Charles River Laboratories International Inc

NYSE:CRL

Earnings Call Transcript 2022-Q2

[Operator]

Ladies and gentlemen, thank you for standing by and welcome to the Charles River Laboratories’ Second Quarter Earnings Conference Call. This call is being recorded. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions]

I would now like to turn the conference over to our host, Todd Spencer, Vice President of Investor Relations. You may begin.

[Todd Spencer, Vice President-Investor Relations]

Good morning and welcome to Charles River Laboratories second quarter 2022 earnings conference call and webcast.

This morning I am joined by Jim Foster, Chairman, President and Chief Executive Officer; and Flavia Pease, Executive Vice President and Chief Financial Officer. They will comment on our results for the second quarter of 2022. 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 webcast replay of this call will be available beginning approximately two hours after the call today and can also be accessed on our Investor Relations website. The replay will be available through next quarter's conference call.

I'd like to remind you of our Safe Harbor. All remarks that we make about future expectations, plans and prospects for the company constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated. During the call, we will primarily discuss non-GAAP financial measures which we believe help investors gain a meaningful understanding of our core operating results and guidance. 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 on the Investor Relations section of our website.

I will now turn the call over to Jim Foster.

[Jim Foster, Chairman, President and Chief Executive Officer]

Good morning. Our financial results reflect the sustained trends that continue to support our businesses and resulted in 9.5% organic revenue growth in the second quarter. These trends were offset by headwinds from our CDMO business and foreign exchange, which were the factors that led to the revised second quarter outlook in early June and coupled with interest rates have intensified since then leading to today's reduction in our revenue growth and earnings per share guidance for the full year. We believe that our guidance for the year appropriately reflects the current macroeconomic environment with regard to foreign exchange, interest rates and cost inflation, which have changed dramatically since the beginning of the year.

I would also like to note that our revised guidance does not reflect any meaningful slowdown in biotech client activity, as biotechs continue to be the principle driver of revenue growth and demand remains healthy.

In fact, we are pleased that our DSA and RMS segments remain on track to achieve their initial revenue outlooks for the year of mid-teens and high single digit, organic growth respectfully.

Our largest business, Safety Assessment, continues to benefit from a growing backlog that is well above the prior year level and solid booking activity. As usual, we continue to monitor key performance indicators and are having regular conversations with our biopharma clients, whose spending patterns for the safety assessment programs to date remain largely unaffected by any change in biotech funding.

Our Discovery Services businesses, which only represents about 15% of DSA segment revenue, is experiencing longer decision making processes by some clients to initiate new projects.

Before I provide more details on these trends, let me provide highlights of our second quarter performance and updated outlook for the year. We reported revenue of $973.1 million in the second quarter of 2022, a 6.4% increase over last year. Organic revenue growth of 9.5% was driven by strong performances from the DSA and RMS segments partially offset by a low growth rate in the manufacturing segment. Due to the CDMO performance the lower than expected CDMO revenue reduced the organic revenue growth rate by slightly more than a 100 basis points in the second quarter.

The operating margin was 21.8% an increase of a 100 basis points year-over-year. The improvement was driven by the DSA segment as well as lower unallocated corporate costs, reflecting actions we have taken to responsibly manage our expenses.

Earnings per share were $2.77 in the second quarter, an increase of 6.1% from the second quarter of last year.

Low double digit operating income growth was largely offset by higher interest expense and tax rate compared to the prior year.

Second quarter earnings per share were in line with our revised outlook, despite incremental pressure from the lower revenue from our CDMO business, the strengthening dollar and rising interest rates over the past two months. These factors are the primary reason for the reduction of our revenue growth and earnings per share guidance for the full year.

We now expect revenue growth in a range of 9% to 11% on a reported basis and 10% to 12% on an organic basis.

For the year foreign exchange is now expected to reduce the reported growth rate by 350 basis points or 200 basis points more than we forecast in May.

And the lower than expected CDMO revenue is expected to be 150 to 175 basis point drag on the organic growth rate in 2022.

Non-GAAP earnings per share guidance is expected to be in a range of $10.70 to $10.95, which represents a reduction of $0.80 at the midpoint. Foreign exchange and interest expense generated a combined headwind of approximately $0.40 since early June. Flavia will provide more details on these non-operating items shortly.

Tempered expectations for our CDMO business in the near term are the primary driver of the remainder of the earning shortfall and are a result of several factors. First, following last year's completion of a large COVID vaccine production contract at our Cognate UK site, we are retooling the production suites and retraining staff to return the capacity to its original purpose, producing plasmids, which is taking longer than expected.

We have also invested time and resources in preparing for regulatory audits and upgrading other sites to CGMP production quality. These actions will generate new business opportunities in the future, but they have had a near term impact on the business. Furthermore, like the Early Discovery acquisition in 2014, the business development process for cell and gene therapy, CDMO services is highly technical and scientifically complex, requiring longer lead times for clients to place new projects and partner with us across our expanded offering. We are making good progress bringing our cell and gene therapy services together and working towards these businesses becoming fully integrated within themselves and with our broader portfolio.

With regard to the integration of last year's Cognate and Vigene acquisitions, we have implemented a refined vision and a strategy for our combined CDMO business, which includes developing centers of excellence for plasmids at our Cognate UK operations for viral vectors at Vigene in Rockville, Maryland, and for gene modified cell therapy production in Memphis, Tennessee. We believe this new structure will provide us with a distinct competitive advantage because it will enable us to optimize our internal processes and offer clients greater flexibility, efficiency, and enhanced speed for the development and go-to-market efforts.

We have also strengthened the management teams and are rebuilding the CDMO sales teams, creating more contact points with clients as we endeavor to further strengthen the pipeline of new projects.

We are also adding new capabilities through modest facility expansions. As we announced in June, we are expanding our Alderley Park, UK operation as part of our center of excellence for plasmids. And we are upscaling other sites for regulatory compliance and commercial readiness. We are very pleased to report that our Memphis site was recently audited and approved by European regulatory authorities or the EMA to commercially manufacture cell therapies. This is a significant accomplishment that prepares us to undertake future commercial projects.

We are encouraged that these developments will help improve the performance of the CDMO business next year. Like Early Discovery, we believe our CDMO business is an integral part of our essential portfolio because it enables clients to access a comprehensive solution for cell and gene therapy, research development and production from one scientific partner.

Clients are continuing to require high quality, scientifically differentiated solutions in the cell and gene therapy sector. And this will only intensify as more therapies are commercialized. As a result, we believe that CDMO growth opportunity remains robust, that we have the right scientific capabilities in place to be a uniquely ideal partner for our clients.

I will now provide details on the second quarter segment performance beginning with the DSA segment. Revenue for the DSA segment was $591.9 million in the second quarter, a 12.9% year-over-year increase on an organic basis. We are very pleased that the DSA organic growth rate improved by 340 basis points from the first quarter level and reached the low double-digit range as previously expected. This performance reinforces our expectation that there will be meaningful DSA growth accelerations throughout the year.

Based on demand and backlog trends, including working through higher pricing already booked, we continue to expect that the growth rate will approach 20% in the second half, tracking to our initial plan. Higher demand and meaningful price increases throughout the sequential growth acceleration in the Safety Assessment business in the second quarter.

The second quarter backlog increased on a sequential basis and also continued to be significantly above prior year levels. The backlog, coupled with solid booking activity in a second quarter, firmly supports our second half outlook.

Clients are emphasizing speed, steady lead times and the availability of space today more so than price when determining which CRO to partner with for their preclinical programs. This year, several clients have chosen to secure space with us in a take or pay arrangement to reserve this study space in advance. We anticipate that additional clients will agree to similar terms to secure space. Our speed and flexibility when working with clients, our superior client service and our broad scientific expertise, continue to resonate with clients and differentiate us from the competition.

With our capacity well utilized both in terms of people and infrastructure, we continue to implement new operational initiatives and evaluate others to enhance labor utilization and infrastructure efficiency, as well as study scheduling. We also believe that we are better positioned to accommodate a higher demand that we are forecasting in the second half of the year because of the significant number of staff that we hired over the past year.

And because of the strong backlog, we believe that we have excellent visibility in the Safety Assessment business and are confident that the anticipated DSA growth acceleration will continue in 2022. For next year we already have a large portion of our Safety Assessment revenue booked into backlog. The revenue growth rates of the Discovery Services business, improved meaningfully from the first quarter level, as expected. As I noted, we are experiencing some lengthening in the time clients take to commit to and begin new projects. And given the shorter term nature of the backlog and project cycles for this business, it's expected to slow the Discovery growth rate for the remainder of the year.

Our technology partnership strategy has been a very successful means of broadening our portfolio, since it has enabled us to continue to add cutting edge scientific capabilities across many of our businesses with limited risk. We continue to believe our clients’ willingness to outsource more of their Discovery programs will be predicated on our ability to provide them with innovative capabilities to meet their critical research needs.

The DSA operating margin increased by 180 basis points to 25.3% in the second quarter due to increased pricing and leverage from the investments in staff to support higher study volume. For the year we continue to expect DSA operating margin will improve as the growth rate accelerates, and we continue to leverage staffing investments.

RMS revenue was $186.4 million, an increase of 8.5% on inorganic basis over the second quarter of 2021 and in line with our high single digit outlook for the year. Organic revenue growth was driven by strong demand and meaningful price increases in the Research Models business in North America, as well as for Global Research Models Services, particularly Insourcing Solutions and GEMS. The RMS growth rate did not improve from the first quarter level as previously anticipated due primarily to the Research Models business in China.

Revenue for our China business increased, but due to COVID-related restrictions in the Beijing and Shanghai regions, the growth rate was limited and reduced the RMS growth rate by just under 200 basis points in the second quarter. These restrictions in China have now been eased and the overall revenue impact will be modest. So RMS is still on track to achieve its outlook for the year. Research Models & Services also had another excellent quarter led by the Insourcing Solutions and GEMS businesses.

Insourcing Solutions growth was driven by the CRADL initiative or Charles River Accelerator and Development Lab, which provides turnkey research capacity to small and large biopharmaceutical clients in key bio hubs. Clients are increasingly adopting this flexible model to access laboratory space without having to invest in internal infrastructure.

The acquisition of Explora BioLabs in April, came at an opportune time enabling us to provide clients with additional capacity and scientific capabilities principally on the West Coast. It also added a new growth engine for the RMS segment by allowing us to accommodate more of our biopharmaceutical clients' needs, particularly biotech clients who have limited or no internal infrastructure in which to conduct research. Demand for CRADL and Explora continues to be robust and Explora had an excellent first quarter as part of Charles River.

We are continuing to expand the footprint of CRADL and Explora to support growth and have added new facilities in California and London in the second quarter with the goal of operating at least 25 vivarium facilities with over 300,000 square feet of turnkey rental capacity by the end of 2022. CRADL and Explora also provide us with a new and unique pathway to connect with clients at earlier stages, as these clients will be able to easily access additional services across the comprehensive discovery and non-clinical development portfolio. We are very pleased with the performance of this business and delighted to welcome Explora to Charles River.

In the second quarter the RMS operating margin declined by 250 basis points to 24.9% driven primarily by the COVID related revenue impact in China. Explora has healthy margins for a service business and had an excellent second quarter, but is it – it is expected to be a small margin headwind to the RMS segment for the remainder of the year, as it continues to open new sites. Revenue for the manufacturing segment was $194.8 million, an increase of 1% on an organic basis reflecting lower revenue in the CDMO business as discussed, as well as a challenging prior year comparison for the Biologics Testing and Microbial Solutions businesses with a 26.6% segment organic growth in the second quarter of last year.

Both of these businesses are expected to generate revenue growth that approach their targeted levels of the year. The growth prospects for these legacy manufacturing quality controlled businesses remain robust, and they will continue to be principally driven by demand for biologic drugs including cell and gene therapies and other complex biologics. Cell and gene therapies will continue to be the primary growth driver for our manufacturing segment, reflecting the rapid increase in the number of cell and gene therapy programs and development. Today more than 3,000 cell and gene therapy programs are in the pipeline, a number which has grown at an average rate above 20% over the last three years. With approximately 70% of programs in a preclinical phase and less than 5% of programs in Phase 3 clinical trials or later we expect these advanced drug modalities will continue to fuel robust biologic testing growth and generate new business opportunities for the CDMO business particularly as additional therapies reach commercial approval.

We believe our consolidated Biologics Solutions offering will provide incremental opportunities for clients to streamline their biologics development workflows and conduct their analytical testing, process development and manufacturing activities with Charles River. The manufacturing segments operating margin declined by 460 basis points to 28.6% in the second quarter of 2022, almost entirely driven by the CDMO business. We have taken actions to manage costs and investment both in the CDMO business and in other areas in order to limit the impact of the revenue shortfall for the year. With regard to our company-wide capital priorities, we have built an excellent foundation for cell and gene therapy solutions since 2020 through M&A and we will focus on integrating these enhanced scientific capabilities as well as all of our recent acquisitions. While we will still evaluate strategic acquisitions, we intend to focus on debt repayment for the remainder of the year.

We also continue to diligently monitor key performance indicators and modify plans for investments, including hiring and capacity expansions should the growth prospects for business change. In this regard we are strategically aligning our hiring and facility expansion plans for our CDMO business, with the current and projected growth rate. Our goal is to balance the need to continue to make disciplined investments to support our growing businesses while responsibly controlling costs and enhancing value for our shareholders. We have reset our financial outlook for 2022 to account for the escalating headwinds that have emerged throughout the year. We remain well positioned to deliver low-double-digit organic revenue growth for the year and stable operating margins, amidst today's challenging macroeconomic environment.

Furthermore, we continue to believe that Charles River is a stronger company today than it has ever been and the partner of choice for our clients' non-clinical development needs. Clients are increasingly choosing to partner with us for our flexible and efficient outsourcing solutions, the scientific depth and breadth of our portfolio and our unwavering focus on seamlessly serving the diverse needs.

With that I'd like to thank our employees for their exceptional work and commitment and our clients and shareholders for their support.

Now Flavia will provide additional details on a second quarter financial performance and 2022 guidance.

[Flavia Pease]

Thank you, Jim, and good morning.

Before I begin, may I remind you that I'll be speaking primarily to non-GAAP results which exclude amortization and other acquisition-related charges, costs related primarily to our global efficiency initiatives, gains or losses from our venture capital and other strategic investment and certain other items. Many of my comments will also refer to organic revenue growth which excludes the impact of acquisitions, divestitures, foreign currency translation and the 53rd week in 2022. As Jim mentioned, we delivered solid results in the second quarter including 9.5% organic revenue growth and the 100 basis points of operating margin improvement. Despite the challenges related to our CDMO business and unfavorable movements in foreign exchange and interest rates. These headwinds also led to the $0.80 reduction in our earnings per share guidance for the year to a range of $10.70 to $10.95 with half of the reduction resulting from unfavorable changes in foreign exchange and interest expense since early June.

Since we provided our initial guidance at the beginning of the year, non-operating items including foreign exchange and interest expense as well as lower than expected tax benefit from stock-based compensation will reduce earnings per share by approximately $0.65 for the year. We expect to generate low-double digit organic revenue growth in a range of 10% to 12% supported by strong trends in most of our businesses. We also expect reported revenue growth in a range of 9% to 11%. As Jim mentioned, lower revenue in our CDMO business is expected to reduce our revenue growth by 150 basis points to 175 basis points. And foreign exchange is expected to reduce the reported growth rate by an additional 200 basis points.

Jim spoke about the impact from the CDMO business. So I'll provide more details on foreign exchange and interest expense, which are expected to reduce 2022 EPS by approximately $0.40 since early June. The reason dramatic strengthening of the U.S. dollar has resulted in foreign exchange, being more of a headwind than previously anticipated. Since we revise our outlook in early June, foreign exchange has reduced revenue by an incremental 200 basis points and earnings per share by nearly $0.25 for the year assuming the near current spot rate in our guidance. The foreign exchange rates that we are assuming for the reminder of the year are included on Slide 31.

The federal reserve rates increases in mid-June resulted in a meaningful headwind to our 2022 earnings per share guidance with approximately half of our $3 billion debt on a floating rate, rate increases will be the primary driver of the $8 million increase in our adjusted net interest expense for the year, which is now in a range of $106 million to $110 million. In the second quarter total adjusted net interest expense was $22.9 million, an increase of $2.5 million sequentially and $2.1 million year-over-year due primarily to higher debt balances from recent acquisitions and rate increases earlier in the year. The current interest rate on our revolving credit facility are based on library plus 112.5 basis point spread at our current leverage, about 80% of our floating rate debt is denominated in U.S. dollars using the one-month LIBOR rate. We have factored the Federal Reserve's 70 basis point increase in July into our updated outlook and have assumed that rates will increase by an additional 100 basis points before year end. At the end of the second quarter, our $3 billion outstanding debt balance represented a gross leverage ratio of 2.8 times and a net leverage ratio of 2.7 times. As Jim mentioned, we plan to focus our capital deployment priorities on that repayment for the reminder of the year.

I will now provide additional details on our financial performance and outlook. On a segment basis our revised revenue growth outlook for 2022 primarily reflects the impact of unfavorable foreign exchange rates and the impact of lower than expected revenue for the CDMO business. On a reported basis we now expect revenue growth rates for the manufacturing segment in the high-single-digit range, DSA in the low-teams, and RMS unchanged in the high single digits. Our organic revenue growth guidance for the DSA and RMS segments remains unchanged at mid-teens and high-single-digits respectively. Based on the previously mentioned headwinds, we have reduced our organic growth outlook for the manufacturing segment to the mid-single-digits.

Despite the revised revenue outlook for the year we expect consolidated operating margin to be essentially flat with 2021. We are perfectly managing costs to limit the margin impact and hold operating margin. We continue to expect the DSA segment will generate operating margin improvement in 2022. However, the RMS and manufacturing operating margins are expected to be lower due to the impact of the Explora acquisition and the softer CDMO performance respectively. Lower than expected CDMO results are forecasted to create a second half headwind of nearly 100 basis points to the consolidated operating margin.

Lower unallocated corporate costs contributed to the operating margin improvement for the second quarter. Corporate costs total 4.1% of revenue or $40.2 million compared to 5.6% last year with a decrease primarily due to discretionary cost controls reduced fringe related costs and lower performance based compensation costs. As a result, we now expect unallocated costs to be approximately 5% of total revenue for the year compared to our previous guidance of a mid-5% range.

The second quarter tax rate was 21.1% representing a 70 basis point increase from the same period last year. The increase was due to lower benefit associated with stock based compensation resulting from the lower stock price partially offset by discrete tax benefit. For the full year, we continue to expect the tax rate will be within the low 20% range on a non-GAAP basis, which is unchanged from the outlook we provided in May. The cash flow was $66.6 million in the second quarter compared to $140.2 million last year.

The year-over-year decrease of more than $70 million was primarily due to higher capital expenditures and unfavorable changes in working capital. Capital expenditures were 82.9 million in the second quarter compared to $46.4 million last year, primarily as a result of planned projects to accommodate future growth. Based on our lower earnings expectations for the full year, we have moderated our free cash flow guidance to approximately $360 million or $90 million below our prior outlook.

We expect capital expenditures to decline by $20 million from our previous outlook to approximately $340 million in 2022. We always strive to be disciplined with our capital investments and align extension plans with our growth outlook, which led to the modest reduction in CapEx for the year. We also remain confident on our future growth potential. So we intend to continue to perfectly invest in our growing businesses, particularly in safety assessment, which requires additional capacity to accommodate client demands.

A summary of our updated financial guidance for the full year can be found on Slide 40. For the third quarter we expect revenue growth in the high-single-digits on a reported basis, reflecting the incremental foreign exchange headwinds. On an organic basis we expect at least low double-digit growth as a result of improvement in both the DSA and manufacturing segments from the second quarter levels. Third quarter earnings per share is expected to decline to a high-single-digit rate from last year's $2.70 due to margin pressure on the manufacturing and RMS segments, as well as meaningfully higher interest expense and tax rate, which is creating a combined $0.30 headwind compared to prior year.

In closing, we continue to be focused on the focused on the execution of our strategy, enhancing the speed and efficiency in which we operate and delivering solid financial and operational results in today's macroeconomic environment. We believe that significant growth potential continues to exist as our clients seek to find cures for unmet medical needs and do so by using breakthrough technologies and new drug modalities that will only enhance demand for our leading non-clinical development solutions.

Thank you.

[Todd Spencer, Vice President-Investor Relations]

That concludes our comments and we will now take questions.

[Operator]

[Operator Instructions] We will take our first question from Derik De Bruin with Bank of America.

[Derik De Bruin, Bank of America]

Hi, good morning everyone.

[Jim Foster, Chairman, President and Chief Executive Officer]

Hey Derik.

[Derik De Bruin, Bank of America]

Hey, so Jim, so the question I'm getting from clients essentially boils down to something like this is like, I mean, given that everyone's sort of concerned about the outlook for biotech and particularly DSA. I mean, why not – why not use this as an opportunity in the quarter to basically trim the guide a little bit more; put another way it's like how much conservatism is built into your DSA guide there? And do you have enough buffer in sort of like offset any headwinds that goes on with it? I mean, I know you're not saving right now, but I mean, just what's the buffer that sort of you built into it?

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes. We feel really good about our guidance. We have really strong backlog in safety assessment at escalating prices, higher volume staffing to do it, capacity to do it, and kind of no dialogue at our clients about spending concerns. We're watching our costs closely. We've indicated that it's taken a little bit longer for the Discovery folks to commit and book studies. So that's embedded in this – in the updated guidance. So we think we're calling this accurately. I don't think I would call it conservative. I think I would call it realistic just given the sort of unprecedented length of the backlog and the strength of the pricing.

[Derik De Bruin, Bank of America]

Okay. And one follow-up if I may. How sustainable the pricing gains? Do you think you can still take price going to 2023?

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes. I mean, it's early to comment on 2023 except that we booked meaningful amounts of studies already in 2023 at higher prices. I think our competitive strength and capacity, availability and as I said a moment ago, additional staff and given the complexity – increasing complexity of the studies, particularly kind of specialty work, if we had to call it today we would say that we'll continue to have pricing power well in the next year.

[Derik De Bruin, Bank of America]

Thank you.

[Jim Foster, Chairman, President and Chief Executive Officer]

Sure.

[Operator]

We'll take our next question from Eric Coldwell with Baird.

[Eric Coldwell, Baird]

Thanks. Good morning. So I have a couple. First in the DSA segment you've got a – as was just mentioned you have a very strong growth rate expected in the second half. Is this an immediate jump up to that 20% level or is it more weighted to 4Q? I'm curious about the phasing and then as part of that with discovery growth moderated, it appears that the clear signal is that safety actually could be growing above 20%. So a couple of comments on the direction and the color of the growth rate in DSA would be helpful?

And then my other question is performance based compensation reduction mentioned in the prepared remarks. How much did that aid 2Q operating profit or is that reduction expected in the second half? So just trying to get a sense on the magnitude of the benefit of reducing accruals for performance space comp? Thanks so much.

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes. I'll take the first part. Flavia, you can take the second question.

So the safety assessment revenue builds through the back half of the year, third quarter, and then the fourth. Now the pricing gets increasingly stronger and the volume is significant and that continues to be a commentary on the demand quotient on how little internal capacity most of our clients have and their desire and need to get drugs through the preclinical stages and files with the FDA. So we – again we feel – we feel good about that. I think, as we said multiple times, its unprecedented demand. I know the growth rate seems extremely high and it is, but it's compared to slow first quarter with pricing wasn't quite as strong. So we feel good about that and we feel that we've taken into consideration some accommodations slow down in commitments that the discovery folks have indicated. And Discovery is only 15% of the DSA, so it's pretty much how safety goes, so does DSA and we feel really good about that.

Flavia, your comment on the second part.

[Flavia Pease]

Thanks Jim. Good morning, Eric, thanks for the question. And indeed the second quarter corporate cost benefited from lower performance based compensation as you mentioned as we adjusted our forecast for the year we threw up the approval there that is not going to continue in the second half of the year. So it was basically in the second quarter.

[Eric Coldwell, Baird]

Flavia, should we just look at the delta and what you reported versus perhaps where you were or what expectations were as the impact or were there other offsetting factors to consider?

[Flavia Pease]

In the second half as we pointed out, there will be additional offsetting factors of the CDMO headwinds continuing. So in the second quarter you had the benefit of corporate at lower level that is not going to continue in the second half.

[Eric Coldwell, Baird]

Okay. Thank you.

[Operator]

We'll take our next question from Dave Windley with Jefferies.

[Dave Windley, Jefferies]

Hi, thank you very much. Thanks for taking my question. Good morning. Perhaps a slightly different version of Derik Eric's question on, on your demand outlook, I guess, Jim there's – we see fairly broad kind of acceptance of the idea that that as funds get a little more scarce that clients would kind of circle the wagons around their most important programs, those likely being the ones fairly advanced in the pipeline, and that might that might have some impact on earlier stage, less mature projects.

And so I guess I'm wondering as you look at some of the CRO competitors that have commented on slowing decision cycles, you're seeing that in Discovery, why you – why it wouldn't be logical to say or it wouldn't be that surprising, I'll say it that differently. It wouldn't be that surprising if two, three, four months down the road safety assessment started to feel that as well, maybe you could help to shine a little bit more light. I know you're very confident about the demand in that environment, but why couldn't safety slow down and what reactions could you – what levers could you pull quickly to adjust to that if that were to happen?

[Jim Foster, Chairman, President and Chief Executive Officer]

Dave, I can't guess as to what the future holds, I can – we can only respond to what we're hearing, what the dialogue is with our clients, pretty much daily or obviously asking these questions. And so we see we see the backlog continuing to build at higher prices. We hear virtually no commentary on the safety side about – concern about pricing. We see people booking way out, well into next year and some in the following year, we're just way out, we've never seen things like this before. We have several take a pay contracts to reserve space, which is totally new. So the demand portion seems to be sort of contrary to the way you ask the question. Having said that safety and Discovery are distinctly different animals, right?

So safety is an activity that is essentially highly outsourced, new biotech companies have no internal capacity or desire to build any and big pharma is increasingly and rapidly outsourcing. So the marketplace is highly dependent on us, and we believe that people that have promising drugs will do everything they can to do the preclinical work, the GLP work and to get those to market. Whereas Discovery is a business that's more internally based with the clients both large and small and as you say, it's likely where people will pause or take longer to make commitments. So we – that's the situation in Discovery, we have a totally different situation in safety. We're watching it, if things suddenly began to change; I just don't think they could suddenly change given how far out we're booked.

And so we have work to slide in whenever there is slippage or cancellations but obviously we would curtail hiring. And we would pull back our cost structure with travel and other things. We watch that very, very carefully. We do – we've hired people sufficiently to accommodate the work that we have booked and the demand that we have, which makes us feel even better about the back half of the year its capacity is pretty straightforward, headcount is much more complex. So having those people on board, I think gives us the confidence that we'll be able to deliver the guidance that we have just updated today.

[Dave Windley, Jefferies]

Excellent. If I could – if I could ask last quarter, I know you don't usually do it, but last quarter you did give us an update on that DSA backlog. I wondered if you do that and/or you've mentioned this take or pay deals, what percentage of your backlog do those take or pay deals now represent? Thanks.

[Jim Foster, Chairman, President and Chief Executive Officer]

It's small Dave. So they're not significant numbers, but as you and I have talked about for years were surprised people didn't do this a long time ago. So if you didn't have your own internal capacity and space was pretty tight and you had hot drugs and given the fact that it's a relatively small spend the preclinical versus the total spend of a drug, yes, we're a bit incredulous that people haven't done this earlier. But we have a lot of conversations going on. I don't think it's going to be a large proportion of our capacity or revenue, but it's a much more balanced supply/demand portion. I think it makes customers feel better about their ability to start really important studies earlier; I think the pricings really good.

While we didn't give the number, the update's $3 billion, so the backlog has increased from the last time we gave those numbers. So it's really, really significant. We've – I understand we're much larger company, but we've never seen this sort of commitment that far out with better pricing. And as we said, in the prepared remarks, the questions are increasingly about do you do this kind of work? Do you have an opening for me? How quickly can we get that opening? And by the way, what's the price? Whereas as you know years ago the pricing conversation seem to be the first line of questioning, so it's a pretty solid demand curve that we're seeing.

[Dave Windley, Jefferies]

Great. Thank you for the answers.

[Jim Foster, Chairman, President and Chief Executive Officer]

Sure Dave.

[Operator]

We'll take our next question from Sandy Draper with Guggenheim.

[Sandy Draper, Guggenheim]

Thanks so much. My question is on the CDMO side. And just trying to understand the dynamics, as you said you had the vaccine trial that that sort of wound down in your retooling and refill and capacity with plasma. I'm just trying to understand once you've done the retooling and the production sites and retrain the staff, is – did you have sort of an immediate backlog, a business that you can rent immediately, or once that's finished do you then go out and start selling that? I'm just trying to understand the timing between the – I'm assuming there's some expense in the retooling, and then when you can start generating that revenue coming back in? Any more commentary on that would be really appreciated. Thanks.

[Jim Foster, Chairman, President and Chief Executive Officer]

Sure Sandy, happy to. We're out marketing this business and our whole CDMO portfolio as thoughtfully as possible. It's a new business for us. It reminds us of our Argenta and BioFocus, early Discovery acquisitions that we made in 2014. So it's an adjacency, it's new for us, in this case that was a chemistry deal in this case, it's new for the world. So there's a limited number of people doing cell therapy work. There's a limited number of people providing the – limited number of people with the drugs, small number of people doing the work and sort of a new regulatory oversight. So I think we're all sort of learning as we go. So I think as a general proposition it's a new area, its complex, the sale cycle is longer than we thought.

We're recapitulating a fair amount of management, at sales organization where building out space, we're enhancing our regulatory capability. We were preparing for an audit like the successful EMA audit that we just had. We have clients that are talking to us about going commercial. And with this one particular facility that we talked about, we were primarily using that space for COVID vaccine production. And so I think clients begin to forget that this was a plasma production operation. So now I don't think we have an immediate backlog where people are going to jump on this, but we will ready to space. We will – this company was quite good at, at making this. I do think there's a shortage of plasma production generally in the marketplace and so there's a need for it. Look, everything is taking longer than we had anticipated from an overall integration point of view and from an overall market understanding where we are, but we're quite confident, particularly as we've refined the centers of excellence, which means we've got plasmas in the UK, we've got viral vectors in Maryland.

We have cell therapy manufacturing benefits that those will provide a really great footprint to service the clients, particularly in addition, and in combination with our Biologics business, Microbial business to some extent safety. So everything is taking longer than we would like Sandy, definitely exacerbated by this contract and the retooling, but we're confident that the overall demand and the quality of the assets and our marketing acumen will hold us in good stead.

[Sandy Draper, Guggenheim]

Thanks for the commentary Jim.

[Jim Foster, Chairman, President and Chief Executive Officer]

Sure.

[Operator]

We'll take our next question from Elizabeth Anderson with Evercore.

[Elizabeth Anderson, Evercore]

Hi guys. Thanks so much for the question. Maybe just sort of following up on Sandy's question a little bit. So it sounds like from what you're saying, sort of between the retooling and the interest in sort of putting everything together that could take a couple of quarters. So is that sort of mean that we're like exiting the year sort of at a similar kind of like low-to-mid single digit kind of growth rate dynamic. Because it seems like from what you're saying in DSA as we exit the year, you're sort of like – from what you're saying about the backlog and the pricing and everything that seems like a set to continue kind of like double-digit growth, research models obviously had to hit from China, but otherwise the demand seems very strong there. So I'm just trying to sort of calibrate where we are sort of exiting the year versus some people’s fears regarding the broader economic environment?

[Jim Foster, Chairman, President and Chief Executive Officer]

Is that a question about the whole portfolio or just manufacturing?

[Elizabeth Anderson, Evercore]

Well, specifically, no, just like I was just trying to frame the question in general, but like specifically on manufacturing support, it seems like from what you were saying and answer to Sandy's question is that with the sort of the retooling and the certification and things like that, that could be sort of a multi quarter effort, but it sort of – it seems like you might be at sort of like mid-single-digits organic growth like exiting the year there.

[Jim Foster, Chairman, President and Chief Executive Officer]

I think that's a good analysis. Probably mid-single the biologics and the microbial businesses will have a much stronger back half of the year and will kind of get back to approaching kind of the usual growth rates. The CDMO businesses, there's several businesses that we bought will do better and improve, but we'll still be way below what we anticipated when we started the year, when we gave you guidance should strengthen materially next year. But yes, I think mid-single is probably the right way to look at manufacturing for the full year.

[Elizabeth Anderson, Evercore]

And sort of exit and – and sort of where we also end up at sort of the end of 4Q kind of range?

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes.

[Flavia Pease]

Yes. Maybe I'll jump in here as I think we commented the manufacturing segment as a whole will be forecasted organic growth of mid-single-digits as Jim said for the year. We had about 10% in the first quarter and reported 1% in the second quarter, you can do the math. It's probably going to be a little bit higher than mid-single in the second half if the full year is at mid-single, but so you are in the right fiscal.

[Elizabeth Anderson, Evercore]

Got it. Okay. That's helpful. Thank you.

[Operator]

We'll take our next question from Christine Rains with William Blair.

[Christine Rains, William Blair]

Good morning. And thanks for taking the question. Can you elaborate on the extended decision timelines for the Discovery business? Where are you seeing this is it across the Board in Discovery or any particular areas or client types? Thanks.

[Jim Foster, Chairman, President and Chief Executive Officer]

Now, I wouldn't say it's any particular areas. I would say it's the nature of the client base, it's largely biotech, there is lots of small companies that have no internal ability probably watching very closely their burn rates, working really hard to get things into safety and spending the money there and maybe have some things on hold. So, it's really been a kind of an interesting process, very active proposal levels, still sort of responses that we have the work or they intend to work with us, but taking longer to actually book the work and sign things. So there is a bit of a way to see attitude there. I guess that makes a fair amount of sense as the future is a little bit murky in terms of the funding paradigm.

So I would say it's more the nature of the clients and less about the specific work. I think we have a really good portfolio there, fair amount of scale, very good lead into safety, good international footprint and, I think, we've done really good work for these folks for almost a decade now. So I don't think it's a commentary in any part about the business. It's more on just cautious nature of some of the clients.

[Christine Rains, William Blair]

Thanks that's helpful.

[Jim Foster, Chairman, President and Chief Executive Officer]

Sure.

[Operator]

We'll take our next question from Justin Bowers with Deutsche Bank.

[Justin Bowers, Deutsche Bank]

Hi, good morning. Two part questions sticking with manufacturing. So in terms of the EMA audit at the Memphis site, it sounds like you are preparing for another regulatory audit, is that at the same site or an additional site? And then how does that change the thinking around doing commercial production across the portfolio?

And then the second part is the change in the outlook in manufacturing is that entirely CDMO or is there any changes in the back half outlook for biologics testing as well?

[Jim Foster, Chairman, President and Chief Executive Officer]

So entirely CDMO. Rest of the segment is doing really nicely. And as I said, a moment ago, biologics, microbial will be approaching the kind of usual growth rates by the end of the year. We spent a lot of time getting ready for the CMA audit, that it's a big deal. I don't know whether we have any competition that has that. So the method facilitates, isn't just fabulous shape from enhanced management point of view, new capacity, a bunch of clients, several of whom are talking to us seriously about when they go commercial.

I think you understand, I guess, the nature of the question is you have these audits because some company has filed for approval of their drug. So they actually be approved by the European regulatory authorities to commercially manufacture cell therapies is a huge undertaking and should hold us in good steps for commercial projects.

I suspect we will have – I’m not sure what the second part of your question. I suspect we will have additional audits both from European and U.S. authorities for additional drugs that are coming down the line. You don't have any – we have a lot of conversations with clients, we've had some milestones as these drugs get closer to commercialization. We have no idea if or when they will become commercial, but there is a high likelihood that some of these drugs are for very, very tough diseases with kind of unmet medical needs. And cell therapy looks like potentially the only way to treat them.

So pretty optimistic about it and really enthused that we were able to get very successfully through this start up.

[Justin Bowers, Deutsche Bank]

I appreciate the question.

[Jim Foster, Chairman, President and Chief Executive Officer]

Sure.

[Operator]

We'll take our next question from Tejas Savant with Morgan Stanley.

[Tejas Savant, Morgan Stanley]

Hey guys, good morning. And appreciate the time here. Jim back to Safety Assessment here, I know you kind of gave some colour on the DSA backlog, but curious as to what that proposal volume growth number looked like versus the 35% you had shared last time.

And then when you think about sort of the pricing increases and those working through the backlog here similar to what you did with interest rates, are there any sort of future inflation increases basically baked into the pricing model or do you essentially move with a little bit of a lag if inflation continues to increase here perhaps in the back half of the year or into 2023?

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes, so we price the work that's booked in 2023 accordingly. We're assuming that certain inflation rate increases in our own cost. And so those – we certainly haven't booked those studies at today's prices. We have a meaningful and appropriate increases in cost given the complexity of our own P&L.

I don't know the answer to the proposal volume question.

[Tejas Savant, Morgan Stanley]

Got it. Fair enough.

[Jim Foster, Chairman, President and Chief Executive Officer]

I don't think it's a number we generally give out.

[Tejas Savant, Morgan Stanley]

Got it. And then one quick one on capital deployment makes complete sense that you are sort of prioritizing debt repayment, you are given the macro backdrop. But how are you sort of like offsetting that versus the risks that you perhaps might miss out in an opportunistic capacity add situation, particularly on the CDMO side?

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes, I mean we're appropriately investing in CapEx to provide enough capacity to accommodate the increased growth of our businesses. Principally safety, I'd say secondarily CDMO. If we don't have the space, as you say, we can't do the work. So we weren't inferring at all that we're starving any of our businesses. So capital, as you know, we have to drop the CapEx, I don't know, 12 to 24 months in advance. So we have to do today, what we're going to need in a year and a half or two years.

So, I think we're funding the growth across multiple facilities, and multiple geographies and multiple businesses at the same time. We’re going to focus on – we'll continue to look at M&A, but we're going to focus on paying down our debt in the short term though.

[Tejas Savant, Morgan Stanley]

Got it. Thank you.

[Operator]

We'll take our next question from Patrick Donnelly with Citi.

[Patrick Donnelly, Citi]

Hey, thanks for taking the questions guys. Jim, obviously there have been a lot of questions about kind of the back half setup and into 2023, maybe if I can ask a little more directly about the 2023 setup, at the Analyst Day, obviously you guys guided towards kind of low double digit organic growth into 2023 and 2024 earnings growth above that. I guess as you sit here today, obviously you talked about the pricing and the backlog build. I guess what's the confidence level of 2023 setup again, being that low double digit organic growth, and then earnings above that given again, some of the moving pieces there with interest expense, inflation, whatever it may be? Can you just talk about the setup as we work our way into 2023? It might be helpful. Thank you.

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes. It's pretty early to go there. We just kind of starting our 2023 operating plan work and we're kind of in the midst of a strategic plan for the next five years, trying to vet the cost structure of running our business, the macroeconomic environment, the competitive scenario and what the backlog looks like.

So, I mean, I think, that all I can say is that we feel the current funding paradigm for most of our clients is really strong. We think that the host of new modalities to treat diseases is really impressive and we're participating pretty much across the Board. We have – half of our business is Safety, we've never seen backlogs like this at prices like this. And our competitive situation, both in terms of taking share and utilizing a broad portfolio continues to be better.

[Indiscernible] Because it's too early. We've talked about what our growth rate is going to be for this year. And as soon as we have something concrete to tell you we will.

[Flavia Pease]

I would just add, I think, Jim commented on the demand side of the business. I think I just want to remind everyone that the macroeconomic environment has changed dramatically since we provided our long-term targets over a year ago. So as you said, we will take the time to update our outlook for 2023 and beyond, and get back to you Patrick and everybody in due time.

[Patrick Donnelly, Citi]

Understood. Okay. And then just the quick one on RMS in the back half, you talked about the China headwinds in 2Q. Can you just talk about the back half setup, the key drivers there and what we should expect on the growth front for that business? Thank you.

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes, that business is in really terrific shape. We've seen really strong sales in North America; China is our highest growth business, unless there is another situation with COVID, we think we're well past that. We have incremental capacity there. Services businesses are unusually strong both GEMS in particular and IS particularly we have the CRADL business. The acquisition that we did of Explora Labs is right on target and accommodating lots of clients who don't want to buy or rent their own facilities and want to use ours.

So, that feels like the right acquisition at the right time given the market me. And we have self-supply businesses, better managed with new products and greater ability to attract owners and more turn capacity. So we feel really good about both the current and the back half of the year in that business, both top and bottom line.

[Patrick Donnelly, Citi]

Okay. Thank you.

[Operator]

We'll take our next question from Jacob Johnson with Stephens.

[Jacob Johnson, Stephens]

Hey, thanks. Good morning. Thanks for fitting me in. Just one question just on going back to the CDMO business, as we think about the kind of reduction in guidance around the CDMO business, is it fair to characterize most of that's related to the COVID roll off the retooling, maybe some integration of that asset, or is there anything in kind of the market macro backdrop that's impacting your ability to grow that business?

I guess the other piece of it is any change in your thinking around the opportunity in cell and gene therapy? Thanks.

[Jim Foster, Chairman, President and Chief Executive Officer]

No change at all in the demand quotient. We remain extremely enthused about cell and gene therapy. The utilization of pretty much of almost all of our portfolio in participating in cell and gene therapy to get those drugs into the clinic. And of course, we actually have a business that manufacturers those drugs to get into the clinic are largely impacted by the European entity that is retooling.

And I would say that the rest of the business for us is heavy integration of a multiplicity of sites in intensified learning curve which, I think, we're doing very well at, but in some ways more complicated than we had thought and just a newer business for us. But given the EMA audit of the strength of Memphis, the retooling of our Maryland facility, and beginning to remarket the entire portfolio, we feel really good about the build and the potential opportunities for next year.

[Jacob Johnson, Stephens]

Got it. Thanks for that, Jim,

[Operator]

We'll take our next question from Casey Woodring with J.P. Morgan.

[Casey Woodring, J.P. Morgan]

Hi, thanks for squeezing me in. I'm just curious as to what sort of visibility you have on the CDMO side. So, it was just two months ago where you reiterated the full year organic guide and now you're saying that business will be a 150 to 175 basis point headwind. So just wondering if there is chance or further delays there or more room for downside.

And my second question is just to follow-up on the Discovery delays wondering if you had ever seen that dynamic before in the business, and if so, how long did those generally last for? And how much of the pipeline ended up coming through versus getting cancelled? Thank you.

[Jim Foster, Chairman, President and Chief Executive Officer]

We've probably seen it before. Discovery newly outsourced clients will have a propensity to keep it in house sometimes. It's kind of a crown jewelled. And if they have any sort of concerns about new spending to develop new drugs, there could be a pause there. So, it's pretty predictable. I would say.

So, I'm not sure it's particularly new. I think we still have a great portfolio there and one that's totally distinguished from the competition, given the breadth of it and the pull through into safety.

The first part of your question was what?

[Flavia Pease]

CDMO.

[Jim Foster, Chairman, President and Chief Executive Officer]

CDMO sorry.

[Casey Woodring, J.P. Morgan]

Yes, [indiscernible]

[Jim Foster, Chairman, President and Chief Executive Officer]

CDMO visibility. Yes. What's changed is we're living in that business longer, where sort of reformatting multiple companies at the same time, literally we bought a lot relatively quickly, acquisitions often become available when they become available. So, I think we bought very good assets. I think we have a unique set of services. We've worked really hard to give you a realistic, makeable case for the back half of the year is all I can say. We're all over it from a sales point of view, and from capacity point of view, from a spending point of view, from a client interaction point of view.

And so we think we have the wagon circle, we think we'll continue to build strength in that business through the back half of the year and be in a much stronger place next year. So, obviously it just has a kind of visibility that safety does, it's a new business for us and basically a new industry for lots of people. So all we can do is stay really close to the clients, which we're doing.

[Operator]

We’ll take our next question from John Sourbeer with UBS.

[John Sourbeer, UBS]

Thanks. Two questions here. Just one a clarification on Patrick's question on RMS. Do you specifically have headwinds baked into the RMS guidance in for China in 3Q in any way to quantify that? And then just a follow-up on the take-or-pay contract. Do you think that this is a sustainable trend or just temporary as additional industry capacity has come coming online? Thanks.

[Jim Foster, Chairman, President and Chief Executive Officer]

Yes, not only do we think it's sustainable, I won't call it a sustainable trend, but as we said in prepared remarks, we think we will continue to have additional clients sign up for these take or pay arrangements. Companies tend to be larger. But if you have a hot drug, you want to start your safety trials as soon as possible. And given the capacity limitations, given how busy we are and probably how busy the competition is, you may not be able to do that. I think that's a good way to retard your ability to get a drug into the market. So I think we'll have more of these. By the way we've had more of these since our last quarterly call. I think we had one last time. We have several now and we have a bunch in conversations. So we think that's totally sustainable.

We don't anticipate additional headwinds in China. So I don't think we baked – we haven't baked additional headwinds from COVID into the back half of the year. We have that pretty much at kind of usual growth rates and margin contribution. I guess that could change. I think it's unlikely given what the COVID situation is now and how poorly they managed that last time that was enormous overreaction to lockdown cities with 12 million people with 2,500 people had COVID.

So, I don't think they are going to revisit that. We're not talking to the government, so we don't know that for a fact, but we haven't conservatized the numbers to anticipate that.

[Operator]

Thank you. We have no further questions in the queue. I will turn the conference back to Todd Spencer for closing remarks.

[Todd Spencer, Vice President-Investor Relations]

Thank you, Shelvin. And thank you everyone for joining us this morning. We look forward to seeing you at upcoming investor conferences in September. That concludes the conference call. Thank you.

[Operator]

Thank you. That does conclude today's Charles River Laboratories second 2022 earnings call. Thank you for your participation. And you may now disconnect.