently delivered its 76th development candidate to a client, enhancing our reputation for scientific expertise in the discovery of new molecules.

As a result of our track record, the new business development structure we implemented last year and our targeted sales initiatives, proposal volumes have increased and we are winning new business, especially from biotech clients. The improvement is not apparent in the second quarter revenue growth rate because, as we mentioned previously, a number of large integrated programs were completed without immediate start-up of new programs. As we've also discussed, this may continue to be the case until our large biopharma clients outsource this work more consistently. However, we're very pleased with the improvement in our new business wins and also with the progress the business development team is making to encourage clients to place work which integrates our Discovery and Safety Assessment services.

We currently have a number of combined programs underway, including one with Nimbus Therapeutics, which we announced in April. After working with Nimbus for a number of years, we formalized a multiyear strategic partnership through which we will collaborate with Nimbus from initial hit identification through Safety Assessment. We are successfully demonstrating to clients that working with us through a broader portion of the early-stage drug research process enhances the value we provide them, both from a scientific and cost-effectiveness perspective.

On Monday, we announced the acquisition of Brains On-Line, a leading CRO that provides critical data to advance novel therapeutics for the treatment of CNS diseases. Brains On-Line is considered the world's premier provider of microdialysis, which measures drug and neurotransmitter levels in the brain to provide valuable information about efficacy of CNS drugs, and also offers sophisticated in vivo efficacy and pharmacokinetics testing.

The addition of Brains On-Line expands our existing CNS capabilities and establishes Charles River as the premier single-source provider for a broad portfolio of discovery CNS services. Brains On-Line also adds 3 sites to our Discovery footprint, providing sites in both Europe and the South San Francisco biohub, thereby increasing the opportunity for clients to work side-by-side with Charles River's scientists.

The revenue contribution from Brains On-Line is approximately 0.5% of total revenue on an annualized basis and we expect that it will be neutral to both GAAP and non-GAAP earnings per share in both '17 and '18. This is a strategic acquisition that enhances our ability to support clients' early-stage drug research in this critical therapeutic area.

Strategic acquisitions remain our preferred use of capital, and we will continue to build out our portfolio in order to enhance our competitive strength. As we discussed on our first quarter conference call, strong bookings and backlog for Safety Assessment gave us confidence that revenue growth for the Safety Assessment business would improve from the first quarter level, which it did, to the low double digits. Continued bookings and backlog in the second quarter support our current expectation that Safety Assessment revenue growth rate for the year will be at or near 10%.

As we have often noted, growth in this business isn't linear. We are likely to see low double-digit growth in some quarters and high single digit in others. Critical factor is that clients are increasingly choosing Charles River as their early-stage drug research partner, relying on us to provide the scientific expertise they need to advance drugs through the discovery and development process, rather than maintaining or building these capabilities in-house. We expect continued growth in demand for outsourced services and market share gains will drive growth in our Safety Assessment business. We also noted on our conference call in May that based on the first quarter of bookings, we expected the second quarter revenue growth rate would be driven by demand for both global and biotech clients and that the growth rate for biotech clients would increase in the second quarter. The revenue growth rate for biotech clients was robust in the second quarter, significantly higher than the first.

Biotech funding from the capital markets was also robust in the second quarter, exceeding both the first quarter of this year and the second quarter of last year. Approximately 25 biotech companies launched IPOs in the first half of '17 compared to 30 in 2016. We believe that the willingness of markets, VCs and global biopharma companies to fund biotech companies is a clear indicator that biotechs are identifying promising therapeutics with the potential to treat or cure diseases that were previously untreatable. Our view is supported by the fact that the FDA approved 28 novel drugs through August 3, a greater number than in all of 2016 and a testament to the strength of these companies' pipelines. The DSA operating margin increased 250 basis points to 23.7% in the second quarter compared to a year ago, with 100 basis points of the improvement due to foreign exchange. We are very pleased with the margin improvement, which was driven in part by Safety Assessment price increases and mix improvement, but primarily by the WIL Safety Assessment sites as we continue to make progress on the planned cost synergies.

For the RMS segment, revenue was $124 million, an increase of 1% on an organic basis over the prior year. As I mentioned during our conference call in February, our RADS business benefited in 2016 from special projects which we did not expect would recur in 2017, resulting in a challenging year-over-year comparison. This will be the case for the remainder of '17. Revenue growth in the second quarter was driven both by Research Models and Research Model Services. For Research Models, China again delivered an outstanding performance, offsetting slightly lower revenue for North America and Europe, due primarily to lower demand from global clients.

In Research Model Services, both the GEMS and Insourcing Solutions businesses delivered strong performances. Clients are using new technologies like CRISPR to create new models faster and partnering with our GEMS business because we provide extensive scientific expertise and a more flexible and cost-efficient alternative to maintaining these capabilities in-house.

The Insourcing Solutions business also increased, due primarily to expansions of existing contracts. For the full year, we expect that the RMS growth rate will be in the low single-digit range because in addition to the RADS issue, revenue for Research Models in North America and Europe will be down slightly and growth in China will be capacity constrained in the second half of the year. Demand for our research models in China has accelerated much faster than we expected, as clients recognize that Charles River produces a superior product and provides better service and support and we take market share. As you know, we are expanding our production capacity with a new site in the Shanghai area and we have accelerated our expansion plan and expect to have sufficient capacity to meet the increased demand by early 2018.

We now expect that over the long term, RMS revenue growth will be in the low single digits. Because the business is mature, we do not expect the Research Models business outside of China will be a material contributor to growth. Growth will be driven primarily by China as it becomes a more material contributor to this segment and by opportunities in the services businesses. At a low single-digit revenue growth rate, we expect that RMS will continue to generate strong cash flow, which we plan to reinvest in our business.

In the second quarter, the RMS operating margin declined by 150 basis points to 27.4%. This is due primarily to the RADS revenue decline and to the Research Models business in North America and Europe. Because these businesses are highly leveraged to volume, the margin is impacted when volume is lower. That said, we continue to identify opportunities to streamline our RMS operations, particularly through the automation of manual processes and implementation of systems to improve data availability and accuracy.

The Manufacturing Support segment reported a robust second quarter with revenue of $93 million. The organic growth rate was just above 10%, led by Microbial Solutions and the Biologics Testing Solutions businesses.

For Microbial Solutions, the primary driver of revenue growth was demand for our Endosafe testing systems and cartridges and Accugenix Microbial Identification services. As was the case in the first quarter, higher cartridge sales were driven by the continued expansion of the installed base of machines. In addition, revenue from microbial identification services increased significantly, as we continued to raise our profile with clients in Europe and Asia. The advantages of our unique portfolio, which includes both rapid endotoxin and bioburden testing systems and microbial identification libraries, continue to resonate with clients. We are optimistic that our ability to provide a total microbial testing solution to our clients will be a driver of our goal for Microbial Solutions to continue to deliver at least low double-digit organic growth for the foreseeable future.

The Biologics business again reported robust revenue growth in the second quarter. We were very pleased with the performance of this business, which provides services that support the manufacture of biologics, including process development and quality control. Recognizing that biologics would represent a larger percentage of drugs in development, we were determined to invest in this business in order to position it to compete effectively as both the number of drugs increased and clients outsourced more services.

For the last few years, we have invested in staff in order to enhance our scientific expertise in our facilities so that we had the capacity to accommodate new work, and in our sales force and go-to-market strategy. We also expanded our Biologics portfolio through the acquisition of Blue Stream in order to provide a comprehensive portfolio of services to support biologic and biosimilar development. As clients increasingly recognize the value of our Biologics portfolio and our flexibility in structuring work relationships, the demand for our services increases. We have been adding small tranches of capacity in order to accommodate the larger volume of work as we win new business, and based on the strong demand for our services, are planning a moderately larger expansion this year. Although our expansion projects put pressure on the manufacturing margin in the second quarter, we believe that investment in our Biologics business is particularly important now, when more work is being outsourced and we can gain share to support our growth in the coming years.

The Manufacturing segment second quarter operating margin was 34.2%, a 120 basis point decline year-over-year. The decline was due to our expansion projects, to increase staffing costs to support future growth and to lower revenue in the Avian business. At 34.2%, we are very pleased with the operating margin, which continued to exceed our long-term low-30% target.

Offering our unique early-stage portfolio, which will continue -- which we will continue to enhance through acquisition, world-class scientific expertise and best-in-class client service at an effective price, has been the cornerstone of our value proposition for clients and has clearly resonated with them. Our second quarter results keep us right on track to achieve our guidance for the year. Organic growth rate was 7.1%. We achieved 50 basis points of operating margin expansion and earnings per share increased at a high single-digit rate, when adjusting for gains on venture capital investments and the excess tax benefit.

We are very pleased with the performance of the collective portfolio. There will continue to be quarterly variations in segment growth rates, but we expect the consolidated portfolio will deliver high single-digit organic revenue growth, earnings per share growth at a higher rate than revenue, and strong free cash flow. We intend to continue to focus on enhancing the 3 primary factors that differentiate Charles River from the competition: First, our unique portfolio of essential products and services, which increases our relevance to our clients' drug research, development and manufacturing efforts; second, our scientific expertise and depth, which we believe is unique and unparalleled in the early-stage CRO universe; and third, our intense focus on efficiency and responsiveness, which enables us to provide exceptional flexible service to clients without adding significant cost. We are continuing to make investments in facilities and significantly increasing staff, which will continue to differentiate Charles River as the CRO partner of choice for early-stage drug research and support our future growth.

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

Now I'll ask David to give you additional details on the second quarter results and updated 2017 guidance.

Thank you, Jim, and good morning. Before I begin, may I remind you that I'll be speaking primarily to non-GAAP results from continuing operations, which excludes amortization and other acquisition-related charges, costs related primarily to our global efficiency initiatives, the impact of the divestiture of the CDMO business and certain other items.

Many of my comments on the second quarter and full year will also refer to organic revenue growth, which excludes the impact of acquisitions, the CDMO divestiture and the impact of foreign currency translation. Full year organic growth also excludes the impact of the 53rd week in 2016.

We are pleased with our second quarter results, which exceeded the outlook that we provided in May for revenue growth, operating margin and earnings per share. Organic revenue growth of 7.1% in the second quarter continues to track within our guidance range of 7% to 8.5% for the year. The primary drivers were our return to low double-digit organic growth in our Safety Assessment business as well as continued strong growth in both our Microbial Solutions and Biologics Testing Solutions businesses. RMS growth moderated in the second quarter, as we anticipated.

Please note that we excluded approximately 1 week of WIL revenue, totaling $5 million, from the organic growth calculation in the second quarter because we didn't own WIL for the first week of the second quarter last year.

The consolidated operating margin met our long-term target of 20% in the second quarter, increasing by 50 basis points year-over-year, primarily as a result of a 250 basis point increase in the DSA operating margin. In addition to the strong operating performance, second quarter earnings per share of $1.29 were aided by a $0.03 gain on our venture capital investments and a $0.03 excess tax benefit related to stock compensation.

You may recall that we did not forecast any additional contribution from venture capital investments and consistent with that approach, we are not forecasting a contribution for the remainder of 2017. We also did not forecast a meaningful contribution from the excess tax benefit associated with stock compensation beyond the contributions recorded in the first quarter. However, the benefit in the second quarter was higher than we previously anticipated because our stock price appreciated by 12.5% to above $100 per share, which resulted in additional option exercise activity during the quarter. For the remainder of the year, based on the current stock price, we believe the benefits associated with additional option exercise activity will be nominal.

Favorable movements in foreign exchange rates contributed to the revenue outperformance in the second quarter as several foreign currencies strengthened versus the U.S. dollar during the quarter. Foreign exchange also contributed 100 basis points to the DSA operating margin in the second quarter and 30 basis points to the consolidated margin. The margin benefit is expected to be lower in the second half of the year because we have anniversaried the weakening of the British pound associated with Brexit. For the year, we now expect foreign exchange to be approximately at 1% headwind to reported revenue growth, which is favorable to the 2% to 2.5% impact that we had previously forecasted. This favorability has no effect on our organic growth rate, but increases our reported revenue growth guidance to 8.5% to 10% for the year.

Unallocated corporate costs increased by $2.2 million year-over-year to $31.8 million, reflecting personnel investments over the past year, but declined sequentially from the first quarter. At 7.1% year-to-date, unallocated corporate costs continue to track to our 2017 target of 7% of total revenue, which is below the 7.5% last year.

Second quarter net interest expense of $7.2 million was unchanged from the same period last year. As expected, interest expense was slightly higher on a sequential basis due to higher borrowing cost associated with the Federal Reserve's rate increase in March. For the year, we continue to expect net interest expense to be at the low end of our initial guidance range of $29 million to $31 million.

The non-GAAP tax rate of 29.4% in the second quarter was favorable to our expectations due to the $1.3 million or $0.03 per share excess tax benefit associated with stock compensation. Excluding this benefit, the tax rate was above the 30% level that we had expected for the remainder of the year, primarily as a result of venture capital investment gains that are taxed at a higher U.S. rate. For the year, we now expect the tax rate to be in the range of 27% to 28% compared to our outlook in May, when we were at the lower end of our original guidance range of 28% to 29%. The favorable outlook is due to both the additional excess tax benefit from stock compensation in the second quarter as well as a discrete benefit related to a tax audit settlement that we expect to record in the third quarter. As a result of the discrete tax benefit, we expect the third quarter non-GAAP tax rate to decrease sequentially from 29.4% in the second quarter.

Free cash flow was $90.1 million in the second quarter, an increase of $21.8 million. After a slow start in the first quarter, we are pleased with the progress that we have made with regard to cash flow generation and continue to expect free cash flow to be in the range of $265 million to $275 million for the year. Capital expenditures of $16 million were essentially unchanged from the first quarter level and increased by $4.2 million year-over-year, reflecting continued investments to support the growth of our business, including capacity expansion projects for RMS China, Biologics and Safety Assessment.

Our CapEx outlook of $75 million to $85 million remains unchanged for the year. Let me provide a brief update on our capital priorities. We continuously evaluate acquisition candidates that will enhance or expand our scientific capabilities and supplement our organic growth. Strategic acquisitions remain our top capital priority and Brains On-Line is another example of our disciplined capital deployment. With an initial purchase price of approximately $21 million, the acquisition did not meaningfully increase our leverage ratio.

We continue to modestly repay debt, which we expect will generate interest savings in the balance of the year. We repaid $54.7 million of debt in the second quarter, which reduced our leverage ratio to 2.3x at the end of the quarter. With our leverage ratio below 2.5x, we expect the benefit from a lower borrowing rate in the third quarter because the interest rate spread will decrease by 12.5 basis points to LIBOR plus 112.5 basis points. We also repurchased 244,000 shares in the second quarter at a total cost of $22.5 million and have $165.1 million available on the stock repurchase program.

For the second half of the year, we expect the Safety Assessment, Microbial Solutions and Biologics businesses to be the primary drivers of growth, partially offset by softness in the RMS segment. We expect RMS organic revenue growth will be essentially flat in the second half of the year due primarily to the RADS project that ended in 2016. In addition to RADS, which compresses the annual RMS growth rate by approximately 1%, we expect slightly lower revenue in the Research Models business in North America and Europe and slower growth in China due to capacity constraints.

For the full year, we expect the RMS organic growth rate to be in the low single digits. Lower revenue growth will put pressure on the RMS operating margin in the second half. The full-year RMS margin will remain in the high 20% range, but will be moderately lower than in 2016. We believe that organic revenue growth in 2017 will be near 10% for the DSA segment and 10% or higher for the Manufacturing segment. We expect that the Manufacturing segment will be the largest contributor to operating margin improvement in 2017 in addition to lower corporate spending as a percentage of revenue. These factors are expected to result in a consolidated operating margin for the year approaching our long-term goal of 20%.

For 2017, we are reaffirming our non-GAAP earnings per share guidance of $5 to $5.15, which represents low double-digit earnings growth compared to 2016. The incremental second quarter contributions from venture capital investments and the excess tax benefit are expected to be offset by the softer outlook for RMS and investments in facility expansion and staffing in several businesses to support future growth.

For the third quarter, we expect our year-over-year reported and organic revenue growth rate will be in the high single digits, reflecting stronger DSA segment growth compared to the 5% organic growth that we saw in the third quarter of last year. We expect earnings per share will increase slightly from the third quarter of last year.

Over the last several years, we have invested in our portfolio, strengthened our scientific and management bench, and focused on becoming a more efficient organization. Our goal is to enhance our clients' journey with us as their trusted scientific partner and continue to strengthen our position as the leading integrated early-stage CRO. We remain on track to deliver full year financial results in line with our organic outlook for -- original outlook for 2017, including organic revenue growth in the high single digits, an operating margin approaching 20% and earnings per share growth in the low single digits (sic) [double digits]. While the segment mix may shift from quarter-to-quarter or year-to-year, our broad portfolio of essential products and services positions us to deliver high single-digit organic revenue growth and operating margin improvement in 2017 and over the longer term. Thank you.

That concludes our comments. The operator will take your questions now.

(Operator Instructions) And the first one will go to Tim Evans with Wells Fargo Securities.

Jim, can you comment a little bit on the RMS segment? Specifically, the kind of the softer demand that you're seeing in North America and Europe? Is that attributable to biopharma clients, pharma clients, academic, government, a little bit of color by client segment? And then just more broadly, can you comment specifically on academic and government across your portfolio?

Sure. I would say that the softness is a -- primarily a manifestation of a continued reduction in infrastructure by the big drug companies. So as we've said many times previously, we have a disproportionately large market share in that segment, the vast majority of share, for sure. And as these entire sites or portions of sites come offline, that impacts us more directly. So it's a continuation. I don't think it's an acceleration. It's a continuation. There's probably some more to come. I would say that except for the very large biotech clients, biotech clients don't have large vivariums. They're not the biggest users of our animals. The other thing that's interesting to note is that a lot of the research model services work is now being outsourced to companies like us. So we're selling to other CROs. We're also using a lot of the animals internally. It's a continuation of a multiyear decline, offset somewhat by price and mix, will continue to be offset somewhat by price and mix and hopefully continue to be offset significantly by growth in China and the services business, which we saw a little of in this quarter. Our academic -- sales for academic clients, I don't have the percentage at my fingertip, but it's a bit of a focus of ours. I'd say we've always had a significantly large market share in Europe and Japan, less so in the U.S., but it's an area that we focus on and we continue to do well at. It doesn't significantly offset the declines by Big Pharma who has tended to be the principal user. So as we've said, we're going to have low single-digit growth for the balance of the year and probably into the future. It's a business that will continue to generate very high 20% operating margins and generate significant free cash flows. We're investing aggressively in China. We have a facility being completed now in Shanghai. And we continue to invest in our service businesses as well. And the business continues to be sort of an underlying feature of Charles River being known by researchers from around the world for its scientific expertise.

We'll go to the line of Ricky Goldwasser with Morgan Stanley.

This is Mark Rosenblum on for Ricky. Could you just give some color around Agilux? You mentioned that performance has been better than your expectation. What trends are driving that and where do you see it kind of going forward?

Yes. Agilux is a highly responsive service provider of bioanalytical services, both in discovery and in development. And the trend is principally -- it's in large measure the plethora of biotech companies in the Greater Boston area who use Agilux increasingly as a service provider, who does great science in close proximity with

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and we're getting obviously some enhancement, which was the raison d'être of doing the deal of the marriage between Charles River and Agilux. So we, legacy Charles River, has provided them an entrée and an introduction to large pharma and also kind of validated them for large pharma. So I think that's been an upside for them as well, and provided certain level of solidity to them as they do this. And I just think, from a competitive point of view, they remained sort of at the top of the heap. So we had very high goals in our acquisition plan for them. They are exceeding them consistently, and I do think it's just a combination of our sales effort and access to clients and the quality of the work.

And we'll go to the line of Eric Coldwell with Baird.

Just a couple of little questions here. You have such a large portfolio of assets, sometimes when businesses don't get mentioned, I'm not sure if it's because there wasn't much to say or if they were actually -- maybe had some struggles in the quarter? But I didn't notice much of a mention on Avian. It seems like that might have been a little weaker. And then also within the manufacturing services group, you did not mention Celsis and I'd love to get an update on that acquisition.

Sure. So Avian, we did mention, just briefly. So it's really 2 things. One is we had some health issues with some flocks last year to report. We didn't restate that. So that's sort of continuing. And we have this single client issue that has nothing to do with us. It just has to do with work that we do for a single client. So it's a small business but it's a little bit of a drag on the Manufacturing segment. Notwithstanding that drag, we have over a 34% operating margin. So we did mention it in the context of the margin erosion there. And Celsis has been performing well. Celsis actually has been beneficial to the Accugenix revenues because it really enlivens that, so we can do bacterial ID and then identify exactly what you've identified specifically. So it's been helpful there. We have nice growth and development in the non-pharma sectors and are beginning to intensify our efforts in the pharma sector, which was not a stronghold of Celsis. And of course, it's our principal focus. We love the 3 parts of that business. They interact well with each other and lots of clients buy all 3 of those products and services, and we think that will be increasingly so.

Thanks. Just quickly on RADS. It looks like the year-over-year delta in RADS is only, say, in the ballpark of maybe $5 million, not a huge impact. Could you -- it's been a couple of years since you've really broken out services versus products in RMS? Is there any chance I could get you to maybe bite and give a little bit of an update on how overall services weights in the portfolio versus models and then maybe go a little more specific on RADS, so we have better sense on size in that business?

So will stop short of delineating size, but I guess what's important to note in the services, which we did say in our prepared remarks and we'll continue to emphasize is, there is outsize growth from the services, for sure, including potentially RADS. We have a 1-client year-over-year anomaly. It's a relatively small but high-margin business and high-science business that's an important part of our services. GEMS is definitely a critical research tool. Genetically engineered models are a critical research tool for all of the drug industry. The advent of technologies, CRISPR, in particular, are allowing the researchers to make better models faster, which should help our service business, which supports that. And we did note that our Insourcing Solutions business had a little bit of upside in the quarter. That's a business that we still think has great promise. It continues to frustrate us a little bit because we would have thought a larger number of our big clients would utilize our services, but we're still hopeful that, that could happen. So I guess I would say that the service business is small but meaningful, should grow disproportionately fast. By the way, has good margins, so has not been dilutive to margins. Remember -- I remember pointing that out years ago because as it was growing, people were a little bit concerned about that. And we're seeing that on an international basis. By the way, we should see the service business, over time, continue to grow in China as well. So I think that's all the color we're prepared to give, Eric.

We'll go to Dave Windley with Jefferies.

In DSA, I guess I wanted to understand kind of your -- I think you're saying high single-digit to low double-digit growth in SA. And then on the Discovery side -- if you could confirm that, is the question there. And on the Discovery side, it sounds like you are pleased with progress that you are making with implementation of the new selling business development strategy. But you also do call out that you didn't see that improvement in 2Q. And so Jim, I was interested in your broader comments about how you see that developing maybe over the next, I don't know, 1 or 2 years in terms of Discovery's maturation.

Sure. So let's start with safety. Terrific demand, a lot of demand in the first quarter for discovery and safety from pharma, which hasn't necessarily been the case. Intensified demand from biotech in the second quarter for safety. Capacity utilization is terrific. Client base is -- continues to grow. The quality of our service continues to grow and we love our WIL acquisition. That's contributing and I don't think we've said that loud in our prepared remarks. We love the deal, it's given us great geographic footprint and really great science and service and it's going really well. We had a comparatively soft first quarter in safety. So stronger quarter, much stronger quarter in the second quarter. And the lack of linearity in that one -- lack of linearity from quarter-to-quarter and always a little murkiness in the fourth quarter is maybe causing the way we phrase it. But basically, the Safety Assessment business is going to perform at or around low double-digit growth or 10% growth. So we're confident with that and we really are enjoying market share gains, the amount of work that's coming outside from Big Pharma and just the whole host of new biotech clients.

Discovery. Maybe we cut it too finely, so let me give you sort of a broader-gauge comment on Discovery. Continues to be perhaps the most strategically relevant or important thing that we've done in the last decade. I think we have acquired extremely good assets. The legacy businesses, which is a euphemism for the in vivo businesses, are performing extremely well, including the oncology business we bought last year in Germany. We are enjoying growth and development in the Early Discovery piece. We have a lot more work with a lot more clients because we have a much more sophisticated selling organization and operational organization that interfaces with the sales force. And we do, we have a lot of very creative deals. We called out the Nimbus one. We're also seeing, which was again, one of the raison d'êtres of doing this deal -- those deals, is to have clients work with us from discovery all the way through to safety. Actually, our clients work with us from some of the early animal work through discovery through safety and we're seeing that as well. So all of the things that we hoped would happen are happening. We're happy with the margin expansion there, both short-term and directionally. And all we called out, I don't -- we didn't mean to overstate this, is the Early Discovery piece has had some very large pharma deals, which were milestone based, which provide some challenging year-over-year comparisons. And until we have more of those deals, the comparisons will be a little challenging just in that piece of it. But Discovery should be increasingly accretive both to the top line and the bottom line, albeit a small piece of DSA. And again, the portfolio is beginning to mesh very well.

If I could answer a quick follow-up. You mentioned in the deck a I believe it was 76th candidate produced or identified, discovered by your Discovery business. I'm wondering, I'm sure not all of those 76 are still active, but to the extent that some portion of them are still being pursued by the clients, what latent financial reward opportunity does Charles River have from that portfolio of [babies] out there?

Yes. So first of all, of the 76 mentioned, some of them will by definition have died. It's actually very difficult for us to track every single one of, using your expression, of our children as they march through the pipeline because, of course, clients don't often disclose whether they're marching forward or not. We know that we had 1 that's been approved by the FDA, and we know that there are a number in Phase III. So we're hoping to see more of those actually get through to the finish line. That said, our model has always been that it's a fee-for-service type structure. We don't take downstream royalties. We don't take downstream payments beyond the work that we've agreed to do. And therefore, there's no conflict of interest. And that's the sort of structure that we've always set up with our Early Discovery portfolio.

I think, Dave, the most important thing to remember there, since it's not a royalty stream business, is that we discover targets that most sophisticated drug companies in the world couldn't discover on their own. By the way, the last time we looked at the data, about 1/3 of those were in clinical trials. So that's a pretty good data point as well. And I guess what it does every time I think about it is it underscores the strength of our science, and I think it keeps the clients coming back for those services and also the pull-through services. So it's a really important early stage in the funnel for us.

We'll go to Derik De Bruin with Bank of America.

So there's been a number of recent Big Pharma restructurings that we've seen. Also, there's -- you had the termination of the Alexion R&D pact with Moderna, which is what -- you're a preferred provider there. And also AstraZeneca has had some setbacks in their I-O program, you're the preferred provider there. Can you talk about some of the changes going on there? Do you see any sort of like these restructuring actions or changes sort of impacting your business?

Yes. So to some extent, this is a continuation of infrastructure reduction, but for the biggest drug companies, it's a constant process of focusing beyond the therapeutic areas where they can distinguish themselves and maybe getting rid of therapeutic areas where they can't vis–à–vis the competition, spending their money more wisely, and some of that's going to have to do with whittling back their R&D infrastructures and organizations. Our experience -- and the result of that for us is that, to some extent, it's accelerating the outsourcing trend -- to some extent it's continuing the sourcing trend, and to some extent it's accelerating it. Remember that still a significant amount of safety is being done internally. And so as they dismantle some of the space and cease doing the work internally, we have an opportunity to do the work. I think we are going to increasingly see that in Discovery as our footprint grows nicely. Given that the increase in pharma -- disproportionate increase in pharma revenue that we had in the first quarter across most of our businesses, I would say that we haven't seen any adverse impact from it. And hopefully, it will engender and cause and force additional outsourcing for us, which is sort of what we are organized to respond to.

Great. And if I can squeeze in 1 follow-up. Is the -- In RMS business, the Research Models business, is the lower sort of expectations for North America and Europe, is that any way reflecting just the downtrend in the use of animal models in just general applications?

I don't think it's anything new, Derik. There's sort of been a continual decline in use for a long time, in favor of more highly valued animals like immunocompromised animals and inbreds. So we have seen that margin enrichment. And then as I said earlier, we have this interesting anomaly with instead of selling it to -- selling the animals to pharma, we sell to CROs, of which we are the largest in the early development phase. So you have to almost think of it on a see-through basis. We're getting our revenue and profitability in our service businesses. And so we're actually the beneficiary of that shift, to some extent. But CROs will buy less than big drug companies.

And we'll go to Jack Meehan with Barclays.

Wanted to get your opinion on just the Safety Assessment competitive environment, if there's any changes you're seeing. And then what's assumed for the portfolio this year in terms of pricing?

Yes, so take the easiest one first. By the way, we are going to stop short of giving real-time pricing data because we feel it's putting us at a competitive disadvantage, since we don't have any public competitors anymore. But we will confirm the fact that we expect that pricing in safety will be between 3% and 5% when we end the year. So that's the story there. I would say that the competitive landscape hasn't changed much. There was a lot of movement in the last couple of years. We had a lot of private equity-owned competitors, which means that at some point those -- our competitors could consolidate or trade again. We've always felt we're the sort of only pure-play company that's in this for the long term. We see some periodic aggressive pricing. I think that's an always, always. That depends on what our competitors' capacity utilization looks like. You see a little more of it in the end of the year to seed capacity going into the next year. But I would say it hasn't been particularly irrational. I would say that as best as we can understand it, our competitors have good demand for their businesses as well. I think that's good for the entire industry. But clearly, we have maintained, retained and continued to be the market leader and continued to take market share from most of our competitors, sometimes with the portfolio of services, sometimes with the volume of science, sometimes -- occasionally with price, but -- and sometimes with all of the above.

Great. Very helpful. And I was hoping to just clarify what's embedded in the second half in terms of acquired growth. We are backing into 4% for the full year. I know the selling week, just want to make sure that was right. And obviously, you've already done a little over 10% on a net basis in the first half. What are the moving parts with the CDMO in the second half?

I'm struggling a little bit to understand the question. Could you maybe restate it?

Just what's embedded in the second half for acquired growth?

Embedded in the second half for acquired growth. You mean growth from acquisitions that we've already done?

Correct. Yes.

Well, actually the -- take WIL, for instance. It's not dissimilar to the legacy Safety Assessment because it's Safety Assessment work that we're providing. We really are -- it's not the sort of number that we kind of are breaking out anymore. We will -- we have to -- what we have to know is that we're delivering all the measures that we've given externally. We are meeting or beating the measures we've had internally. We did declare at the very start when we bought WIL that the sort of growth rate that they were seeing was not dissimilar to the growth rate that we were seeing in Charles River.

So, I'll just add that. The only acquisition we made in the second half of last year was Agilux. So from -- growth from acquisitions, it would just be that one.

And we'll go to Tycho Peterson with JPMorgan.

This is Tejas on for Tycho. Just wanted to ask a couple of quick ones here, Jim, on the ag and industrial customer base and what's going on over there. It sounds like industrial customers faced a tough comp but implementation was a little bit behind schedule for the REACH initiative. So growth seems to be okay there. Is that still the trend? And then in terms of your ag customer base, does that still remain -- I mean, are market conditions there still challenging?

We continue to enjoy both of those markets just as client diversification efforts in the REACH initiative is still an important one for us and should continue to be. And the ag business, I don't remember calling that out specifically one way or another. It's a business that is reasonably consistent. And again, it's important to us from a diversification and expansion of client point of view.

Got it, Jim. And then just 1 quick follow-up on the academic end market. I know it's relatively small for you in terms of direct U.S. academic exposure. But are you expecting a little bit of help there in terms of some sort of a budget flush dynamic, given that the NIH budget came in ahead of expectations? Or is sort of uncertainty about next year still keeping expectations pretty muted there?

It's hard to tell. The dollars -- the revenue dollars in the U.S. are not insignificant. They are meaningful. On a percentage basis, it's always been sort of the smallest segment for us. And we have competitors that have always done better on a percentage basis because of their lower price points, which is no longer the case. We've been pounding on the academic market, I'd say, for at least half a dozen years and we have picked up some share. And yes, I guess we should be the beneficiary of additional NIH dollars, but it's pretty subtle, even to our RMS business, and certainly subtle to the totality of our revenue. But we would obviously always prefer to have the NIH revenues up for the whole host of our client base.

And we'll go to the line of Jon Kaufman.

So in the prepared remarks, in the press release this morning, you noted that DSA growth was driven by midsized biotech as well as global clients. And then you also spoke about robust revenue growth from biotech and good funding. So all that sounds great, but I'd like to dig into this a little bit deeper and ask, what are you seeing specifically from the smaller biotech companies? How does demand from smaller biotech compare to demand elsewhere? And how did revenue growth in the quarter from the smaller clients compare to growth from the midsized and large clients?

We don't slice it that finely for public consumption. So I'm not going to give you any specific numbers, except to say that the biotech sector, including very small biotech clients, continues to be an increasing proportion of our revenue, increasing driver. These are companies, many of which are virtual, but these are small companies that have virtually no internal capability. They have an idea or a drug or something patented and then they increasingly want to outsource all of the development work, how to get the drug to proof of concept or to kill it. So given the enormous amounts of cash that's come into -- from the capital markets to these companies directly, I think it was up 45% from Q1 to Q2; given the enormous amount of money that's going into the venture capital sector, given -- from the venture capital sector; given the enormous amounts of money coming into biotech revenue from Big Pharma, the companies are extremely well financed and doing lots of work. We never hear anything otherwise. We just have a very large and growing cadre of clients. So I would say that's -- our business with the small biotech companies continues to be quite strong.

Okay. That's helpful. And then just 1 quick follow-up, if I could, and just in regards to guidance. It sounds like facility expansions and other investments in business over the remainder of the year will impact margins a little bit, but are there any other reasons why guidance was maintained as opposed to increased following the good quarter?

So part of that has to do with the RMS, which we specifically called out and we've had a number of questions actually post the prepared remarks. The second point, to your point, was around the investments, facility expansion, staffing, talking about China, but we're also investing in Safety Assessment, Biologics and Microbial for the sort of demand that we're seeing in the future. I guess the third point I would call out is that Q4 is always difficult to call. If you remember last year, our Q4 was stellar, but we've had quarters -- Q4 quarters in the past where clients have been holding back. So it's difficult at this point in the year to be able to certain what Q4 would look like, and for that reason, we also felt that should go into the mix in terms of how we prepared guidance for the remainder of the year.

We'll go to Robert Jones with Goldman Sachs.

This is Adam Noble in for Bob. Going back to the RMS business, could you give us a sense of what the current mix is between the developed markets in North America and Europe versus China? And once you've had more time to build out capacity for China in 2018, what type of growth do you think is possible over there?

So we haven't broken out the growth rate for China, except to say it's exceptional. It's reminiscent of what the growth rates were in the U.S. and Europe many years ago when that was -- those were new markets. And so we're sort of just scratching the surface on that. Obviously, it's a gigantic geography with lots of people and potential patients, real patients. And we're working to elevate the quality of animals that are used in the research. And I think we're doing a good job of that. So we think it has long term, consistent and conservative growth metrics. It's still a relatively small part of what we do, but sort of similar to our Japanese operation, which we've had for a long time, which has slowed. It will eclipse that sometime soon, I suspect. And the other markets, U.S. and Europe are mature. We have very large market shares. We continue to get price and some mix, occasionally some market share gains, particularly in the academic sector. So again, that's kind of what the global marketplace looks like. Those are the only geographic locales that are meaningful. There's not going to be a new one. And all of that is kind of buttressed by the service revenue, which is, again, not linear, but I would say over the period, yes, that's has been consistently up.

That makes a lot of sense. And just to sneak one really quick one on FX. You mentioned that FX was a benefit of about 100 bps to the DSA margin. Could you remind us overall the impact on -- from a weakening dollar on margins for the businesses? And how much of that is embedded in the second half 2017 guidance?

So, Adam, what we've called out in foreign exchange is there is a negative impact on foreign exchange for the year. At the beginning of the year, we said that would have a 2% to 2.5% impact on our revenue growth. Now of course, we're seeing foreign currencies strengthening. And so the impact we're seeing now is about 1%. We also called out that, in the beginning of the year, that the sort of headwind that we were seeing when we were seeing 2% to 2.5% was about $0.10. But of course, with the anniversary of Brexit, we'll see that have an impact in the second half there.

We have one last question from Sandy Draper with SunTrust.

And most of my questions have been asked. So maybe, Jim, a broader picture on the Manufacturing business, which obviously is doing incredibly well and the confidence for continued double-digit growth is certainly encouraging. I'm just trying to get a sense of framing how to think about that in terms of market growth. Is there -- is it really even market share gains? Is there someone to actually gain share from? Or it's people adding stuff, just going to completely greenfield areas? I'm just trying to think about how I sort of frame that low double-digit type of growth. What's really driving that over the long term?

So Microbial Detection and Biologics were the principal drivers. Biologics continues to be driven obviously and only by the increased number of biologics coming through the pipeline and getting to market. And I think we all believe that will only continue. So our business has actually accelerated in the last few years. And as we indicated in our prepared remarks, our adding staff and equally importantly, capacity all over the world to accommodate that. We don't see any reason why that should moderate. The Microbial Solutions business is a big market where we're the key player. We have multiple technologies that the competition doesn't. In the core businesses, which is the endotoxin detection market, we are constantly in the process of converting clients from sort of old-line technology to our handheld device -- our devices and cartridges, which have much higher ASPs and better margins. And that's a process that will continue. So we have an expanding market, technology conversion, and on the Biologics side, sort of the importance of the core technologies, which are driving it. And as we've said and continue to say, we don't see any reason why this low double-digit organic growth shouldn't continue indefinitely. And when we say indefinitely, we sort of look at the world in these 5-year chunks as we do our strategic plan.

Thank you for joining us this morning. We look forward to speaking with you soon and seeing you at the Wells Fargo, Baird and Morgan Stanley conferences in September. This concludes the conference call.

Thank you, ladies and gentlemen. That does conclude the conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.