Charles River Laboratories International Inc (CRL) 2017 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Charles River Laboratories Third Quarter 2017 Earnings Call.

(Operator Instructions) As a reminder, this conference is being recorded.

I would like to now turn the conference over to our host, Corporate Vice President of Investor Relations, Susan Hardy.

Please go ahead.

Thank you.

Good morning, and welcome to Charles River Laboratories Third Quarter 2017 Earnings Conference Call and Webcast.

This morning, Jim Foster, Chairman, President and Chief Executive Officer; and David Smith, Executive Vice President and Chief Financial Officer, will comment on our third quarter results and updated guidance for 2017.

Following the presentation, they will respond to questions.

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

A replay of this call will be available beginning at noon today and can be accessed by calling (800) 475-6701.

The international access number is 3203653844 and the access code in either case is 413675.

The replay will be available through November 23.

You may also access an archived version of the webcast on our Investor Relations website.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 14, 2017, as well as other filings we made 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 pleased with our third quarter results, which demonstrate the strength of our global business.

Demand for our products and services remained strong, as clients chose to partner with Charles River to take advantage of our unique portfolio with 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 processes and one we believe is unmatched by any other early-stage CROs.

Our belief was reconfirmed by 2 sell-side analyst surveys issued in October, which identified Charles River as the best-positioned CRO to win preclinical work.

We will never take our position for granted, and we utilize our entrepreneurial culture to identify new paths in which to execute our strategy.

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.

In addition, we maintain an intense focus on efficiency and responsiveness, which enables us to provide exceptional flexible service to clients without adding significant costs.

We are focused on a successful execution of our strategy, which is the basis for our performance year-to-date, our expectations for 2017 and beyond and our ability to deliver value to shareholders.

Let me give you the highlights of our third quarter performance.

We reported revenue of $464.2 million, a 9% increase over the third quarter of last year.

Our broad portfolio of essential early-stage drug research and manufacturing products and services delivered strong organic growth at 6.3%.

From a client perspective, our biotech clients were the primary driver of the revenue increase.

Sales to these clients increased in each of our business segments.

The operating margin was 18.8%, a 90 basis point decrease year-over-year.

The decline was driven by the RMS segment, where low revenue growth has impacted the consolidated margin as well as higher corporate costs.

As you know, the RMS operating margin is highly leveraged to research model volume, and volumes outside of China have trended lower.

In order to improve the operating efficiency of our Research Model business, we are closing our production facility in Maryland.

Earnings per share were $1.30 in the third quarter, an increase of 10.2% from $1.18 in the third quarter of 2016.

The increase was due primarily to higher revenue and venture capital investment gains.

We remain enthusiastic about the outlook for our businesses and continue to invest in our growth through strategic acquisitions, facility expansions and additional staffing.

Demand for our products and services is robust, and we continue to gain market share, which supports our expectations for revenue and earnings per share growth in 2017.

With only the fourth quarter remaining, we are narrowing our organic revenue growth range to 6.5% to 7.25%, and non-GAAP earnings per share to a range of $5.08 to $5.18.

I'd like to provide you with details on the third quarter segment performance beginning with the RMS segment.

RMS segment revenues was $122 million, an increase of 0.4% on an organic basis over the third quarter of last year.

Our Research Model business in China delivered another exceptional performance, and our global Insourcing Solutions and GEMS businesses also performed well.

These are the businesses, which, we believe, will primarily support our long-term expectation of low single-digit growth for the RMS segment.

As we mentioned previously, to support the growth opportunities in China, we are expanding production with a new site in the Shanghai area.

Construction is now complete, and we expect to begin shipping models from this site in early 2018.

Because the research model markets outside of China are mature, volume growth is limited.

The use of research models has changed over time with different screening technologies, more efficient study design and the use of higher-value specialty models, which are more predictive of human disease, combining to reduce the volume of models used in drug research.

In addition, global biopharmaceutical companies have engaged in significant infrastructure consolidation over the last decade, which has also reduced research model volume.

Despite these changes, research models remain an essential, regulatory-required, low-cost scientific tool for early development research and are a vital component of our portfolio.

The expertise we have developed in research model technologies has provided the foundation on which our Discovery and Safety Assessment businesses rely.

And these businesses are the largest customer of our Research Model business.

Given the importance of the production business to Charles River, it's incumbent upon us to ensure that we operate it as efficiently as possible.

To that end, we implemented an action this week to close our research model production facility in Maryland before the end of 2018 and consolidate production in our other facilities.

We will continue to provide the same research model strengths to clients without interruption of availability or service.

In the third quarter, the RMS operating margin declined by 180 basis points to 25.5% due primarily to lower volume in Research Model business outside of China.

In addition to the closure of our Maryland site, which we expect will generate savings in 2019, we continue to invest in automation of our Research Model business.

Our goal is to maintain our leadership position in the research model marketplace and support our Discovery and Safety Assessment businesses while sustaining an RMS operating margin in the high 20% range.

DSA revenue in the third quarter was $246.9 million, an 8.1% increase on an organic basis.

The Discovery Services business was stable, and Agilux again performed better than our expectation.

The integration has preceded smoothly, and we are gaining additional business from Charles River clients now that we can offer the Agilux portfolio of services.

This is the reason that we continue to make acquisitions in the discovery space, when they are available and fit our criteria.

Having a broader portfolio of discovery services enables us to work with clients earlier and bring them downstream to our Safety Assessment and Manufacturing services.

And for clients with whom we work in safety assessment, our Discovery portfolio enables them to move upstream and utilize our capabilities rather than internal infrastructure or other CROs.

This improves the efficiency and effectiveness of our clients' drug research efforts, and we believe that our clients recognize this value.

The Early Discovery business recently delivered its 77th development candidate to a client, enhancing our reputation for scientific expertise in the discovery of novel molecules.

We believe this is driving demand for our services, especially with biotech clients.

Next year, when we have anniversaried the large integrated programs, which were completed in 2016, we expect the revenue growth rate should improve.

We base our expectation on the fact that when adjusting for those integrated programs, the growth rate in 2017 was higher, as many of our biotech clients either initiated or continued to work with us on integrated programs and other projects.

Revenue growth for Safety Assessment was in the high single digits, and we continue to expect to report high single-digit growth for the full year.

Bookings and backlog in the third quarter were strong, capacity remained well utilized and the mix of services was favorable.

Pricing has increased, but at a slower rate than last year.

The critical factor driving our growth 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 to the discovery and development process rather than maintaining or building new capabilities in-house.

We believe that growth in our Safety Assessment business will continue to be driven by demand for outsourced services and market share gains.

Biotech clients were the primary drivers of safety assessment revenue growth in the third quarter.

Biotech funding from the capital markets exceeded the third quarter of last year and this year's second levels, making this the fifth consecutive quarter of funding growth and putting 2017 on track to be one of the strongest years for biotech funding.

We continue to believe that the willingness of the markets, VCs and global biopharma companies to fund biotech companies is a clear indicator that biotechs are identifying products in therapeutics with the potential to treat or cure diseases that were previously untreatable.

For many biotech companies, whether midsize, small or virtual, Charles River is the clear choice when partnering with a CRO who can support their drug research efforts across the early-stage continuum.

Our broad portfolio, scientific expertise, superior client service responsiveness, speed, flexibility and collaborative working style help our clients bring drugs to market faster and more efficiently to the millions of people who need them.

The DSA operating margin declined 30 basis points to 22.4% in the third quarter compared to a year ago period due primarily to foreign exchange.

As we initially guided, WIL's operating margin was above 20% in the quarter, and we expect that we will exit 2017 with WIL's margin above 20%.

The Manufacturing Support segment reported a robust third quarter with revenue of $95.3 million.

The organic growth rate was 10% led by the Microbial Solutions and Biologics Testing Solutions businesses.

For Microbial Solutions, the primary driver of third quarter revenue growth was demand for our Endosafe testing systems and packages.

Like the first half of 2017, demand for our PTS family of products was robust in the third quarter.

The PTS is a rapid testing system, which improves the efficiency of the manufacturing process and for which there is no competitive alternative.

In addition to its benefits for manufacturers, the unique characteristics of the PTS have also made it an excellent choice for other clients, such as nuclear pharmacies who had no viable rapid testing tool to enable them to best comply with regulatory testing requirements.

The continued expansion of the installed base of machines is driving higher cartridge sales, and the enhancements we made to our cartridge manufacturing process last year are resulting in improved operating leverage.

We are very pleased with the performance of the Microbial Solutions business; 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 low double-digit organic revenue growth for the foreseeable future.

The Biologics business again reported robust revenue in the third quarter.

We're very pleased with the performance of this business, which provides services that support the manufacturer of biologics and biosimilars, including process development and quality control.

The increasing number of biologics and biosimilars in development represent a significant opportunity for our Biologics business, which is why we have meaningfully invested in this business in order to position it to compete effectively in the outsourced services market.

For the last few years, we have invested in staff in order to enhance our scientific expertise and accommodate the higher volume of work as we won new business in our facilities so that we have the capacity to accommodate new work and in our business development team to improve our client service in better identifying new opportunities.

We also expanded our Biologics portfolio through the acquisition of Blue Stream last year in order to provide a comprehensive portfolio of services that support biologic and biosimilar development.

As clients increasingly recognize the value of our Biologics portfolio, our speed and responsiveness and our flexibility and structured working relationships, the demand for our services increases.

Based on the strong demand, we undertook a moderately larger expansion this year and expect further investment next year.

We are also continuing to hire staff.

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's third quarter operating margin was 36.5%, a 270 basis point improvement year-over-year.

The increase was due primarily to higher revenue from the PTS family of products and the benefit of investments we made to improve our cartridge manufacturing process.

In addition, an inventory adjustment related to our Avian products also contributed.

We were very pleased with the operating margin, which continued to exceed our long-term, low 30% target.

We have differentiated Charles River as the early-stage CRO partner of choice based on our unique portfolio of essential products and services, which increases our relevance to our clients' drug research, development and manufacturing efforts; our scientific expertise and depth, which we believe is unique and unparalleled in the early-stage CRO universe; and on our global network of facilities, which enables clients to work with us in close proximity to their operations; and because of our intense focus on efficiency and responsiveness, which enables us to provide exceptional flexible service to clients without adding significant cost.

As a result of our intense focus on our business, Charles River has grown significantly in the past 5 years.

Since 2013, through both internal growth and acquisitions, we have increased revenue, non-GAAP earnings per share and free cash flow by more than 50% or compound annual growth rates of approximately 12%, 15% and 13%, respectively.

Revenue growth at nearly 60% has challenged the organization to maintain and enhance its quality of service and responsiveness, which was one of the reasons we have hired significant numbers of staff in 2016 and '17.

We believe the coming years will present a significant opportunity for continued growth as large biopharma companies increase their reliance on outsourcing, the number of biotech companies expands and academia relies on CROs, like Charles River, to help them navigate the drug development process.

In order to be prepared for our future growth, we will continue to invest in strategic acquisitions, which is always our preferred use of capital because it enables us to expand our unique portfolio in order to enhance our ability to support our clients' drug research efforts.

We will continue to make investments in facilities, so that we have the capacity to accommodate the demand for our services.

We will continue to increase staff, adding both our scientific and management bench strength.

We want to enhance our scientific capabilities in order to ensure that we can more fully support our clients across the early-stage spectrum.

And we want to ensure that we have the management depths required to manage our existing business and future growth.

These investments are putting some near-term pressure on the operating margins where we believe they are imperative to maintain and enhance our position as the premier early-stage CRO to continue to differentiate Charles River from the competition, to support our future growth and to create value for shareholders.

We are very pleased with the performance of our collective portfolio in the third quarter and for the year to date.

There will continue to be quarterly variations in segment growth rates, but over the long term, 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.

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

Now I'll ask David to give you additional details on our third 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 exclude amortization and other acquisition-related charges, cost relating 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 third 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.

In the third quarter, we were pleased that most of our businesses continued to deliver strong performances, resulting in organic revenue growth of 6.3%.

Microbial Solutions, Biologics, Safety Assessment and Research Models China performed well, and we firmly believe that these businesses will continue to be important drivers of future growth.

In the third quarter, our consolidated operating margin declined by 90 basis points to 18.8%, primarily driven by a 180 basis point decrease in the RMS operating margin and also due to higher corporate costs.

As Jim mentioned, we have committed to close our research model facility in Maryland before the end of 2018, which will improve our RMS operating efficiency.

Associated with this planned closure, we expect to incur impairment and related charges in the fourth quarter of $16 million to $20 million or $0.20 to $0.25 per share, which will be excluded from non-GAAP results.

Most of these charges will be noncash.

The goal of this action is to align our RMS infrastructure with anticipated demand and to sustain the RMS operating margin in the high 20% range.

The closure of the Maryland site will generate modest cost savings in 2018 as we wind down operations and transition production activities to other sites.

We expect to generate annualized savings of at least $3 million starting in 2019.

Unallocated corporate costs increased by $5.5 million year-over-year to $34 million in the third quarter, reflecting personnel investments over the past year and higher expenses, primarily related to planned investments in IT projects.

For the year, we continue to expect unallocated corporate cost will be approximately 7% of total revenue.

Earnings per share of $1.30 were above our expectations, increasing 10.2% year-over-year, but were in line with our prior outlook when adjusting for venture capital investment gains and the excess tax benefit associated with stock compensation.

Venture capital investment gains totaled $0.07 in the third quarter and the excess tax benefits added $0.02.

This compares favorably to our prior third quarter forecast, which included nothing for venture capital gains and a nominal benefit for the excess tax benefit.

Our venture capital relationships have become a core aspect of our biotech sales strategy because our investments enable us to gain preferred access to a growing number of emerging biotech companies in the VC portfolios.

This year, we are on pace to achieve the highest level of revenue and investment gains since we commenced our VC investment strategy in 2009.

We have recorded venture capital investment gains of $0.15 year-to-date through September.

Historically, we have not forecasted gains beyond the annual $0.04.

However, we know that one of the portfolio companies completed an IPO in October, which we expect will generate a $0.02 gain on our VC investments and have, therefore, included this amount on our fourth quarter outlook.

Investment gains were not our primary objective for entering into these relationships.

The driving force was and remains the relationships forged with emerging biotech clients at the earliest stages of drug research and working with them to support their efforts through the discovery and early-stage development process.

The success of this strategy is demonstrated by the revenue generated from the VC relationships, which is on pace to eclipse $90 million in 2017.

In addition, the average annualized return on the revenue generated from and investments in our venture capital relationships continues to exceed 20%, which is well above our cost of capital and hurdle rate.

The excess tax benefits associated with stock compensation, which resulted from required adoption of a new FASB rule, ASU 2016-09, the beginning of this year, now totals $0.20 per share year-to-date through September.

This was higher than our original estimate for the year as a result of the stock price appreciation in 2017 and related option exercise activity.

Based on the option exercise activity in October and consistent with last quarter, we have also included a small benefit in our fourth quarter outlook.

Third quarter net interest expense of $7.5 million increased slightly on a sequential basis due to higher borrowing cost associated with the Federal Reserve's rate increase in June and higher debt balances.

For 2017, we expect net interest expense to be approximately $29 million, at the low end of our initial guidance range for the year.

The non-GAAP tax rate was 26.6% in the third quarter.

As we discussed in August, we expected the tax rate to be below the second quarter level of 29.4% because of a discrete benefit related to a tax audit settlement.

In addition, the excess tax benefit associated with stock compensation of $900,000 or $0.02 per share also reduced the tax rate.

For the year, we now expect the tax rate to be in a range of 27% to 27.5%, which is at the lower end of our previous range.

Free cash flow was $37.5 million in the third quarter, a decrease of approximately $25 million from the third quarter of last year.

The reasons for the decrease were the timing of capital expenditures, which increased by $12.4 million to $22 million in the third quarter and the timing of certain working capital items that are expected to normalize by the end of the year.

We continue to expect free cash flow to be in a range of $265 million to $275 million for the year, and our revised CapEx outlook is approximately $75 million.

We continue to believe that strategic acquisitions remain our best use of capital.

Dependent on the timing of acquisition opportunities, we expect to favor debt repayment over stock repurchases in the fourth quarter of 2017 and throughout 2018.

In the third quarter, we repurchased 350,000 shares for a total cost of $36 million.

With the year-to-date repurchases totaling $90.6 million, we exceeded the original value that we allocated to stock repurchases for the year.

Despite the higher spend, we did not fully offset dilution from equity awards because of the timing of repurchases, stock price appreciation and additional option exercises.

This created a small earnings per share headwind in the third quarter and the year.

Total debt increased by approximately $39 million during the third quarter, primarily as a result of borrowing related to our stock repurchases and the Brains On-Line acquisition in August.

Our leverage ratio also increased slightly to 2.35x, but is still below the 2.5x threshold that affords us a lower borrowing rate.

For 2017, we updated our guidance as follows.

Organic revenue growth is expected to be in a range of 6.5% to 7.25% for the year.

Compared to our original outlook of 7% to 8.5% growth, the revised outlook reflects slower organic revenue growth expectations for both the RMS and DSA segments of low single-digit and high single-digit growth, respectively.

We continue to expect organic revenue growth of 10% or higher in the Manufacturing Support segment.

The consolidated operating margin is now expected to be similar to the 2016 level of 19.2%, below our original outlook for the year and our long-term target of 20% because of the RMS margin pressure as well as investments in staffing to support growth, principally in the DSA segment and Biologics business.

We raised our non-GAAP earnings per share guidance to a range of $5.08 to $5.18 or an increase of $0.055 at the midpoint, primarily as a result of the incremental venture capital investment gains in the second half of the year.

For the fourth quarter, reported revenue growth is expected to be in the low-single digits due primarily to the impact of the 53rd week in 2016, which was required in 2016 to align with the December 31 calendar year-end.

The 53rd week will reduce the fourth quarter growth rate by nearly 5%.

On an organic basis, excluding the 53rd week, we expect the year-over-year revenue growth rate will be similar to the third quarter level.

We expect sequential improvement from the third quarter reported revenue, driven by increases in DSA and Manufacturing Support revenue.

We also expect the operating margin will improve on a sequential basis, but higher revenue and operating income will be offset by the unfavorable effect of nonoperating items.

These unfavorable items include our forecast of venture capital investment gains of $0.02, which is a $0.05 headwind from the third quarter, and a sequential increase in the tax rate.

As a result, we expect non-GAAP earnings per share to be below the third quarter level.

To close, we remain committed to our focus on enhancing the relationships with our clients, investing in initiatives to support these clients in our long-term growth prospects, driving global efficiency and deploying capital effectively.

We believe this focus positions the company for continued long-term success and higher returns for our shareholders.

Thank you.

That concludes our comments.

The operator will take your questions now.

(Operator Instructions) And our first question comes from the line of Tycho Peterson with JPMorgan.

I want to kind of hone in on some of the comments you made, Jim, on pricing trends.

You noted they were -- pricing increases were slower relative to last year.

Just curious as you -- if you can elaborate on that.

Are competitors getting a little bit more irrational on pricing?

I would say not.

We're enjoying terrific demand in the Preclinical business.

Bookings and strong capacities is well utilized.

We're enjoying a really positive mix these days of specialty versus gen-tox.

We're getting price and we're using price periodically and strategically to both win and gain and hold market share, so also pleased with our share growth.

So I wouldn't say that there's any irrational activity going on in the marketplace, but a tool being used intermittently to build share.

Okay.

And then If I could just squeeze one follow-up on margins.

You're making a lot of incremental investments at the moment.

As we think ahead to 2018, can you give us a sense of where you are just generally in the investment cycle around facilities and staff?

Should we think about 2018, in other words, being another big investment year?

Or do you start to get some margin leverage?

So we don't want to talk too much about '18, but I would say that we've -- some of our investment in staff has been to catch up.

And we're pleased to have to catch up.

In other words, business has been so good.

Demand has been so intense that, particularly in the DSA segments and Biologics, we've been hiring a lot of people.

If you look at the fact that it took Charles River 66 years to reach $1 billion in sales and we're on this track to hit a couple of billion in the next -- in the 4 years.

Post that, that's just a lot of people to add to the organization, to train them and have them be able to do exceptional work.

So I suspect, without getting too much into '18 because our plan isn't even -- but I suspect we'll add people again next year.

I suspect there'll be less catch-up next year than we've had, perhaps, this year and last.

So I think that a lot of those expenditures have taken place.

And our next question comes from the line of John Kreger with William Blair.

Jim, it seems like your growth outlook for tox is just a little bit more modest than maybe a quarter or 2 ago.

Could you just expand upon what you're seeing in the market if we're reading that correctly?

Yes, we're not seeing any fundamental changes in the market at all.

So biotech is extremely well funded.

Biotech is the primary client base.

It's driving our sales growth.

We have a plethora of new clients.

We have VC firms introducing us to their start-up companies.

We're seeing pharma dismantle space.

We're seeing interesting structural moves with our competition where, as I said earlier, we're gaining share generally every once in awhile through being more aggressive with price but, in large measure, because of the breadth of our portfolio.

We've been saying for the last -- for all of this year, as far as we're concerned, that we're tracking at or around 10%, and that's scaling now more around 10% to slightly less.

This is a very big robust business, and so at some point, this double-digit growth rate is probably mathematically going to be elusive for us.

So I wouldn't read anything into that.

We're just kind of clarifying the reality.

The -- we don't have predictable growth rates from quarter to quarter in this business.

So we have had quarters that have been 10% or higher.

We've had quarters that have been in high-single digits.

It's just feeling like that for this year.

And when we give our guidance for next year, we'll tighten that one up as well.

Okay?

That's very helpful.

And maybe one quick follow-up, kind of a macro.

We hear from a lot of companies pretty consistently that the broad industry pipeline is shifting towards higher complexity and more specialized type of disease categories and products.

Assuming you agree with that, what does that mean for your businesses?

Is that a tailwind or a headwind for how that sort of filters into the kind of the services that you provide and how quickly that turns into revenue for you?

It means that our tox studies have become increasingly more complex.

And so that will -- maybe that's adding a little bit to the headcount.

But it's also adding to the top line and the margin contribution because those studies are more expensive.

So I think that's been actually rather a natural evolution over the last few years.

It just seems like our prices -- our studies are getting increasingly more complicated.

That also is a way for us to distinguish ourselves from our competitors who, perhaps, can't respond and perform as well to those complex study designs.

So we like it.

And our next question comes from the line of Derik De Bruin with Bank of America.

So on the RMS business, just a couple of questions.

So I guess, were you capacity constrained in China?

And we -- just sort of talking about the sort of growth that you'll see once those facilities comes online.

And then just in the more developed markets, I mean, are you expecting to see any sort of uptick in academic demand from those -- for the Research Models business?

So on the last question, I would say we hope so.

We're focused heavily on that.

It is an area, Derik, where while we have large revenue on a percentage basis, it's relatively small certainly compared to pharma and biotech.

And it's an area, as the pricing has leveled between us and the competition, and I think our outreach has improved, that we have been gaining some progress.

And that's certainly plausible, particularly for U.S. and Europe.

And China, it's a great problem and opportunity and challenge in reality, so we're growing significantly fast in that business.

We don't break out the exact growth rate benefits, so I think it's our fastest growing business.

It has great margins, even though it's got probably lower prices, but it's lower cost structure as well.

Yes, we're pretty full, but we're keeping up with demand.

It -- revenue probably could be higher if we could have built and opened our new facility faster, but we didn't.

We've done it as quickly as humanly possible.

Actually, I just got back from China.

The spectacular facility, up to Charles River standards, it's as good as any of our facilities anywhere.

It's quite large.

It's quite close to Shanghai, but not in the middle of it, so cost structure will be lower.

Our ability to make daily deliveries will be there.

And yes, we should see nice growth in China, I'm sure.

I would hope for next year.

And if I can squeeze in a follow-up.

The -- on the Discovery businesses, you've -- you highlighted it was stable.

Can you talk a little bit more about that?

And then on -- are you still waiting for M&A additions in the Discovery space?

Yes.

So we're looking at M&A across pretty much all of our business segments, believe it or not.

And Discovery, I would say, is first among equals.

It's also -- is a relatively modest number.

Potential acquisitions and many of them are small.

So yes, yes, looking at -- talking to companies real time, but yes, we hope it's an area that we flesh out further through acquisition.

And Discovery business has just -- all of the metrics are positive.

Enhanced management team, enhanced sales team and methodology, more clients, more deals, some creative deals.

Agilux, which is our most recent acquisition, is crushing its acquisition plan.

The Early Discovery business, which is our big chemistry business, is stabilizing.

And the in vivo businesses, the oncology and CNS business have been performing well.

So the segment is becoming more important strategically, both with safety clients, as we said in the prepared remarks and vice versa and a segment of our business that we're going to focus on to enhance our capabilities, both from internal investment and M&A.

(Operator Instructions) And our next question comes from the line of Jack Meehan of Barclays.

I wanted to dig in a little bit more on the Discovery trends.

Obviously, revenue has been choppy, sort of stable, maybe that's better for the quarter.

Could you just comment on the work backlog you have?

And when do you think the performance can pivot higher and this can be a real growth driver?

Yes.

We would hope to see an uptick in that business next year.

And the piece, as I said earlier, that's sort of been holding the business back is the Early Discovery business, which had some very big pharmaceutical clients with some attractive and lucrative milestone deals where the milestones hit.

And once those rolled off, the year-over-year comparisons have been arduous.

So as we've annualized and lapped those and strengthened the business and signed a bunch of additional deals, we're quite optimistic about next year.

The rest of the portfolio -- and by the way, the only Discovery piece is the largest piece of the portfolio, so it has a disproportionate impact, but the rest of the portfolio is performing extremely well.

So it would help if Discovery would begin to contribute in more meaningful ways next year, without getting too deep into next year.

Our goals for that business, in addition to it being an important strategic tool for us, was to grow rapidly and to be a driver of our overall growth and to continue to grow significantly, both in that measure but also through M&A.

So we really feel like we have that business at a very strong jumping off point right now, and we look forward to an improvement.

Great.

And as a follow-up.

On the Safety Assessment side, I'd be curious if you could opine just on outsourcing and whether you're seeing -- has there been any change in the demand for pharma to outsource those services that you're seeing?

No, no.

The outsourcing demand, we probably say this every quarter, but I will say it again, is as good as we've seen it.

There's no evidence of anything, except more pharma companies, several of whom we are in conversations with, reducing infrastructure and outsourcing more work and actually some opportunities with some of them, with some outsourcing Discovery work as well.

There's just a consistently growing number of biotech companies that exist and who need our services.

And because of our resourcefulness and responsiveness, and in some measure because of our relationships with the venture folks, we just have a large number of those clients who are extremely well financed.

We reckon that there's still 3-plus years of cash in their bank accounts.

We never hear any concern about affordability.

So demand is extremely good.

We're doing very well against the competition.

And the business remains extremely strong.

And our next question comes from the line of Robert Jones with Goldman Sachs.

This is Nathan Rich on for Bob this morning.

On the RMS business, what are the biggest factors you guys are looking for to get margins back towards that high 20% target that you have?

And how much is capacity an issue for this business?

And just wondering if we should expect limited upside to margins until you close the Maryland facility next year.

Yes.

So I think you'll see on a year-to-date basis or for this year that operating margin is well off, still in the high-20s.

So we don't overreact to anything here.

I'd say our capacity utilization in our Research Model business has forever been really tight and well managed.

And we periodically have a situation like we have now where we're slightly out of sync.

We had it a few years ago with a facility in Michigan.

This facility that we're closing is relatively small, poorly utilized.

It's built for the government for an NCI contract, which was rolled off.

We're going to keep the revenue that we would have gotten from that facility without the drag.

So that should help the margin.

We're always looking at capacity utilization.

We're always looking at price.

We're always doing what we can to sell more specialty models, so that we have a better mix.

All of those things are in play.

We have this big driver from China and our service offerings driving that business.

And by the way, the Service businesses have extremely good operating margins.

The operating margins are not dilutive.

In fact, they're beneficial.

So we're hopeful that we will deliver high 20% operating margins in that business on a forward-going basis, and that we will continue to do what's necessary to run it efficiently, both to be able to respond to demand or respond when the demand is insufficient.

We're certainly logarithmically stronger than the competition and larger and more proximate than the competition.

So we'll maximize that business given the realities of the sheer numbers of research models having declined probably over the last 3 decades.

It's not a new phenomenon.

And just to put the comments that Jim started with into context.

If you look at the first 9 months of this year, year-to-date, RMS margin is 27.7%, so well within the expectations.

This is more about making sure that we can maintain or grow that for the future.

And our final question comes from the line of Ricky Goldwasser of Morgan Stanley.

So a couple of questions here.

Firstly, Jim, on acquisition, to your point, expect to continue and be acquisitive and part of the growth in your budget is based on that.

But to your point, you're also of sizable scale now.

So how are you thinking of acquisition?

What types -- how big of an acquisition should we expect?

And how should we think about your leverage and potential opportunities?

So deal flow is good, Ricky.

So there's lots of things we are seeing.

And as I said earlier, literally across every segment -- across every piece of the segment.

So there's potential in Discovery.

There may be in Safety.

There may be in RMS.

There may be in Biologics.

I mean, we -- the whole shooting match, which is actually pretty exciting.

They come in a range of sizes.

And I would say that many of them are on the small side.

And we -- while they're just as challenging to do from a due diligence point of view and sometimes worse, we do them when they strategically are scientifically powerful, like we did a very small deal, I think, last quarter, Brains On-Line, which added some CNS testing capabilities that we didn't have and that no one else in the world has.

So we'll do those as they come up.

I would say that at our size, if we could write the script, which we can a little bit, depending on what's available, we love the size of the WIL deal.

So it's a $0.25 billion in revenue.

It moves the needle.

It's -- it enhances our clients' breadth.

It enhances our geographic breadth in service breadth, and it just matters, plus it's been wildly accretive.

And it wasn't cheap but it was affordable.

It was $600 million and we could finance it ourselves.

So we like to keep our leverage below 3 turns.

We have had that creep up to, I think, 3, 4 is as high as it got.

But we'd actually let it get up to 3.5 or maybe a little bit higher temporarily to do a larger deal with the knowledge, that with the additional free cash flows and our historical free cash flows, that we could get that down below 3 turns.

So there are no giant deals, if that's sort of what you're asking.

I'm not sure we would want one if there was one available.

But there's nothing really, really large that we are either looking for or exists.

So even the deals are on the larger side -- size would be more like WIL.

And then there would -- then they would be smaller than that.

So as we look at our portfolio and we don't really control when they come to market, although sometimes we can, when we think about the valuation models, so we've run out and then if we feel that there are deals that are out there that are affordable, that would be accretive, that would help our top line and bottom line and, most importantly, enhance the portfolio in ways to make us competitively stronger than we are now, and that's really the only reason we should do an acquisition is to enhance the portfolio and not just simply to be bigger.

I do think we have an extremely professional, reasonably large, full-time integration team now that allows us to do a much better job on the integration, which, obviously, ensures the smooth complementary relationship between the buyer and the seller, but also our ability to deliver on the synergies that we often have and to deliver the accretion that we have.

So we feel terribly good about the universe and our affordability and the deal flow.

And we will be disappointed.

I was going to say surprised.

I don't know if I'd be surprised.

We'll be disappointed if we don't get the deals done in '18 just given the deal flow.

Okay.

And then one question on China.

We're hearing from some players in the pharmaceutical chain about just kind of like regulatory changes on the product side.

Are you seeing any change?

Is there any indication that it could change on the regulatory environment on your end?

Not really.

We're seeing China begin to protect its residents from the massive pollution there.

So you see some more environmental things that have added a little bit of costs on relocations.

But besides that, nothing that would hinder our business.

We have similar regulatory oversight bodies that kind of oversee quality of animal care and quality of our production facility.

And I was just there, as I said, last week and it's kind of like going to our facilities anywhere else in the world.

So no, we're not seeing anything surprising or unusual noise or anything rumor to be.

And our clients, our Chinese -- our clients for our Chinese research model facility are Chinese companies, so we're primarily -- not eternally, we're entirely supporting that marketplace.

And at this time, there are no further questions.

Thank you for joining us this morning for our third quarter earnings conference call.

We look forward to speaking with you again soon.

This concludes the conference call.

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