Charles River Laboratories International Inc

NYSE:CRL

Earnings Call Transcript 2018-Q2

[Operator]

Ladies and gentlemen, thank you for standing by, and welcome to the Charles River Laboratories Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. And as a reminder, this conference is being recorded.

I would now like to turn the conference over to our host, Todd Spencer, Corporate Vice President of Investor Relations. Please go ahead.

[Todd Spencer, Charles River Laboratories International, Inc.]

Thank you. Good morning and welcome to the Charles River Laboratories Second Quarter 2018 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 results for the second quarter of 2018.

Following the presentation, they will respond to questions. There's a slide presentation associated with today's remarks, which is posted on the Investor Relations section of our website at ir.criver.com. A replay of this call will be available beginning at noon today and can be accessed by calling 1-800-475-6701. The international access number is 320-365-3844. The access code in either case is 451293. The replay will be available through August 22. You may also access an archived version of the webcast on our Investor Relations website.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 make about future expectations, plans and prospects for the company constitute forward-looking statements for purposes of the Safe Harbor provisions under the Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by any forward-looking statements as a result of the various important factors, including but not limited to, those discussed in our Annual Report on Form 10-K, which was filed on February 13, 2018, 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.

[James C. Foster, Charles River Laboratories International, Inc.]

Good morning. We're very pleased with the company's performance and the continued execution of our growth strategy. We believe our growth is indicative of an extremely healthy market environment and our position as the premier early-stage CRO with the unique ability to support our clients from target discovery through nonclinical development. Biotech funding from the capital markets is on track to reach the second highest level on record.

We believe that our clients, both large and small, are intensifying investments in their pipelines, which is creating new business opportunities for Charles River. The time is now to capitalize on these opportunities and we believe that it is incumbent upon us to continue to invest in our portfolio, our people and our infrastructure to enhance the value that we provide to our clients and to our shareholders. The investments that we have already made to support robust client demand are generating the intended benefits, resulting in sequential improvement in the second quarter organic revenue growth rate and operating margin. We are optimistic that the progress we have made, and the favorable market conditions will continue in 2018 and beyond. This is reflected in our expectations for higher revenue growth, earnings per share, and free cash flow this year.

Let me begin by giving you the highlights of our second quarter performance. We reported revenue of $585.3 million, a 24.8% increase over last year. Foreign exchange benefited revenue growth by 2.6%, and the acquisitions of MPI Research, Brains On-Line and KWS BioTest contributed 15.1%. The organic revenue growth rate of 7.1% improved from the first quarter level, reflecting sequential improvement in both Manufacturing and RMS segments. The DSA segment continued to perform quite well, reporting high single-digit organic growth. Revenue growth was broad across our spectrum of clients, with both biotech and global biopharma clients contributing substantially to the increase as well as academic institutions.

As anticipated, the operating margin increased by 190 basis points sequentially to 18.7%. The sequential improvement was primarily driven by the DSA and Manufacturing segments. On a year-over-year basis, the operating margin declined by 130 basis points as we continue to add personnel and capacity to accommodate increasing client demand. The study mix in the Safety Assessment business, while favorable to the first quarter, also continued to be a headwind when compared to the prior year.

Earnings per share were $1.62 in the second quarter, an increase of 26% from $1.29 in the second quarter of last year. The significant increase was due to a combination of venture capital investment gains, the contribution from the MPI acquisition, and a lower tax rate. Venture capital investment gains were $0.17 per share in the second quarter of 2018, compared to $0.03 last year, and were the primary driver of the EPS outperformance versus our prior outlook.

Based on our second quarter performance and our outlook for the remainder of the year, we believe that the pace of demand will accelerate in 2018. As a result, we are increasing our revenue growth guidance to 7% to 8% on an organic basis, 130 basis point improvement from our prior outlook, and to 19% to 21% on a reported basis.

We are also increasing our non-GAAP earnings per share guidance by $0.08 at the midpoint to $5.85 to $6, primarily reflecting better than expected gains from venture capital investments. We are pleased to be in a position to achieve low double-digit earnings growth this year while continuing to invest in our people, our infrastructure and technology in order to accommodate increasing client demand.

I'd like to provide you with details on second quarter segment performance beginning with the DSA segment. DSA segment revenues were $346.4 million in the second quarter, a 7.3% increase on an organic basis over the second quarter of 2017. Acquisitions contributed 28.1% to DSA reported revenue growth, while MPI exceeding our expectations in the first quarter as part of the Charles River family.

We continue to benefit from strong client demand for our Discovery and Safety Assessment services, which we believe is a testament to the strength of the market environment and our premier, early-stage portfolio that enables clients to work with one CRO from target identification through IND filing. We believe these factors will lead to high single-digit organic revenue growth for the DSA segment in 2018.

The performance of the Discovery business strengthened in the second quarter, and we remain very optimistic about its prospects this year. The Early Discovery business recently delivered its 79th development candidate to a client, enhancing our reputation for scientific expertise in the discovery of new molecules. We believe this is driving demand for our services, especially with biotech clients. As a result of our track record and our ongoing efforts to create a more cohesive discovery offering, client interest was exceptionally strong across our service areas, particularly for integrated drug discovery programs.

Because many of our biotech clients are virtual or have limited internal capabilities, they rely on our early stage scientific expertise, often beginning with the target identification capabilities of our Early Discovery business and encompassing multiple DSA sites and services as the programs advance. As I mentioned last quarter, more than half of the integrated programs span multiple Discovery sites, and many are progressing into our Safety Assessment business. 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 a cost-effectiveness perspective.

Our In Vivo Discovery business continued to perform very well, particularly in both oncology and bioanalytical services. Our clients' ability to work with a single-source partner to support the discovery of their novel cancer therapeutics, coupled with the significant investment in this area of drug research, is driving demand for our oncology capabilities.

Demand for our comprehensive suite of large and small molecule bioanalytical services, which was strengthened by our 2016 acquisition of Agilux, also continues to increase. Bioanalysis is an emerging area of outsourcing driven by the complexity of the science and increasing costs, and we believe that we are well-positioned to accommodate our clients' nonclinical testing needs.

The Safety Assessment business reported another good quarter with MPI performing very well. The acquisition, which was completed early in the second quarter, has achieved the goals set forth in the first 120 days of the integration process and is on track to deliver $13 million to $16 million of operational synergies by the end of 2019. Capacity utilization at our legacy sites remained at near-optimal levels and utilization at MPI increased due to the benefits from joining a synergistic parent with access to a broader biopharmaceutical client base. There is available capacity at MPI, which was one of the tenets of the acquisition, and we intend to continue to bring small tranches of capacity online across our global Safety Assessment network to accommodate robust client demand.

By focusing on expanding our global scale through acquisitions like MPI and WIL, enhancing our scientific expertise, improving our operating efficiency, and creating a more seamless and flexible client experience, we are positioned exceptionally well to provide support which our clients require to expedite their drug research efforts. Our extensive capabilities are especially important now when global biopharma companies are increasing their reliance on CROs, and small and midsize companies, which have always relied on external resources, are benefiting from a robust funding environment. Our outlook for the Safety Assessment business is predicated on these trends, as well as robust booking and backlog activity during the second quarter. These trends give us confidence that Safety Assessment revenue growth will accelerate in the second half of the year.

The DSA operating margin declined 200 basis points year-over-year in the second quarter to 21.5%, but on a sequential basis, rebounded by 290 basis points as we previously anticipated. The primary factor driving the year-over-year margin decline was the unfavorable study mix as well as a 60 basis point headwind from foreign exchange.

As we discussed in May, a mix of long-term and short-term studies fluctuates from quarter to quarter and continued to be weighted towards long-term projects in the second quarter. The study mix improved sequentially as many of the long-term studies progressed beyond the initial start-up phase. This was reflected in the 290 basis points sequential improvement in the DSA operating margin. Study mix is largely a timing issue, reinforcing that our business is not linear. We expect the DSA operating margin to improve further in the second half of the year as the mix returns to more optimal levels.

For the RMS segment, revenue was $130.4 million, an increase of 2% on an organic basis over the second quarter of 2017. The RMS growth rate improved for a second consecutive quarter, driven by China and the Research Models, Services businesses. For Research Models, China delivered another outstanding performance. Growth accelerated as the new Shanghai facility continued to ramp up to full capacity, and we won new business in China because of our expanded footprint and high-quality models. With year-to-date revenue of slightly less than 10% of our total RMS revenue, China is becoming a larger contributor to the RMS segment's growth rate.

Broad-based demand across the GEMS, RADS, and Insourcing Solutions services businesses also contributed to RMS revenue growth in the quarter. We believe that clients are choosing to use our capabilities, or in the case of Insourcing Solutions, our people, in lieu of their own to enhance their operational efficiency and leverage our scientific expertise. Our clients' use of innovative technologies like CRISPR to create genetically-modified models faster and more cost-effectively, also continue to drive increased demand for our GEMS business.

Insourcing Solutions, or IS, continues to win new business as clients adopt flexible solutions for their vivarium management and research needs. We have been awarded new contracts from academic and government institutions, which have historically been IS's primary client base, and are attracting new biopharmaceutical clients because of the flexible models under which they can opt to work with us.

The RMS operating margin of 26.8% declined by 60 basis points from the second quarter of last year, primarily driven by the Services business and MPI intercompany sales. Approximately half of the decline was attributable to sales to MPI that are now intercompany transactions with the revenue and profitability recognized in the DSA segment.

As we have mentioned in the past, the DSA segment is the largest client of our Research Models business by a wide margin. Models used by the DSA segment represented more than 5% of our total global Research Model volume to date, which was more than twice the volume of our largest RMS client. This underscores the importance of our Research Model business. Not only are research models essential, regulatory required, scientific tools, but the RMS business is a vital component of our portfolio that enables us to perform high-quality, early-stage research for our clients.

Revenue for the Manufacturing Support segment was $108.5 million, a 13.1% increase on an organic basis over the second quarter of last year. As anticipated, demand in both Microbial Solutions and Biologics businesses rebounded in the second quarter with each business reporting organic growth above the 10% level. The Avian business also had another good quarter. Microbial Solutions reported a robust second quarter, driven by sales of Endosafe cartridges, core reagents, and Accugenix microbial identification services. We also sold significantly more Endosafe PTS and MCS instruments compared to the second quarter of 2017, which in turn will drive greater demand for cartridges.

As the only provider who can offer a comprehensive solution for rapid quality-control testing of both sterile and non-sterile biopharmaceutical and consumer products, we are in a unique position to support our clients' rapid testing needs. We continue to invest in technology and product enhancements for the Microbial Solutions business to enhance the functionality of our rapid testing platform and drive greater client adoption of our products and services.

The performance of the Biologics business improved significantly in the second quarter, with organic revenue growth above the 10% level on a year-over-year basis. As we discussed in May, sample volumes were seasonably softer in the first quarter after the holiday period, but improved in the second quarter as expected. The number of biologic and biosimilar drugs in development has been growing at double-digit rates, which continues to drive the demand for our services and the need for new capacity. We continue to make progress with our plans to open a new facility in Pennsylvania, as well as other small expansions globally. Once the new Pennsylvania site opens, we intend to transition certain laboratory operations to the new site at a measured pace, a process which is expected to continue through most of 2019.

There will be modest pressure on the Manufacturing segment's operating margin through the transition process, but we believe capacity expansion is critical to accommodate client demand, which is expected to be robust for the foreseeable future. The Manufacturing segment's operating margin improved sequentially in the second quarter as expected, by 170 basis points to 33.6%. This increase was driven by volume leverage after a slower start to the year in both the Biologics and Microbial Solutions businesses. On a year-over-year basis, the operating margin declined by 60 basis points, primarily the result of higher costs associated with ongoing capacity expansions in the Biologics business.

We believe this is an unprecedented time in our markets and for our company. The R&D model for the biopharmaceutical industry is evolving. Large biopharma companies are increasingly choosing to externalize research to improve their pipeline productivity, efficiency, and speed to market. They're doing so by sourcing molecules from and partnering with biotechs and academia to drive innovation and increasing their reliance on outsourcing, which is driving increased demand for our early-stage services.

The biotech industry is much larger and better funded today due to broad-based investment in the sector from large pharma partners, capital markets and venture capital firms. With ample cash on hand and limited or no internal infrastructure, biotech companies are heavily investing in their pipeline and outsourcing this drug research to early-stage CRO partners like us.

Through the end of this year, our revenue will have nearly doubled since 2013, including acquisitions, and our employee base has increased by approximately 75% over the last five years. During this time, we have made disciplined investments to add modest amounts of capacity and hire talented personnel to meet the needs of our clients and accommodate increasing demand. We expect these investments to continue as we anticipate doubling the size of the company again in the next five years.

As we continue to grow, we must ensure that our business can be flexibly scaled to respond to the rapidly evolving market environment, and that we enhance the speed and responsiveness of our interactions, both internally and with clients. To facilitate this, we adopted a new operating model to create a more agile organization that accelerates the decision-making process by empowering our business unit leaders and giving them the tools and resources they need to respond to business opportunities and challenges with minimal constraint. We have more closely aligned critical support functions with the operations they support and are encouraging closer working relationships within and across our businesses. This is intended to build a more client-centric organization with fewer layers and driving the decision-making to the point of impact.

During the implementation of this new operating model, it became clear that in order to further streamline the decision-making process and the organizational structure, we needed to eliminate the role of Chief Operating Officer, and Davide Molho, President and COO, has left the company to pursue other interests. I'd like to thank Davide for his significant contributions to Charles River's growth and success during his time with the company and wish him the best in the next stage of his career.

I'm confident that a more streamlined organization will empower our businesses and make us a more nimble and responsive company, further distinguishing ourselves from the competition. We must also continue to invest in a number of areas to support the anticipated growth including our portfolio through internal initiatives and strategic acquisitions, our scientific expertise, our technology platforms, and our people. Technology will continue to be a critical differentiator to support faster and more seamless interactions with our clients. We are focusing on projects to enhance our client-facing platforms to facilitate the ease with which clients can work across our businesses and gain access to real-time data as well as projects to strengthen cybersecurity. We expect to continue to invest meaningfully in information technology to further enhance our digital platform.

To support the robust demand for our products and services, we are also hiring significantly across multiple geographies. In a competitive job market, we continue to closely monitor the markets in which we operate and are focused on maintaining our position as an employer of choice. In order to maintain a competitive compensation structure, we implemented a program to increase the hourly wages of employees in certain businesses, predominantly in North America, the UK, and China. The majority of these wage adjustments were effective as of July 1.

This program will reduce earnings per share by nearly $0.10 in the second half of the year, which has been factored into our current guidance. We believe this adjustment to our compensation structure will enable us to maintain our employee recruiting and retention standards within targeted levels, including voluntary turnover at our current level of less than 10%. We also believe that this is simply the right thing to do for our employees, who provide dedicated service to Charles River and our clients.

It's also imperative for us to continue to enhance the client experience. The fact that we worked on 80% of the FDA-approved drugs in 2017 is testament to the fact that our clients view Charles River as the go-to, early-stage CRO, a position we do not take for granted. To maintain and enhance this position, we intend to provide our clients with the fastest speed and responsiveness in our working relationships; to build the best-in-class digital enterprise that will provide a more seamless interface; to drive efficiencies that will reduce costs for us and our clients; and to continue to invest in strategic acquisitions to expand our unique portfolio.

The pipeline of acquisition candidates across our portfolio remains robust. And M&A is our preferred use of capital. Our goal will be to balance investing in the future organization, with achievement of our long-term target of a consolidated operating margin of 20% or better, while driving higher revenue, earnings per share and 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, David will give you additional details on our second quarter results and updated 2018 guidance.

[David R. Smith, Charles River Laboratories International, Inc.]

Okay. Thank you, Jim; and good morning. Now, 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; costs related primarily to our global efficiency initiatives; the divestiture of CDMO business in 2017; and certain other items. Many of my comments will also refer to organic revenue growth, which excludes the impact of acquisitions, the CDMO divestiture, and the impact of foreign currency translation.

We are pleased with our results for the second quarter, which included strong revenue, earnings per share, and free cash flow growth. Second quarter earnings per share were $1.62, an increase of 25.6% year-over-year and outperforming our expectations. Along with the strong revenue growth and higher operating income due in part to the contributions from the MPI acquisition, earnings per share were aided by venture capital investment gains of $0.17 per share compared to $0.03 in the second quarter of last year, and a lower tax rate due primarily to modest benefit from U.S. tax reform.

The outperformance to our prior outlook was driven primarily by the venture capital investment gains. Our initial guidance for 2018 included an estimate of venture capital investment gains of $0.14. VC investment gains for the second quarter were $0.17 and total $0.26 year-to-date. The year-to-date gain was substantially higher than our initial full-year estimate. And because we do not forecast the performance of these funds beyond our annual expected return, we have not included any gains in the second half of the year. As a reminder, given the inherent difficulty of forecasting VC gains or potential losses, we intend to eliminate the VC investment performance from our guidance beginning in 2019.

Unallocated corporate costs were $36.6 million or 6.2% of revenue, which is below last year's level of 6.6% and our full-year guidance. At 6.8% year-to-date, we continue to expect non-GAAP unallocated corporate costs to be slightly below 7% of total revenue in 2018. We continue to invest in a more scalable infrastructure, but intend to manage the future investments to support our growing business while keeping corporate costs within a targeted range of 7% or lower.

Net interest expense was $16.7 million in the second quarter, an increase of $9.5 million year-over-year, and $9 million sequentially, primarily reflecting increased debt levels to fund the MPI acquisition and higher borrowing costs associated with the issuance of $500 million of fixed rate senior notes in April. For the year, we now expect net interest expense of $57 million to $60 million, an increase of $1.5 million from our prior outlook due to the potential for additional interest rate increases by the federal reserve this year.

Our second quarter tax rate was 23.6%, a 580 basis points decline from the second quarter of last year. The year-over-year decrease was largely the result of the benefit from U.S. tax reform and the tax impact of operational efficiency initiatives. For the full year, we continue to expect our tax rate to be in a range of 23.5% to 25% on a non-GAAP basis, which assumes a tax rate in the mid-20% range for the remaining quarters of 2018.

Turning to cash flow, the second quarter was very strong. Free cash flow increased to $102.7 million, an increase of 14% from $90.1 million last year. The primary reason for the increase was our focus on working capital management. For the year, we have increased our free cash flow outlook by $20 million to a range of $260 million to $270 million, reflecting the second quarter improvement in working capital and our expectations for the remainder of the year. CapEx increased by $5.2 million year-over-year to $21.2 million in the second quarter. We remain on track to meet our full-year outlook of $120 million.

Strategic acquisitions remain our top priority for capital allocation, followed by debt repayment. At the end of the quarter, we had an outstanding debt balance of $1.82 billion. On a pro forma basis, our gross leverage ratio was 3.05 times, and our net leverage ratio was 2.7 times. Absent any acquisitions, our goal will be to reduce the gross leverage ratio below 3 times by the end of the year, which would result in a 25 basis point reduction on the interest rate for the variable rate debt under our credit agreement. We continuously evaluate our capital priorities and intend to deploy capital to the areas that we believe will generate the greatest returns.

Year-to-date, we have not repurchased any shares and do not intend to in 2018 at this time. In the absence of repurchases, we expect to exit 2018 with a year-end diluted share count of approximately 49.5 million shares. And the share dilution is expected to reduce earnings per share by slightly more than $0.05 compared to 2017.

With respect to 2018 guidance, we increased our revenue growth outlook to a range of 19% to 21% on a reported basis and to 7% to 8% on an organic basis, reflecting strong demand trends and a slightly higher contribution from acquisitions, primarily MPI. Foreign exchange is expected to be less favorable as a result of the weakening of the U.S. dollar. We now expect an approximate 2% benefit from FX for the year compared to our prior outlook of a 3% benefit. This will create a slight headwind to full-year earnings per share versus our prior outlook.

We are seeing strong trends across most of our businesses and are slightly raising our expectations for segment revenue growth. We now expect organic revenue growth in the high-single digits for the DSA segment, low-double digits for the Manufacturing segment, and low-single digits for the RMS segment. We are also increasing our earnings guidance by $0.08 for the full year, with non-GAAP earnings per share expected to be in the range of $5.85 to $6. The increase is primarily driven by the better than expected venture capital investment gain. The favorable earnings outlook also reflects our plans to make the necessary investments in our business to accommodate current demand and to position the company for future growth.

As Jim mentioned, the adjustments to our compensation structure to support our employee recruiting and retention efforts and maintain our position as an employer of choice will reduce earnings by nearly $0.10 per share in the second half of 2018. A detailed summary of our financial guidance can be found on slide 14.

For the third quarter, we expect the reported revenue growth rate to be similar to the second quarter level, or above 20%. On an organic basis, we expect the third quarter growth rate to improve from the second quarter rate. This expectation is based in part on strong bookings and backlog in the DSA segment, which we believe indicate that demand trends are intensifying in our business. We expect mid-single-digit growth in non-GAAP earnings per share when compared to the third quarter 2017 level of $1.30.

As I previously mentioned, we have not included an estimate for venture capital investment performance in our outlook for the third quarter or the remainder of the year, which creates a headwind of approximately $0.07 compared to the third quarter of 2017. In addition, incremental personnel costs related to the adjustment in our compensation structure will pressure the operating margin.

In conclusion, we are pleased with our second quarter performance, we are confident about the prospects of the third quarter, and are on track to achieve our full-year financial outlook that includes higher organic revenue growth, non-GAAP earnings per share growth in the low-double digit, and an increase in free cash flow. We continue to take a disciplined approach to the manner in which we are growing the business by evaluating the needs of today and investing to accommodate the anticipated growth of tomorrow to enhance our position as the premier early-stage CRO. Thank you.

[Todd Spencer, Charles River Laboratories International, Inc.]

That concludes our comments. Operator, we will now take questions.

[Operator]

Thank you. Our first question comes from the line of Tycho Peterson, JPMorgan. Please go ahead.

[Tycho W. Peterson, JPMorgan Securities LLC]

Hey, thanks. Jim, I want to start with maybe the drivers of greater than expected MPI strength. Can you talk about how much of this was legacy impact, pipeline versus your legacy Charles River clients adding work? And then, if I could ask one follow-up. On the study mix issues, how long do you expect this to persist and weigh on margins? Thanks.

[James C. Foster, Charles River Laboratories International, Inc.]

The study mix is difficult to predict but follows a typical pattern. So, you want a mix of long and short-term studies. And you don't typically have long-term studies unless you have the short ones. So, you sort of have the life cycle issue. You have higher start-up costs for the long-term studies, which we talked about a lot on the last quarter call.

We're working through those. We're in a more standard phase of the long-term studies, where the margins are actually comparable to some of the short-term works. So, given the backlog and bookings and mix shift, which we saw from quarter one to quarter two, and we are guiding you for second half of the year, we anticipate strong half of the year, both top line and bottom line in DSA, and obviously, in the SA part of that as well.

Not sure exactly what your MPI comment was.

[Tycho W. Peterson, JPMorgan Securities LLC]

Yeah, just on the strength. How much was legacy MPI pipeline versus Charles River customers adding work?

[James C. Foster, Charles River Laboratories International, Inc.]

Yeah. I mean, it's both. MPI performed extremely strongly, as well or better than we had anticipated. Maintaining clients, delivering the margins, having some of their legacy clients be open and begin to utilize Charles River locations. And the inverse, Charles River clients who have historically not been MPI clients were, of course, where we have space, beginning to utilize that. So, we're extremely pleased with the integration process and the client receptivity from both sides of the house.

[Tycho W. Peterson, JPMorgan Securities LLC]

Okay. Thank you.

[James C. Foster, Charles River Laboratories International, Inc.]

Sure.

[Operator]

Our next question is from David Windley, Jefferies. Please go ahead.

[David Howard Windley, Jefferies LLC]

Hi. Thanks for taking my questions. Good morning. Jim, a lot of emphasis on investment in the platform this morning in your comments. I was hoping you could elaborate on, say, what the trigger was for this. Was this a long evaluation in terms of looking at what needed to be done? And maybe a little bit more elaboration on how you're streamlining the senior management structure in light of – I think you just promoted Davide in February of this year. So, just trying to understand how this evaluation has progressed and brought you to this point. Thanks.

[James C. Foster, Charles River Laboratories International, Inc.]

Sure. So, significant investment in people and space, and meaningful investments in IT, and that's just a function of the scale and size and growth rate of the company. Labor is our principal resource, competitive advantage and always the rate-limiting factor. So, you need people in advance of the work – not too far in advance, that hurts your margins. But you can't sort of hurry up and hire them once you have the work, because it's some months to many months of training.

So, given the competitive nature of the markets that we're in, and given our need to hire hundreds and hundreds of people, we made some adjustments to base pay, which we're sure will bear fruit. We're going to continue to invest meaningfully in IT, principally for clients: Enhance client interface; use data better; and of course, the cybersecurity, which keeps everybody with one eye open while they're sleeping. And we want to keep as far ahead of that process as possible.

On the organizational structure, we made a significant move in the last couple of months to more decentralize the way we run the business, so that we really have business leaders and GMs who feel as if and have the ability to run their own businesses and make decisions quickly and decisively. And so, we've married some of the staff functions, which we're reporting in corporately with those operating folks, so they have their own teams. And we're already quite confident that we're beginning to pick up the pace of decision-making and have that decision-making closest to where the issues arise.

With regard to the COO position and Davide, that's merely a larger commentary and reflection of the organizational efficiency that we're driving for. And while that was a relatively recent move, as you've indicated, it's also – it was a novel move. So, a 70-year-old company that never had a COO. And what we found was that, that layer was not beneficial in terms of the speed with which we're moving, and to some extent, sort of counterproductive to that. So, in that context, we eliminated that role. So, the organization feels more nimble. We have lots of really smart people. And the less top-down decisions are made, and the more, as I said before, closer to the decisions as possible, I think the better off we are.

[David Howard Windley, Jefferies LLC]

Got it. Thank you. I appreciate the answers.

[James C. Foster, Charles River Laboratories International, Inc.]

Sure.

[Operator]

Our next question is from John Kreger, William Blair. Please go ahead.

[John C. Kreger, William Blair & Co. LLC]

Hi. Thanks very much. Jim, just to follow on, on Dave's question. Given the big demand opportunities that you talked about, has your thinking changed at all in terms of what businesses you want to be in? Are you sort of expanding the boundaries of where you see Charles River having a competitive edge? Thanks.

[James C. Foster, Charles River Laboratories International, Inc.]

So, I guess you're talking about both organic investment and M&A. And I would say, not. We intend to stay in the non-clinical arena. As we, I think, posted in our first quarter call, we have about a $15 billion market, if you aggregate all of our businesses growing at sort of mid-single digits. So, it's a big market, one where we have leading market shares in virtually everything we do and opportunities to enhance those shares. We are investing meaningfully in organic growth in places where that's the best way to grow, but – well, no buts.

Additionally, the M&A pipeline is quite diverse and quite robust. There's a lot of assets out there. As always, we have multiple conversations going on now. I would say that we have increasingly less strategic competitors as we look at some of these and perhaps more financial sponsors looking at them. While sponsors often pay up, they should never have both the top or bottom line synergies that we have.

So, we have a vision and a view towards how we will continue to expand and enhance our portfolio, not just to be bigger, but to be more responsive partner for big pharma; and particularly, for biotech, and all the areas that we're in, particularly, Discovery, maybe Safety, definitely China, more large molecule-related services, probably more laboratory-based services. So, I would say that fill in some very subtle areas where we are under scale and expand some areas where we have significant scale but need to be larger.

And I continue to feel that our portfolio is the principal competitive advantage we have both in terms of the quality of the science, but also the depth and breadth of the activities that we are very good at, and solving a lot of problems for clients, if you look at most of biotech, who will never build this sort of capacity. I can say that with authority. They just will never do it. It makes no sense for them. And the ability for them to do it on a cost-effective basis quickly outside to get great science is really the role that we are increasingly playing.

[John C. Kreger, William Blair & Co. LLC]

Thanks much.

[James C. Foster, Charles River Laboratories International, Inc.]

Sure.

[Operator]

We have a question from the line of Ricky Goldwasser, Morgan Stanley. Please go ahead.

[Mark Rosenblum, Morgan Stanley & Co. LLC]

Hi. It's Mark Rosenblum on for Ricky. I just had a question on the digital interface that you guys mentioned in your prepared remarks. Could you just give some examples or some context of what kind of services you're building out for clients?

[James C. Foster, Charles River Laboratories International, Inc.]

So, it's a whole host of things. It's everything from online ordering to really using our data better to design studies – both predict the end points, design studies, and in a perfect world have some linkages with the clinical folks, so that you design clinical studies and pull that all the way back to pre-clinical.

Probably most importantly though is availability of data on essentially a real-time basis for our clients that they can access themselves. So, if you think of how our business is evolving literally with thousands of biotech clients, the scalability of that model is very much dependent on some additional people, which we've added. We added a whole group of what we call alliance managers this year to interface with some of the smaller clients and shepherd them across our geographic portfolio.

But the real magic there will be for clients to feel that they have control over the day, that they're knowledgeable about it, that they can look at it at their leisure realtime. And if they have a question or a problem, or want to, or need to talk to somebody, they can do that.

So, data, as you hear a lot from the clinical folks, is a really important part of this business. Our ability to use data that we have from thousands of studies in a more predictive way, I think, will be powerful if we're successful in that. But certainly, having clients have access to their own data is not optional, it's definitely essential. And we are building that process out as we speak.

[Mark Rosenblum, Morgan Stanley & Co. LLC]

Got it. And just a follow up, do you have a sense of timeline on how long it will take to build these interfaces?

[James C. Foster, Charles River Laboratories International, Inc.]

It's going to be sort of continual. Aspects of it will be beta-tested, then rolled out, and then added to continuously. So, I'd say, over the next couple of years, we will make meaningful moves in these areas. That should enhance the people that we have, and we hope, obviously, distinguish us from the competition.

[Mark Rosenblum, Morgan Stanley & Co. LLC]

Okay. Thank you.

[James C. Foster, Charles River Laboratories International, Inc.]

Sure.

[Operator]

We have a question from the line of Derik de Bruin, Bank of America. Please go ahead.

[Juan E. Avendano, Bank of America Merrill Lynch]

Hi. This is Juan Avendano on behalf of Derik. Congratulations on the quarter. Would you be willing to break out the organic revenue growth performance and DSA between Discovery and Safety Assessment? And also, what's the breakout embedded in your high-single-digit guidance for DSA in 2018?

[James C. Foster, Charles River Laboratories International, Inc.]

Yeah, so, we would always love to be responsive to your questions, but we're just not going to do that. It's important that we all look at that segment as one. We want clients to start with us as early as possible. And if their drug continues to look promising, to work with us in the discovery phase, and as we move into the pharmacology phase, and into the GLP tox phase. So, the holistic view by both our shareholders, and our clients, and ourselves is pretty important. And we made some operational changes last quarter with the way we operate this. And we have a senior operating person overseeing both businesses: A senior finance person; senior IT person; HR, etcetera.

So, we would like you to gray the demarcation, but suffice it to say, that we're happy with the growth rate in the second quarter. We think that will intensify in the back half of the year, so we will be happier. We're doing a very good job taking share. And we have 20% of folks who use Discovery, also use Safety. And we have about half of the clients in Discovery, who do integrated studies with us, work across multiple sites. So, we're seeing the expansion and the utilization of the portfolio exactly the way we had hoped when we bought all of these businesses.

[Juan E. Avendano, Bank of America Merrill Lynch]

Okay. Thank you. And if I may have a follow-up. The study mix improved sequentially, but it was still a headwind to DSA operating margin. Besides the mix of long-term and short-term studies, what are the trends that you're seeing across general toxicology and specialty toxicology studies? Is this also contributing to the unfavorable study mix that you're seeing?

[James C. Foster, Charles River Laboratories International, Inc.]

No, I mean, it's mostly mix, very much mix. And it is and will work itself through the year. And as I said earlier, we want a healthy mix of both short and long-term studies, so we do have that and will continue to have that. So, no, nothing more than that.

[Juan E. Avendano, Bank of America Merrill Lynch]

Thank you.

[Operator]

Our next question comes from the line of Ross Muken, Evercore. Please go ahead.

[Ross Muken, Evercore Group LLC]

Good morning guys, and congrats. So, on Manufacturing, maybe just tease out a little bit sort of the sequential improvement in the biologics business. Seems like activity levels were up there, which I'm sure some of it's seasonality. That seems strong. In Endosafe and Avian, it seems like those are still going quite well. I guess, how are you still thinking about those for the rest of the year?

[James C. Foster, Charles River Laboratories International, Inc.]

So, biologics often has a slow first quarter. We don't know why; just is. Seems the volume tends to be a little bit lighter as it definitely was in the first quarter. And we guided you all to a strengthening in the second quarter, which we both anticipated and achieved. And we anticipate that, that business will, from a volume and demand point of view, have a good year.

There's just a plethora of large molecules, and at least the beginnings of biosimilar drugs out there. So, building out a lot of space, hiring a lot of people, highly competitive space. It's definitely our most competitive space, and yet, growth rate is quite robust. And we think this is sustainable for years.

Microbial had a really strong quarter, as it usually does, but a really strong quarter across most of the parts and pieces. As we said in the prepared remarks, more instruments sold. And of course, it's all about cartridge sales, so the razorblade sales. And we should continue to see that continue for the balance of the year.

And our little Avian business, which had kind of a not wonderful 2017 due to some client issues, totally dislocated from our capabilities and performance – had a nice quarter. That's a okay growth rate business with good operating margins and very large market shares. So, Manufacturing continues to grow at significant double-digit organic growth rates with operating margins in kind of the low to mid-30s range. That is sustainable indefinitely. And we don't see anything on the horizon to impair that. In fact, we do see significant opportunities in all three of those businesses from a demand point of view and a competitive point of view.

[Ross Muken, Evercore Group LLC]

That's helpful, Jim. And maybe just one follow-up, quick one. On the VC gains, obviously, it's tough to predict, and it's now built in terms of what we've seen into the full year basic. I guess, how are you philosophically thinking from a guidance standpoint on how to handle this going forward? Because obviously at some point, we may get some pause in that contribution, although the strategic merits are still there. But it could create some noise in the P&L when the underlying is doing very well. So, I guess, what are the debates you guys have gone through in terms of how to account for that and help the Street maybe on a go-forward basis? Model the underlying versus that maybe more accurately.

[David R. Smith, Charles River Laboratories International, Inc.]

And so, that's one of the reasons why even at the beginning of this year, we started to signal that in 2019, we didn't want to give guidance for the VCs. We have been judging ourselves against the performance of our organic business, the core business, i.e., with the VCs stripped out, because as you've seen, in recent quarters, they can bounce around quite wildly. And I guess, we're trying to signal to yourselves that we'd like you to consider to consider Charles River and its core business and almost put the VCs to one side, which is why we're essentially saying that, because of volatility, it's our intent to remove the guidance – or in our guidance, the VCs from 2019 onwards.

[Ross Muken, Evercore Group LLC]

Got it. Thank you.

[Operator]

We have a question from the line of Donald Hooker, KeyBanc. Please go ahead.

[Donald H. Hooker, KeyBanc Capital Markets, Inc.]

Great. Good morning. So, with respect to the new capacity in China and the research models area, how much capacity does that give you, looking forward, to sustain that high level of growth you're generating in China? I mean, when is sort of do you look down the road and see another capacity addition?

[James C. Foster, Charles River Laboratories International, Inc.]

So, it'll be continuous. It's a really big market. On a unit basis, it's certainly as big or bigger. You've got lower price points but lower cost. As we've said before, we have some government competitors who are small and not very sophisticated; and we have some small quasi-independent businesses that compete with us. And none of our sort of standard U.S. or European competitors are over there. So, we have a really wonderful market position.

So, we're the principal player in the Beijing market. We've opened this wonderful new facility which, by the way, the part that we opened, we're selling in real strong and are finishing the balance of the building now. That will give us much more capacity. We may need additional spaces in Shanghai market. We're investigating that right now. We, for sure, will need additional capacity west and south. It's a gigantic country and – so, big research centers, and a lot of money being pumped into the Chinese life sciences arena by the government. And so, we look at the world through sort of the lens of five-year strategic plans. We are entirely confident this is a high-growth business, certainly through the five years. I definitely think it's high growth longer than that.

And it's not just research models, all of the ancillary services that we have: Genetically engineered model services; our laboratory services. And we hope our insourcing solutions services where we both provide space for clients to work in and manage their space, there's some opportunities there, as well.

So, it's early days. As we told you, it's slightly less than 10% of our research models revenue are growing disproportionately fast. So, you'll see that paradigm shift change quickly. Not just that we're biased, but our animals are of definitely of a higher-quality than the competition's, and our science is better. So, if the Chinese folks want to play on the international scene and sell their drugs internationally, I think, they're going to have to use higher-quality animals to do their basic research.

So, we're just in a great place. We're spending a lot of time educating that market with seminars, and meetings, and publishing about not just the benefits, but the necessity of using high-quality animals that are of consistently high quality. So, definitely more investment. I think the returns will be fine. It's a necessity. There's maybe some M&A opportunities there, which we'll obviously pursue if we can, if they make sense for us. But we are out and about literally right now looking for additional space, so stay tuned.

[Donald H. Hooker, KeyBanc Capital Markets, Inc.]

Thank you.

[Operator]

Our next question comes from the line of Robert Jones, Goldman Sachs. Please go ahead.

[Jack Rogoff, Goldman Sachs & Co. LLC]

Great. This is Jack Rogoff on for Bob. Thanks for taking my question. Your 3Q guide seems to imply a steep margin ramp in 4Q. Can you talk about the sequential margin cadence you expect for the back half?

[David R. Smith, Charles River Laboratories International, Inc.]

So, you're right. There is a steeper climb in the second and the fourth quarter. And that's partly because we're seeing, as we mentioned in terms of the DSA study mix, washing through and returning to normal sort of levels. Also, we've seen seasonality impact, particularly in some of our businesses where there is a stepping up in the final quarter. So, it's a combination of those different factors, which comes to the conclusion that we've reached in the guidance that we've provided to you.

[Jack Rogoff, Goldman Sachs & Co. LLC]

Got it. Thanks.

[Operator]

Our next question is from Jack Meehan, Barclays. Please go ahead.

[Jack Meehan, Barclays Capital, Inc.]

Hi. Good morning, everybody. I wanted to go back to the DSA acceleration that you're looking for in the second half. Right now, funding is positive; your customers are flush with cash; utilization is optimal. It feels like the perfect set-up to start using price as a lever, at least, think about the way you prioritize work. Could you just weigh in on that, and what you're seeing in terms of the competitive landscape?

[James C. Foster, Charles River Laboratories International, Inc.]

So, we're going to weigh in on that in concert with our stated decision not to talk a lot about pricing from a competitive point of view, which is too much of a blueprint for the competition. So, we don't like that. So, suffice it to say that demand is quite good. Capacity utilization is quite strong. And we have the benefit of actually having some space with MPI, if we need it, having known that when we bought it, because we never know for sure what the competition's capacity looks like. They know a little bit better about our capacity, because we have calls like this. But based upon the competitive dynamics right now and the lack of sort of price cutting and lack of aggressive activity, it feels like the competition's pretty full, which is a really good thing, I think, for everybody.

So, all I can tell you is that we appropriately try to get price when we can. And sometimes, we can't, because clients are price-protected with longer-term arrangements, or the price escalation is simply pre-negotiated. And, obviously, different types of work have different pricing metrics and different margin paradigms. So, you know that our specialty work, for instance, often has less competition and a higher profit margin.

So, all I can tell you is that we're very cognizant of the opportunities that pricing can provide, the necessity of pricing to be able to afford things like improving in wages, and building facilities, and investing in IT, and obviously enhancing operating margin. I do think that for a lot of our clients, pricing is certainly not the first thing they look at. They're interested in our capacity and our capabilities. And so, we do have opportunities, which we pursue almost daily.

[Jack Meehan, Barclays Capital, Inc.]

Great. Thanks for all that color. David, I had one follow-up for you, just around some of the moving parts as we start to think about 2019. I know you're not in a spot to give guidance at this point, but I do think it's important, because there's a few things going on. If we balance – I think you should have about $0.35 of extra WIL accretion, maybe a little – another $0.10 of carry-over from the wages, and then the headwind related to the VC gains this year. Do those things shake out as neutral? Are we thinking about that the right way?

[David R. Smith, Charles River Laboratories International, Inc.]

Well, you're right. I mean, in the information we gave on WIL, so that $0.35 is incremental over the $0.25 that we said this year. And you're right, we get a full-year effect on the wages, so that's a additional $0.10 headwind for next year. The VCs, so we're $0.26 year-to-date, that will be a headwind.

Let me complete this story. We've tried to give you some signals in terms of where we are with corporate costs, which is under 7% of revenue, so that's stable. And the tax rate, we think, the second half of the year tax rate is something similar to what we would expect in the future. So that gives a little bit of color to look into 2019.

[Jack Meehan, Barclays Capital, Inc.]

Great. Looking forward to seeing you guys next week.

[Operator]

And we have time for one last question, and that comes from the line of Justin Bowers, Bloomberg Intelligence. Please go ahead.

[Justin Bowers, Bloomberg Intelligence]

Hi. Good morning, and thank you for the question. Can you remind us on what your targeted savings are this year for your efficiency measures, and kind of where you are halfway through the year, and also acknowledging that you're reinvesting a lot of that back into the platform?

[David R. Smith, Charles River Laboratories International, Inc.]

What was the number we've given publicly?

[Todd Spencer, Charles River Laboratories International, Inc.]

$65 million.

[David R. Smith, Charles River Laboratories International, Inc.]

$65 million. So, $65 million is the public number. We are on track with that, as you heard from Jim's prepared remarks. WIL is also delivering to the original guidance, as well. So, there's nothing that is being disturbed in terms of our ability to deliver the savings that we're expecting. So, that's on track.

[Justin Bowers, Bloomberg Intelligence]

Okay. And then, just one quick follow-up, Jim. Can you just comment on kind of the RFP activity and how that's been in the beginning of the third quarter? And then, more broadly, could you just compare kind of the current environment to 2015, where we had another robust funding year, just in terms of biz development and outsourcing prospects?

[James C. Foster, Charles River Laboratories International, Inc.]

Demand is very good, very strong, and persistent, and consistent. As you know, we have kind of a disproportionate amount of business with biotech, a principal driver of our growth. We never really quite see spending directly proportional to the inflow of funds. But, we see just strong spending patterns and not a lot of starts and stops and pulling back, and waiting for the next fiscal period to fund work.

So, it feels very strong as we said. It feels like the back half of the year will be solid. Obviously, it's too early to even predict about next year, but the external funding paradigm for the biotech folks has been almost as strong as ever right now. And if you combine that with the therapeutic breakthroughs and new treatment modalities, it's an unusually robust time in the history of biotech, so we feel really good about it.

[Justin Bowers, Bloomberg Intelligence]

All right. Thank you.

[James C. Foster, Charles River Laboratories International, Inc.]

Sure.

[Operator]

And I'll turn the call back over to Todd Spencer. Please go ahead.

[Todd Spencer, Charles River Laboratories International, Inc.]

Okay. Thanks. Thank you for joining us on the conference call this morning. We look forward to seeing you at our upcoming Investor Day in New York next week. This concludes the conference call. Thank you.

[Operator]

And ladies and gentlemen, that concludes our call for today. Thank you for your participation and for using AT&T Executive TeleConference Service. You may now disconnect.