CRL — Q2 2019 Earnings Call Transcript

Thank you. Good morning, and welcome to Charles River Laboratories' Second Quarter 2019 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 2019. Following the presentation, they will respond to questions. There is a slide presentation associated with today's remarks which is posted on our Investor Relations section of our website at ir.criver.com. A replay of this call will be available beginning at noon today and can be accessed by calling 800-475-6701. The international access number is 320-365-3844. The access code in either case is 470022. The replay will be available through August 14. You may also access an archived version of the webcast on our Investor Relations website.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 under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by any forward-looking statements. During the call, we will primarily discuss results from continuing operations in non-GAAP financial measures, which we believe help investors gain a meaningful understanding of our core operating results and future prospects. 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 through the Financial Information link. I will now turn the call over to Jim Foster.

Good morning. We believe that Charles River is a stronger company today than it's ever been. We have invested tremendous effort over time to add people and capacity to accommodate growing client demand and to build a scalable operating model, to maintain and enhance our scientific leadership, to strengthen our relationships with clients and work with them to devise outsourcing solutions which enable them to increase productivity and speed to market, and to create a culture of continuous improvement in which our employees are open to working in new ways which improve our efficiency and responsiveness to clients. We maintained our focus on early-stage drug research and manufacturing support solutions, strategically expanding our portfolio to provide clients with the critical capabilities they require to discover, develop and safely manufacture new drugs. The acquisition of CiTox, which was completed on April 29, was another step forward in our strategy. We will continue to invest in and enhance our industry-leading portfolio to fulfill our long-term strategic goals to further differentiate ourselves from the competition and to move with the fast pace of innovation in our markets. By doing so, we will enhance the value we provide to our clients' research efforts and become an even stronger drug discovery and development partner. These initiatives have positioned us exceptionally well to compete for business now when biotech companies are aggressively investing new funding in their pipelines, global pharma companies are continuing to make decisions to outsource, and academic institutions are working with biopharma companies to discover new drugs. Our second quarter results demonstrate the effectiveness of our strategy and the progress that we have made on its execution as well as a continuation of the strong industry fundamentals, including biotech funding. As anticipated, second quarter organic revenue growth was within our prior full year range of 8% to 9.5%, and low double-digit earnings per share growth exceeded our prior outlook. As a result, we expect to meet or exceed the 2019 financial guidance that we provided in May. I will now provide highlights of our second quarter performance. We reported revenue of $657.6 million in the second quarter of 2019, a 12.3% increase over last year. Organic revenue growth was 8.5% with continued strength reported across each of our business segments. From a client perspective, biotech clients continued to drive revenue growth as the funding environment remained robust and the invested funds in new areas of drug research. The operating margin was 18.5%, a decrease of 20 basis points year-over-year. On a segment basis, the Manufacturing and RMS segments were the primary drivers of the decline. The margin headwinds that we have mentioned since last year, the compensation structure adjustment, the large Insourcing Solutions contract, and the Biologics capacity expansion reduced the operating margin by 50 basis points. Earnings per share were $1.63 in the second quarter, an increase of 12.4% from $1.45 in the second quarter of last year. Strong revenue growth and higher operating income drove the year-over-year increase, while a lower-than-anticipated tax rate contributed to the outperformance versus our prior outlook. With first half organic revenue growth at 9.6%, we are well positioned to achieve our updated organic revenue growth outlook of 8.5% to 9.5% for the year. We increased our non-GAAP earnings per share guidance by $0.05 to a range of $6.45 to $6.60, reflecting our expectation of a lower tax rate in 2019. This represents earnings per share growth of 11% to 14% year-over-year. I'd like to provide you with details on the second quarter segment performance, beginning with the DSA segment. Revenue was $405.5 million, an 8.7% increase on an organic basis over the second quarter of 2018. Both the Safety Assessment and Discovery Services businesses continued to perform very well, with Safety Assessment revenue growth moderately outpacing Discovery Services in the second quarter. Safety Assessment had another strong quarter, benefiting from robust demand from biotech clients and increased pricing. Our global Safety Assessment capacity remained well utilized, and bookings and proposal activity continued to reinforce our outlook for high single-digit organic growth in the DSA segment for the year. As a result of our dedicated focus on portfolio expansion, enhancing our scientific capabilities, improving our operating efficiency and developing flexible and customized working relationships, we are positioned exceptionally well to provide the support that our clients require in order to expedite their drug research efforts. And with the acquisition of Citoxlab in April, our extensive capabilities and global scale present an even more compelling value to our clients, whether they are global biopharma clients increasing their reliance on CROs or small and midsize biotech clients which have always relied on external resources. Our growth demonstrates that our clients recognize the value we provide, and we believe that they will continue to be significant client demand for our services. To manage our larger infrastructure and enhance the speed and responsiveness with which we can work with clients, it has become increasingly important that we ensure a seamless client experience across all of our sites and encourage clients to work across multiple sites. This offers clients access to much broader capabilities than they might have at a single site and reduces lead times to start studies. It also benefits our operating efficiency through shared resources and optimized capacity utilization. We are already beginning to see the benefits of our efforts to encourage client mobility, with a notable increase in the number of Safety Assessment sites used by our clients in the second quarter over the prior year. This, in turn, improves our proposal win rates because we're able to meet our clients' scheduling requirements and tighter start times. The integration of Citoxlab is progressing smoothly, and I'm pleased to say that we have accomplished the major goals we set for the first 90 days. Chief among those was integration of Citoxlab's talented staff and its clients, and initial feedback from both groups has been positive. Citoxlab's scientific teams have met with their Charles River colleagues to begin to share best practices and work collaboratively across our global network of sites. And as was the case for both WIL and MPI, the teams at CiTox are very engaged and optimistic about the future of the company and the opportunities for career growth and are motivated to play a key role in further enhancing our position as the leading early-stage CRO. This collaborative and positive approach is already paying dividends as we have recognized some early opportunities to drive operational synergies, including leveraging other Charles River sites to conduct pathology and laboratory sciences work that Citoxlab had previously outsourced. We remain confident in our ability to achieve $8 million to $10 million in operational synergies over the next two years as the combined teams continue to forge stronger and more seamless relationships. The Discovery business had a solid quarter, led by strong demand for early discovery services as well as client utilization of our new site in South San Francisco. Demand for our early discovery services continues to strengthen as clients partner with us for a single project or for their larger integrated discovery programs. Client interest in our integrated drug discovery programs was very strong in the second quarter, leading to our highest-ever win rate on proposals for these projects. These wins are building an excellent pipeline for early discovery projects in the second half of the year. We continued to expand our Discovery portfolio and footprint. The addition of Citoxlab's discovery capabilities provides additional solutions in drug transporter and drug-drug interaction research to enhance our clients' drug discovery efforts. In addition, clients are increasingly placing work at our expanded South San Francisco discovery site, which opened at the beginning of this year. It offers a wider range of discovery capabilities, from CNS to DMPK and bioanalytical services, to this fast-growing West Coast biotech client base. We also continued to evaluate opportunities to add innovative discovery capabilities to our portfolio, as we believe creating a comprehensive solution at the earliest stages of drug research will enhance client retention or stickiness as their programs progress through the pipeline. Our recent alliance with Distributed Bio is a prime example of this. Our combined large molecule discovery capabilities are generating considerable client interest. We intend to continue to build our Discovery portfolio to reinforce our position as the premier single source provider for a comprehensive range of discovery services. The DSA operating margin declined 40 basis points year-over-year to 21.1% in the second quarter, but improved significantly on a sequential basis as we anticipated. The year-over-year decline was principally caused by higher costs associated with staff and capacity investments, including last year's adjustment to our compensation structure. This was partially offset by higher pricing and the operating income benefit from R&D tax credits related to the Citoxlab acquisition. Notwithstanding this benefit, the acquisition of Citoxlab created a small margin headwind in the second quarter. We expect the DSA operating margin will continue to improve sequentially in the second half of the year, primarily driven by the anniversary of the compensation structure adjustment on July 1 and slower hiring after an acceleration of staff additions into the first half of the year to help support the strong client demand. RMS revenue was $136.1 million, an increase of 6.8% on an organic basis over the first quarter of 2018. The primary drivers of RMS revenue growth continued to be strong demand for Research Model Services and for research models in China. From a services perspective, the Insourcing Solutions contract with NIAID, which commenced last September, contributed approximately 350 basis points to the revenue increase. Aside from the benefits from the NIAID contract, the Insourcing Solutions business continued to perform very well as clients took advantage of our flexible solutions for their vivarium management and related research needs. Last quarter, we discussed the success of our CRADL initiative, or Charles River Accelerator and Development Labs, to provide both small and large pharmaceutical clients with turnkey research capacity in the Boston/Cambridge biohub. We were pleased to announce earlier this month the planned expansion of our CRADL initiative to the South San Francisco biohub, which is expected to open in early 2020. We continue to support clients through a variety of working arrangements from our traditional insourcing option of providing staff and expertise to manage a vivarium at a client site, to CRADL where we provide flexible vivarium space at a Charles River site. Our GEMS business also continued to benefit from our clients' use of CRISPR and other technologies to create genetically modified models faster and more cost-effectively. Clients come to us because we have the expertise to help them derive and maintain proprietary model colonies which play an increasingly critical role as drug research becomes more complex with a shift to oncology, rare disease, and cell and gene therapies. Revenue growth in our Research Model production business continued to be driven by China, which is performing very well. The research model market in China continues to be a significant growth opportunity for us, and our goal is to achieve a 50% market share throughout all of China. To achieve this goal, we intend to continue to add capacity in new regions of China. Outside of China, we expect a continuation of the research model trends that have been largely present for several years: declining demand from large biopharma, increasing demand from biotechs and consistent price increases. Combining these factors with our expectations for continued growth in China and our services businesses, we expect to continue to generate low single-digit growth for the RMS segment over the longer term. The RMS operating margin decreased by 130 basis points to 25.5%. The decline was driven by three factors: the lower-margin NIAID contract, the compensation structure adjustment, and lower demand for research models outside of China. The headwinds from the NIAID contract and the compensation structure adjustment will be anniversary’d during the second half of the year. To help offset volume pressure in mature markets, we continue to look at new ways to enhance operating efficiency, from cost reduction to driving towards a more digital RMS enterprise, with the goal of sustaining RMS operating margin. Revenue for the Manufacturing Support segment was $116 million, a 9.8% increase on an organic basis over the second quarter of last year. The increase was driven by strong demand across both the Microbial Solutions and Biologics Testing Solutions businesses. Microbial Solutions had another strong quarter with growth in the low-double digits. Our advantage as the only provider who can offer a comprehensive solution for rapid quality control testing continued to resonate with our clients, which was demonstrated by robust demand across our Endosafe testing systems and cartridges, core reagents, Accugenix microbial identification services and Celsis bioburden solutions. Sales of our Celsis product line had a particularly strong quarter. We launched a new Celsis rapid sterility test earlier this year, which is already beginning to gain client adoption and replace manual testing methods used to expedite the release of their pharmaceutical products. We also continued to invest to support future growth, including through geographic expansion and operational enhancements. We are opening a site in Shanghai to create a stronger presence in the growing China market and are also investing in process improvements to further enhance Microbial Solutions operating efficiency. Revenue growth in the Biologics business dipped slightly below the 10% level in the second quarter, but the business still had a very good quarter overall, and we continue to expect growth in the low double digits for the year. Revenue was driven by the robust growth in biologics drug development as demonstrated by the number of large molecule drugs in the pipeline and the new innovative solutions to cure unmet medical needs. To accommodate this demand and enhance our position as a premier provider of these critical services, we are adding capacity globally. The new Pennsylvania facility, which is our largest global expansion, continues to progress well, and the transition is expected to be completed by the end of the year. As we have mentioned in the past, we are operating two facilities as we transfer services to the new site in order to ensure that the transition is seamless for our clients. This is creating duplicate costs during the transition, resulting in a 60 basis point headwind to the segment's operating margin in the second quarter; however, these costs are expected to moderate during the second half of the year. The Manufacturing segment's second quarter operating margin was 30.9%, a 270 basis point decrease year-over-year. The decline was primarily related to higher costs from investments to support growth in both the Microbial Solutions and Biologics businesses that I previously mentioned. The second quarter margin was slightly lower than we had anticipated. But as we have regularly said, our business is not linear and we expect the Manufacturing segment's operating margin to approach the mid-30% level in the fourth quarter as many of these headwinds dissipate. As we continue to enhance our position as the leading early-stage CRO, we have become the go-to partner for an expanding number of clients who recognize our scientific expertise, global scale and deep commitment to them. We have increasingly become an integral part of the solution to more efficient and productive drug research, where the clients utilize Charles River to augment their internal expertise or because they have no in-house infrastructure and choose to partner with the most experienced scientific CRO. Working collaboratively with us to design studies or projects and interpret the results expands our clients' bandwidth and capabilities as they make critical go or no-go decisions about their early-stage pipelines. Our importance to our clients increases as we expand our broad portfolio. Therefore, they increasingly rely on our expertise across a wider array of scientific solutions. We believe that the continued expansion of our portfolio and our scientific expertise, superb execution and our flexibility and responsiveness are the basis for long-lasting relationships with our clients and our future growth. We are maintaining our intense focus on the initiatives that we view as critical to expanding the value we provide for clients. We are continuing to assess opportunities to broaden our portfolio of early-stage drug research and manufacturing support solutions with strategic acquisitions as well as through internal investments in unique arrangements such as our large molecule discovery partnership with Distributed Bio. The cutting-edge innovation in drug research is generating significant funding that continues to fuel the pipelines of the biotech industry, which in turn fuels our growth. We intend to remain on the leading edge of this innovation by further investing in our scientific capabilities, whether it be to add new technologies to enhance our therapeutic area expertise or to better capitalize on emerging scientific trends, such as the proliferation of large-molecule drugs in the pipeline and on the market. While acquisitions are a vital component of our growth strategy, we will also continue to invest in the staff and resources necessary to support current and future growth, in technology to be able to work more seamlessly and efficiently with our clients and protect their data, and in our scientific expertise to further differentiate ourselves from the competition. By doing so, we aim to partner with our clients to support a broader spectrum of their scientific needs, which will help us achieve our long-term growth goals and enhance shareholder value. In conclusion, I'd like to thank our clients and shareholders for their support and our employees for their exceptional work and commitment. Now David Smith will give you additional details on our second quarter results and 2019 guidance.

Thank you, Jim, and good morning. Before I begin, may I remind you that I'll be speaking primarily to non-GAAP results from continuing operations, which exclude amortization and other acquisition-related charges, costs related primarily to our global efficiency initiatives, and certain other items. Many of my comments will also refer to organic revenue growth, which excludes the impact of acquisitions and foreign currency translation. We are pleased with our solid results for the second quarter, with organic revenue growth of 8.5% and earnings per share growth of 12.4%, both consistent with our long-term financial targets as well as our outlook for the year. Reported revenue growth of 12.3% was also in line with our prior outlook of low double-digit growth despite a larger-than-anticipated 1.9% headwind from foreign exchange due to the strengthening of the U.S. dollar. The operating margin declined 20 basis points year-over-year to 18.5% in the second quarter, but improved sequentially from 16.3% in the first quarter, in line with our prior expectations. As Jim discussed, the year-over-year decrease reflected margin pressure from the NIAID contract, the biologic capacity expansion, and last year's compensation structure adjustment, which collectively reduced the operating margin by 50 basis points. We expect the second half operating margin to improve over the first half level as we anniversary the compensation structure adjustment and the other headwinds become smaller. For the full year, we're continuing to expect the operating margin to be similar to the 2018 level of 18.8% despite slight margin dilution associated with the Citoxlab acquisition. Second quarter earnings per share increased 12.4% to $1.63, which exceeded our prior outlook of high single-digit growth, due in part to a lower-than-expected tax rate. Our second quarter tax rate was 22.1%, representing a 120 basis point decline from 23.3% in the second quarter of last year. Primarily associated with the Citoxlab acquisition, we recognized incremental R&D tax credits, which reduced the tax rate and generated a small corresponding benefit to the DSA operating margin in the quarter. As a result of the R&D tax credits, we are lowering our full year tax rate outlook by approximately 100 basis points to a range of 22.5% to 23.5%. Unallocated corporate costs for the second quarter were $34.9 million or 5.3% of revenue, which was below last year's level of 6.2%. As we continue to build a scalable infrastructure to support our growing business, we expect to maintain our non-GAAP unallocated corporate costs at or slightly below 6% of total revenue in 2019. Total adjusted net interest expense for the second quarter was $16.8 million, an increase of $0.6 million sequentially, reflecting a partial quarter of borrowing costs for the Citoxlab acquisition. For the year, we continue to expect adjusted net interest expense of $68 million to $71 million. As a reminder from last quarter, adjusted net interest expense is calculated as the net of interest expense, interest income, and an FX adjustment related to forward FX contracts recorded in other income. We continuously evaluate our capital priorities and intend to deploy capital to the areas that we believe will generate the greatest returns. Strategic acquisitions remain our top priority for capital allocation followed by debt repayment. At the end of the second quarter, we had an outstanding debt balance of $2.1 billion compared to $1.6 billion at the end of the first quarter, which excluded the acquisition of Citoxlab. Our gross leverage ratio at the end of the second quarter was 3.25x and our net leverage ratio was 2.9x. Absent any acquisitions, we are on track to reduce the gross leverage ratio below 3x within 12 months of the completion of the Citoxlab transaction. Year-to-date, we have not repurchased any shares and do not intend to in 2019. Free cash flow was $104.8 million in the second quarter, a slight increase compared to $102.7 million for the same period last year. Our free cash flow guidance for the year is unchanged at $310 million to $320 million. CapEx was $24.8 million in the second quarter, and we continue to expect to invest approximately $170 million in CapEx for the year. With respect to 2019 guidance, we are narrowing our revenue growth outlook to a range of 16% to 17% on a reported basis and 8.5% to 9.5% on an organic basis, reflecting continued strong demand trend and the contribution from Citoxlab. Foreign exchange is expected to be less favorable as a result of the strengthening of the U.S. dollar, and we now expect an approximate 1% to 1.5% FX headwind for the year compared to our prior outlook of approximately 50 basis points. We are increasing our non-GAAP earnings per share guidance by $0.05 for the full year to a range of $6.45 to $6.60. The increase primarily reflects the associated benefit from the lower-than-expected tax rate. We continue to see healthy client demand across our businesses and are reaffirming our full-year expectations for the segment revenue growth. We expect reported and organic revenue growth in the mid-single digits for the RMS segment and low double digits for the Manufacturing segment. For the DSA segment, including a contribution from Citoxlab, we expect reported revenue growth in the mid-20% range and high single-digit organic revenue growth. A detailed summary of our financial guidance can be found on Slide 38. For the third quarter, we expect the reported revenue growth rate to be in the mid-teens. On an organic basis, we expect the growth rate to improve slightly from the second quarter level as the Manufacturing segment growth is expected to rebound into the low double digits, which is consistent with the long-term target and our outlook for the year. We expect low-teens earnings per share growth when compared to the third quarter 2018 level of $1.45. The third quarter operating margin is expected to be similar to the second quarter level. The compensation structure adjustment on July 1 is now guided, which mitigates one of the headwinds, but we expect to incur modest costs related to cybersecurity enhancements in the third quarter. In conclusion, we are pleased with our second quarter performance, which included healthy revenue, earnings, and free cash flow growth. We are confident about the prospects for the third quarter and are on track to achieve our full-year financial outlook. We will continue to execute on our strategy of expanding and enhancing our business to meet the needs of today while investing to accommodate the anticipated growth of tomorrow, always endeavoring to enhance our position as the leading early-stage CRO.

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

This is Rong Li on for Ricky Goldwasser. So I just wanted to follow up on the margin dynamics. So when we think about the biggest drivers of margin improvement in the second half of the year, how should we think about the various impacts from pricing versus mix of product and services and the cost reduction? I wonder if you can give some color around how you manage margins and SG&A going forward. And then my second question is around the RMS segment. And you mentioned about the cost reduction to drive a digital RMS enterprise. I wonder if you can talk a bit about the initiative you are contemplating here.

Well, that's a big question. In summary, I think a lot of what we've described this morning is very similar to what we described in the first quarter. What we've been using this morning to do is to reaffirm some of the comments that we made before. A lot of what we talked about, the RMS, and which Jim called out, will continue to go through the year. We did talk last quarter extensively about how the DSA margin in the second half of the year would be stronger than the first half of the year, and we have reaffirmed that this morning. We called out in the last quarter quite a lot of the drivers after why we found out that was the case. Manufacturing is weaker in Q2, but we have reaffirmed that will continue to build towards the mid-30 margins that we strive for long-term, and we will achieve that by Q4. So without repeating a lot of what we described on the call, I'll move on to your other question, which I think was around the RMS digital enterprise. In simple terms, the way I would describe that is the way of simplifying our ordering and access to our inventory, and it will also allow clients' access to our data. And that's a key driver, we believe, in enhancing the way that clients will interface with us, but also will enable us to be more efficient and that will drive more efficiency going forward.

We also reduced some capacity at the small facility we have in San Diego. We're continuing to look closely at our capacity. We will continue to look at ways to systematize things that have been overly manual historically in this business. Going back to David's response to the digital enterprise, our overriding focus there, in addition to being obviously more efficient, is to drive more sales, particularly in the academic sector where we think that we can distinguish ourselves with that sort of technology.

Got it. You mentioned improved pricing in South America. Can you share your current expectations for pricing? Do you see it as a significant factor for margin improvement? I'm curious about how you view pricing in relation to other elements that might help drive margins moving forward.

You're talking specifically about Safety Assessment or across the whole business?

Across the whole business.

Yes. We will continue to achieve price increases, and this is a significant aspect of our business strategy. While we won't disclose specific margins or pricing in Safety Assessment, we are satisfied with the prices we are obtaining. This reflects the complexity and challenges of our work. Moreover, I believe clients are becoming more willing to invest in science and responsiveness.

Congrats. Just on the Safety Assessment business. With Citoxlab sort of rolling in, in kind of geographic presence even more balanced across what's now by far the largest network, I guess. How is that helping evolve maybe some of the business development conversations you're having with maybe some of the large pharmas? And in general, that business also had a couple other areas that strengthen you like devices, et cetera. How are you thinking about some of those ultimately as kind of incremental growth drivers in the DSA unit for the foreseeable future?

We are really pleased to expand our capabilities in medical device testing, which adds to our previous offerings. This market is very strong for us, and we are excited about it. We are also enthusiastic about the discovery assets we acquire, especially regarding drug transporter elements, which will play a key role in our Discovery business. As this portfolio grows, we are enhancing client engagement. Regarding Safety Assessment, it increasingly involves client mobility. Clients are able to work more quickly due to increased options, becoming more strategic in their collaboration with us and feeling more comfortable utilizing multiple Charles River locations. Over time, they may become indifferent to where the work is done because they receive consistent, high-quality results from various sites. The acquisitions we made in the last three years have significantly expanded our safety site footprint, leading to increased interest from both legacy Charles River clients and those at our new sites. We are observing a growing trend where clients are interested in auditing each other's sites. The options we offer compared to our competition, especially relative to what large pharmaceutical clients can do internally, are vastly superior. We expect this trend to continue, as limited space makes clients more willing to engage with multiple sites, which helps them start work within their desired timelines.

And maybe on the sort of RMS business with respect to China. Having just been there, I mean, biotech is absolutely on fire in terms of investment and aspirations. And it seems more and more the desire for kind of western products and to use kind of what's leading in the U.S. continues to be an increasing bias. I guess how are you thinking about kind of the evolution of that business model specifically? But also, what else ultimately you can kind of wrap in around that to sort of grow your presence there?

Yes. The Research Model business, we are continuing to aggressively build out new capacity. We finished the big Shanghai facility, and we're looking at two other locations right now to expand our bandwidth. It's a relatively straightforward proposition in terms of being in close proximity where the research is being done and have a higher quality of product than the competition, which we're quite confident that we do are. The competitive base continues to be primarily Chinese companies. And while they may figure it out in time, the quality is just not very high and not consistently so when it is high volume, starting and stopping of Chinese companies face. As you see this massive infusion of capital going into both pharma and biotech companies in China and expanding into new locales, it's just not going to be able to do the research with our high-quality animals. So we're enjoying a terrific growth rate in that business which we think are absolutely sustainable. And of course, we've added capability in our Microbial business as well. The strategy to expand the portfolio in China to be as comprehensive as it is in the rest of the world is inevitable, but it's not entirely straightforward proposition because of the M&A opportunities over there have valuations that we're not very happy with. They're pretty high. So we're figuring out the best way to proceed, and slightly that we'll have to start some things up. I would imagine that Discovery would be first and Safety would follow.

Jim, you mentioned a couple of metrics that I would like more details on. One is regarding the increase in the number of sites that clients are using compared to the second quarter of last year. Could you provide an average of what clients were using last year versus this year? Additionally, regarding the goal of achieving 50% market share in China, could you clarify where we currently stand? I'm curious about those figures.

So we have about 30% share now, and we're confident and insistent and persistent in our average to get through at least the 50% share, which is sort of where we are in the rest of the world. Hopefully, it will be higher, but we'll settle that. Rapidly growing market. We think it will be as larger and larger in the U.S. as we've said before. Units are increasing dramatically. And it's a market that is reminiscent of some decades ago in the other parts of the world. And with the level of investment, that's why we can continue.

To clarify, the data points you provided fall between Discovery and Safety. However, the focus is not just on those aspects but also on the clients who are prepared to utilize Montréal, Ambro, CiTox, and others.

That's right. So the first comment is about the strength and diversity and kind of depth of the portfolio and the ability to target clients. Really, the client mobility comments, specifically with reference to Safety, is just as lit the large number of sites which provide clients options and then with the continuity of quality of service across those sites. So it will become increasingly fungible for them, and the options are easier for them to give the answer around that. I think that a lot of them to move more quickly than they have historically where they would only work with one side or maybe two, and that's becoming a competitive advantage for us.

Understood.

But the percentage increase on the number of clients using more than one site, it's the increase and its percentage times is double-digit. So it's meaningful.

I want to touch on Manufacturing. You noted Biologics dipped a little bit. You are still confident in a recovery. Can you just talk to that confidence in the back half of the year rebound? And then has the Pennsylvania manufacturing support facility actually come online? And if so, can you talk anything about capacity utilization in the early days here?

Yes. We're currently in the process of securing the necessary components for the Pennsylvania facility, which includes ramping up specific laboratories and activities at both the old and new sites. Some operations will overlap temporarily as we ensure a successful transition to Good Manufacturing Practices and move clients to the new facilities. Many of the new capabilities are now operational, and clients are already collaborating with us. Throughout the remainder of the year, our capabilities will continue to evolve. We're on track, and everything is progressing well. The new facility is excellent, and I believe our clients will be pleased with it. It will operate more efficiently due to its larger and more organized layout compared to our existing facility, which has been expanded over time. The previous quarter was solid, slightly below double digits, but the first half of the year exceeded double digits. This business tends to start slower as clients determine which molecules to test, but we usually see stronger growth in the latter part of the year, as we have experienced over the last couple of years. Therefore, I am confident we will conclude the year with over double-digit sales growth, and margins are expected to keep improving.

Okay. And then as we're sitting here, there's headlines come across in the White House for the prescription import program, pilot program potentially coming. You've kind of talked on drug pricing headline risk in the past. But if we really do get an import program, what's your sense of what that potentially could do to early stage, if anything at all?

It's difficult to predict with certainty. While we work with many clients in the drug development sector, drug pricing hasn't been a significant topic of conversation for us at this time. The new program seems to only impact existing drugs and generics, not the breakthrough drugs that are key to our work. It's hard to imagine that investment in research and development or efforts to accelerate pipelines will slow down. Additionally, if pricing pressures increase, we might see more outsourcing rather than less. Our focus is on being efficient, responsive, and cost-effective to help our clients reduce their internal costs. Their success relies on bringing new drugs to market, which is where we come in. We'll monitor the situation closely, but it hasn't been a major topic in discussions aside from the occasional mentions in Washington.

Okay. And if I could ask one last quick one. On cybersecurity, any lingering liability issues there or anything we should be thinking about going forward? Obviously, you've stepped up your investments there on the IP side.

Yes, that incident really had no impact on our daily operations. It affected a very small percentage of our clients, just 1%. We've spoken with all of them, and as a group, while they weren't pleased with the incident, they appreciated our transparency and were understanding of the situation. In many ways, this has improved our reputation with them regarding our responsiveness and openness in handling the issue. Additionally, we've enhanced our internal capabilities moving forward.

Two questions. First, Manufacturing Services, given your comments about Microbials and Biologics growth which were both solid, Avian must have been fairly slow in the quarter. I'm hoping we could get an update on that business specifically. And then second question. You've acquired three notable Safety Assessment competitors in recent years. Can you just give us a refresher on how and how much that impacts the reported growth rates in Research Models? And any impact on 2019 growth in RMS related to the CiTox acquisition, just the mechanics of that?

So Avian, which we don't break out very often because it's a small business, didn't have a strong quarter. So you're right with that. We're not going to give the exact percentages. And then that business, like many of our businesses even though that would probably point us as some fluctuations in terms of the clients' buying patterns, which are a little bit difficult to predict. Do we have the percentage on the second part of his question?

The last time we updated, about 5% of our Research Model volume comes from intercompany sales that contribute to the intercompany DSA segment, including our recent acquisitions. This impacts the year-over-year growth rate, especially when we brought in a new competitor in Safety Assessment.

Jim, we hear a lot currently about cell and gene therapy being really driving a lot of increased activity. I'm curious how that impacts your businesses. Does it flow through as any other new drug would? Or are there any sort of unique aspects of that, that play into your capabilities?

Yes. Definitely going to be a driver of growth for all of us in the drug development space. We reckon we have about $100 million of revenue right now across that portfolio. Yes, those drugs are going to go through sort of normal pharmacology and safety requirements to get the new market. We're also seeing benefits in our Biologics business to test those drugs both before they go into the clinic and after they get into the marketplace. It's going to have some benefits to our Microbial business as well. So pretty much across our entire portfolio will have engagements with cell and gene therapy drugs. I think that will be an area of continued focus for us to continue to expand our scale, to make some technology investments in that space and perhaps some M&A in that space as well.

Great. And then maybe just a quick one on your Safety Assessment business. How are lead times right now compared to a year or two ago? Are you seeing them stretch out or are they pretty stable?

We like where the lead times are because clients are waiting, and I think I have to do a better job in planning and prioritizing the products by the same token, since we bought several of our competitors. I think in some ways we have to be more responsive now particularly to clients that are using a larger percentage of our portfolio. So both bookings and proposals are quite strong. It's a lot of work out there. We're trying to be as responsive to clients as possible. They're not particularly patient and where previously they may have gone to work with one of our competitors, obviously, that's now part of our portfolio. So I think in some ways, we'll be more responsive to them.

And to the earlier question around client mobility, that actually helps us to ensure that the lead times are not expanding.

This is Juan Avendano for Derik. On capital deployment, do you expect M&A to take a backseat to organic investments in CapEx going forward, given that we now know that there are a few Safety Assessment, M&A opportunities going forward? And as we know also, you have the San Francisco facility under Biologics capacity expansion ongoing. And so if you could just give us some thoughts on capital deployment. And any shifts in the ranks and priorities across CapEx and organic investments and M&A?

Yes, strategic acquisitions will always be our top priority for capital deployment. This is how we build our business and create a unique portfolio. We are actively seeking M&A targets that can enhance our offerings, especially in the Discovery space. In the cell and gene therapy area, we don't see any significant acquisitions in Safety, but we might explore opportunities in other regions. Acquisition prospects remain across various sectors where we are involved. At the same time, we will invest heavily in our existing business and portfolio, as our current guidance suggests a strong organic growth rate between 8.5% and 9.5%. We aim to strengthen these businesses and expand their capacities. Additionally, we are making strategic investments in companies like Distributed Bio, where we may engage in small equity investments or provide loans to gauge the viability of their technologies. Depending on the outcome, these investments may either be set aside as R&D expenses or evolve into joint ventures or acquisitions. Overall, we are effectively covering various opportunities. Our company has significantly grown through acquisitions, and we are improving our ability to conduct due diligence and effectively integrate acquired entities. You can expect to see us actively invest in all three areas.

Okay. Got it. And so a follow-up again and so maybe perhaps that the number of tuck-ins that you'd be doing in areas outside of Safety Assessment would be enough to move the needle on an overall M&A basis?

We'll see. There's a lot of them and there are some deals that are larger than tuck-ins. And it's tough to predict because even deals that we were interested in doesn't mean it will prevail and it will elect for prices. But there's a fair amount of activity that would significantly enhance both the price and the impact of our portfolio, and yes, that's where we're looking at.

Got it. And then if you could give us a qualitative update on the Microbial Solutions market. We haven't spoken about this in a while. But we know that it's about a $2 billion market opportunity. If you could give us an update on perhaps the percentage of customers that have migrated into the real-time faster microbial testing solutions, the penetration rate of those or maybe the number of installed microbial solution cartridges in the market. Any qualitative update on that market since you acquired Celsis in July of 2015 will be appreciated.

We are in a strong and rapidly expanding market. We recently introduced a sterility product that represents an additional $500 million to $600 million opportunity, making the total market size approximately $2 billion to $2.5 billion, as mentioned. Our business performance has been robust, consistently achieving double-digit growth rates for over a decade, and we expect this trend to continue. Our technology outperforms that of our competitors and we are successfully transitioning many clients from their older technologies to our new, more advanced solutions, including our handheld unit and cartridges. While we won’t provide specific unit numbers, we can highlight the strength of our growth rate and profitability. The core business, along with the two acquisitions we’ve made, are well integrated and we are making significant strides in the pharmaceutical sector and other market segments we serve, with plenty of growth potential ahead.

I guess maybe somewhat staying on the Manufacturing theme, maybe a little bit of a shorter-term and longer-term question, Jim. When I think about the Manufacturing business, and when I think about the growth drivers and I sort of break it into market growth, your ability to drive existing product growth, and your ability to launch new products, is there a way to sort of frame that in terms of when we think about the growth, how much is dependent on just the overall market growth? Is it more dependent on your success in selling or is it more dependent on your success in rolling out new products? And obviously, doesn't have to be exact, but some type of qualitative commentary around those buckets in Manufacturing.

Yes. There is strong market demand in Biologics due to the rise of large molecule drugs and new methods. We face significant competition, but all of us in this sector are performing well. While there are new SAs and capabilities we need to adopt, they are relatively simple. We set ourselves apart through our scale, geographical reach, and responsiveness. Currently, we are heavily investing in expanding our Biologics capacity, which may slightly impact margins, but we expect strong top-line growth this year and hope for continued improvement in the future. The Microbial sector also shows robust market dynamics, with a significant shift away from older, slower QC testing methods that waste time and money for drug and consumer goods companies. We believe we can surpass our competitors by enhancing our capabilities. Continuous innovation is essential, even if it means making our own products obsolete. This sector is unique as it is the only one where we hold IP. We've been successful in staying ahead of the competition by providing better solutions that allow clients to operate more centrally and minimize the risk of contamination. The Microbial landscape is complex, but we hold a leadership position and plan to continue investing vigorously to sustain it.

I wanted to follow-up on the CapEx expectations and guidance. So to get to the $170 million for the full year, I think there's a big ramp in the back half. So was wondering if you could give us some color on where you're investing. And maybe specifically, in the Safety Assessment business, are there any aspirations to open up additional wings at some of your existing sites or some organic expansion that you're planning?

Yes. So you're right. There is a right platform. If you actually look at our history, we've had a pattern where we tend to spend more on the second half of the year but that's just coincidence. You're right, the majority of that CapEx expansion is in Safety. There are some refurbishments or expansions that we're doing in Great Blakenham and we know, for instance, and in Canada, which we expect to come online and help us with the sort of capacity needs that we have in the sort of nearer term. So hopefully, that helps give you a bit of color.

Yes, that does. To conclude, regarding the Safety Assessment margins, I understand you have provided extensive insights over the past few years on the factors affecting those margins. Do you believe that margins could start to stabilize or even expand a bit in 2019 or possibly by the fourth quarter? Or are there additional investments that might impact that?

We expect margin expansion in the second half for DSA. The compensation structure adjustment was completed on July 1st last year. Although we've experienced some setbacks from Citoxlab, we are focused on improving those margins. Therefore, we anticipate stronger margins for DSA in the second half of the year compared to the first half. This approach will help us achieve similar total margin levels as in 2018.

David, maybe just to follow up on the DSA question. Obviously, you guys sound very confident in the ramp. But just looking at some of the moving pieces, is there any more you could share around, for instance, the R&D tax credits? It seemed like it was one of the offsets to some of the declines you highlighted in the quarter. Trying to get a sense of what that impact was on the EBIT line. And then, if I just look at the margins in the quarter, you guys described the better utilization of staff. You guys talked about the mobility improvement and the mobility between sites. But obviously, yet the margin was still down year-over-year in the quarter. So just trying to get a sense of the build from here with some of those moving pieces against the expected ramp in the back half.

The R&D tax credit provides a benefit not only for Q2 but also extends into Q3 and Q4. This will positively impact the DSA margin due to potential upside. When we acquired Citoxlab, we were unsure about the reliability of that tax credit, which is why this information is new for you today. Previously, we were not confident that these tax credits would be consistent over time. However, we now feel assured that they are, which is why they contribute to future margin expansion for the DSA and the effective tax rate reduction for R&D that we announced this morning of 100 basis points. We also discussed our plans for staffing adjustments, and we believe we have achieved the right-sized workforce for the DSA, meaning we won’t need to hire as aggressively in the latter half of the year, which will be beneficial moving forward. Additionally, the changes in compensation structure are now finalized. We continue to see positive price volumes, but our main challenge remains with Citoxlab. Similar to our experience with WIL Research in 2016, we are focused on strengthening those operations, and we feel confident that we will achieve similar results with Citoxlab.

Do you think you're seeing any sort of benefit to date given some of the commotion and recent transaction with the competitors Envigo and Covance? And I'm just curious if there's any changes in what you're seeing across the competitive landscape in light of those transactions and how you think you're positioned longer term.

I would say that that transaction has been quiet, somewhat neutral from a market point of view. We haven't seen that company act fundamentally much differently than it has historically. Typically, it has competed with us more on price than anything else. And I think that our ability to drive efficiency and have a larger portfolio and a bigger international footprint should hold us in good stead.

Okay. Great. And would you say that overall that Citoxlab integration process is running ahead of plan, in line with plan? Or what are some of the early milestones there? And then also, just any surprises that you've seen with that integration process?

Yes, the integration is definitely complex. We have nine locations spread across North America and Europe. The business was well-managed, and we followed a detailed 90-day integration plan, executing it carefully day by day and week by week. There haven’t been any major surprises. The scientific team is very happy to be part of a strategic home rather than being under financial ownership, and they have been highly collaborative in terms of science. We are focused on implementing best practices and are confident that we will achieve $8 million to $10 million in cost savings over the next few years. We have also maintained all our clients. Overall, the process has gone well, although we are still in the early stages. We are also very satisfied with the management team, most of whom are still with us.

I understand this call is taking a bit longer, but I will keep it brief. Can you provide an update on the breakdown between the Discovery and Safety Assessment segments in the DSA? I believe you've shared this information in the past. Also, there seems to be a difference in the growth rates of these two businesses. Regarding Discovery, have you seen any scale if you consider it separately? I tend to view it as having a more stable operating margin, but I'm not certain if that is accurate. Could you update us on the operating margin for the Discovery business on a stand-alone basis?

So what we've called out in the past just in terms of the size or the relative size between Discovery and Safety Assessment is about five, six times bigger than Discovery. We've also called out in the past that the Discovery margins are lower than Safety Assessment. And we have also, I think, in recent conversations, we've been talking about how Discovery margins have stabilized, whereas some years ago, they were a bit more choppy. So hopefully, that gives you a bit of framework.

Just a question on kind of back to margins. I know second half margins, etc. expand given the fact that you cited. And I know it's too early to talk specifically about next year. But just wondering, high level, are there any other factors to be aware of whether additional capacity needs to investments, other pay increases that potentially could hamper your ability to kind of continue to drive your reported margins in line with your underlying margins expansion goals?

So if your question is more about next year, then we do have a conference in September 12 where we'll talk a little bit more about our 5-year plan and how we expect to achieve that. So I don't really want to take too much of the thunder away from that conversation. But what we feel that we stabilized in DSA largely. And therefore, I can give you a bit of a clearer view that we've done the investments that we need to do. We're continuing and been investing in capacity expansion over the last several years. That will continue. I don't think that in and of itself has ever caused a problem with the way that we've been talking to our margins. It's part of, if you like, the underlying baseline.

Okay. Great, David. And then just more of a tactical question. So comps in DSA do get a lot harder in the back half of the year. I know you have high single-digit guidance, which is a range. But is it realistic you think you can sustain this kind of Q2 level in the back half against those tough comps?

Yes. We've raised our guidance to a range of 8.5% to 9.5%, increasing the lower end. The upper end is 9.5%. Looking at our year-to-date performance, our organic growth has been approximately 9.8% so far. Therefore, we believe we should comfortably remain within the range of 8.5% to 9.5%.

I'm not going to ask about margins. So you discussed the improvement in the Discovery RFP win rate, the all-time highs. Can you give us a sense of how much that's improved over the past year or past three years? And then when you're not chosen an RFP, how much of this is driven by the scheduling or capacity issues versus sponsor keeping the work in-house or other factors?

I mean it's materially changed. I can't give you a percentage over the last few years as our portfolio and capabilities have expanded. So it's all about scale. It's all about being able to articulate the science. It's also about the clients being open and ready to have sort of some of this work which sometimes they instinctively doubt. I think our competitive prowess is good or better than anybody else in the field. And the clients are increasingly understanding that some of these later stage Discovery activities can be found as well or better externally at better costs and can allow them to utilize their internal resources better typically to some of these biotech companies who have pretty high burn rates and a finite amount of money to work with. So that was our original strategy towards more and we're obviously hoping to continue to feed more business from the Safety space, which is also working well. And we'll going to continue to invest in our capabilities, both organically and through M&A.

Okay. And then just going to squeeze in one quick follow-up to a previous question. On the tax rate discussion and the R&D credits, is there anything about those that are sort of specific to this year? Or there's something that you think should continue to provide a benefit once Citox is annualized in the numbers?

They provide an ongoing benefit. With the acquisition of Citoxlab, there were some R&D tax credits that they were benefiting from. During the acquisition and due diligence, we weren't fully confident in the defendability of those tax credits. At our last discussion, we had only owned them for a week. However, since then, we have gained confidence in our position, and I want to emphasize that these credits are an ongoing benefit to Charles River.

Great. Thank you for joining us on the conference call this morning. We look forward to seeing you in upcoming investor conference as well as in our Investor Day on September 12. This concludes the conference call.