CRL — Q3 2022 Earnings Call Transcript

Good morning and welcome to Charles River Laboratories third 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 third quarter of 2022. Following the presentation, they will respond to questions. There is a slide presentation associated with today's remarks, which will be posted on the Investor Relations section of our website at ir.criver.com. A webcast replay of this call will be available beginning approximately 2 hours after the call today and can also be accessed on our Investor Relations website. The replay will be available through the 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 this 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.

Good morning. I'm very pleased to speak with you today about our third quarter results. Our solid financial performance was highlighted by a 15.3% organic revenue growth and non-GAAP earnings per share of $2.63, both of which exceeded our prior outlook. Third quarter organic growth rate accelerated 580 basis points from the second quarter level due primarily to the DSA segment, which delivered an outstanding growth rate of more than 20%, in line with our outlook since the beginning of the year. The DSA growth acceleration reflects continued robust price increases and meaningfully higher study volume in the Safety Assessment business, trends which have been supported by the strength of its backlog that continues to afford us with excellent visibility into the future client demand. The strong operating performance against the backdrop of escalating macroeconomic pressures demonstrates the power of our unique portfolio which differentiates Charles River from other companies that provide R&D support services to the biopharmaceutical industry, especially from the late-stage clinical service providers. We are uniquely positioned as the leading global non-clinical drug development partner, working with clients from discovery and early stage development through the safe manufacture of life-saving therapies. Our focus is centered on preclinical R&D which requires extensive scientific knowledge and the ability to innovate, understand and distinguish viable molecules from those that are not. Post-pandemic, we are an even more essential partner to our biopharmaceutical clients because our core competencies are precisely tailored to their intensified focus on scientific breakthroughs, personalized medicine and speed-to-market. With a comprehensive portfolio spanning small molecules, biologics and cell and gene therapies, we provide a flexible and efficient platform that accelerates early stage biomedical research and therapeutic innovation. We are a leading global partner for outsourced discovery and regulated safety assessment services. We are also the largest provider of small research models and associated services that enable our clients to conduct their own research, and we offer a comprehensive portfolio of manufacturing solutions from quality control testing solutions to the production of cell and gene therapies that enable us to continue supporting our clients as they work with other providers to conduct human clinical trials and reach commercialization. We have a large and diversified client base which makes us an exceptional barometer for the health of the broader biopharmaceutical industry. And unlike clinical providers, greatly reduces our reliance on a small group of clients. We have worked with more than 2,000 biopharmaceutical clients this year, and our top 25 clients are primarily large biopharmaceutical clients that are well financed and have been a stable source of sustained revenue growth with accelerated spending in the third quarter. Our top 25 clients represented only 28% of total revenue last year, and our largest client represented just above 3% of total revenue. We also believe that our biotech clients will remain a sustained growth engine for Charles River. We have averaged adding more than 400 new biotech clients per year since 2017 and are already above that level this year. Our biotech clients continue to be a principal driver of revenue growth, increasing a healthy double-digit growth rates in the third quarter and year-to-date, a trend that we believe supports our view that biotechs with promising molecules are continuing to find available funding. In addition, we saw early indications of the return of IPOs and secondary offerings in the third quarter. Venture capital funding remained very healthy and large pharma continues to support the biotech industry. Our concentration of at-risk biotech remains low at approximately 5% of both DSA and total revenue for public biotechs with less than two years of cash on hand. This is slightly below our prior estimate, which evaluated DSA backlog. We believe the early stage research that we conduct is instrumental in our biotech clients' achievement of the important milestones that enable them to secure their next round of funding. Therefore, we believe they view continuing the regulated safety assessment programs as critical to their continued success. The total cost of the safety assessment program is a fraction of the cost of clinical trials, typically ranging from $6 million to $8 million including post-IND studies. Yet it is an important milestone to demonstrate that clients' efforts are driving innovation and validating the efficacy and safety profile of their lead compounds. At 5 to 10 times less than the cost of clinical trials, biotech clients are motivated to plan their spending around the achievement of IND approval before seeking additional funding or finding a larger biopharmaceutical partner to move into clinical trials. As a result of the importance, both biotech and larger biopharma clients are continuing to move their regulated safety assessment programs through their pipelines. I will now provide additional highlights of our third quarter performance. We reported revenue of $989.2 million in the third quarter of '22, a 10.4% increase over last year. Organic revenue growth of 15.3% exceeded our prior outlook of at least low double-digit increase. All three business segments reported solid revenue growth, particularly the DSA segment, due to the robust performance of the Safety Assessment business. The operating margin was 20.4%, a decrease of 100 basis points year-over-year. The decline was driven by lower margins in the manufacturing in RMS segments as well as higher unallocated corporate costs, both of which were previously anticipated. Earnings per share were $2.63 in the third quarter, a decrease of 2.6% from the third quarter of last year. Higher revenue was offset by the operating margin decline, increased interest expense and a higher tax rate. Based on the third quarter performance, we are narrowing our 2022 revenue growth and non-GAAP earnings per share guidance to the upper ends of the previous ranges. We expect organic revenue growth in the range of 11% to 12% and non-GAAP earnings per share of $10.80 to $10.95. I'll now provide details on the third quarter segment performance, beginning with the DSA segment. Revenue for the DSA segment was $619.5 million in the third quarter, a 20.8% year-over-year increase on an organic basis. The DSA growth rate surpassed the 20% level, tracking to our initial plan that had forecast meaningful DSA growth acceleration throughout the year. The exceptional demand, which has manifested itself in sustained backlog growth is a function of our clients' robust pipelines, our competitive strengths and the scientific breadth and geographic reach of our portfolio. Broad based growth in the Safety Assessment business was the principal driver of the nearly two-fold increase in the DSA revenue growth rate from the second quarter level. The factors that led to this meaningful step-up were substantially higher study volume and continued meaningful price increases. Study volume was a significant contributor, driven by strong demand across the Safety Assessment business for most major study types of general and specialty toxicology. As expected, study volume rebounded meaningfully from first half levels, and we were able to accommodate additional client demand as a result of having hired and trained additional staff over the last year. We are continuing to successfully recruit and retain staff to support future growth and do not foresee challenges with staffing levels as we head into next year. Pricing also continued to trend meaningfully higher year-over-year and sequentially, which we believe reflects the complexity and specialized nature of the work we do. Today's inflationary cost environment and the fact that capacity remains well utilized. Although pass-throughs are higher costs for certain study related resources that are passed directly to clients were higher in the third quarter, they accounted for less than half of the sequential step up in the Safety Assessment growth rate and had effectively no margin impact. Pricing, exclusive of the impact of pass-throughs, increased broadly in the third quarter. Clients continue to emphasize the breadth of capabilities, study lead times and the availability of space more so than price, when determining the preferred partner for their preclinical programs. As the premier partner for our clients' non-clinical development programs, it's not surprising that clients are continuously choosing to work with Charles River for our broad and scientifically differentiated portfolio, superior client service and speed as we aim to take an additional year out of the early stage development timelines. As expected, the Discovery Services growth rate moderated in the third quarter, primarily due to the lengthening of clients' decision-making time frames to start new projects, a trend which we discussed in August. We believe the Discovery business will demonstrate favorable long-term growth prospects as many of our clients, including biotechs, prefer to outsource their drug discovery projects rather than maintain in-house infrastructure. Given the critical importance of the early-stage research in which they are engaged, they prefer an integrated full service partner like Charles River. We continue to expect mid-teens DSA organic revenue growth in 2022. DSA backlog and booking activity through the third quarter continues to support sustained growth. For next year, we have a significant amount of safety assessment work already booked. The strong Safety Assessment performance has been under the leadership of Shannon Parisotto. Shannon has been with the company for over 20 years, starting at our Nevada site shortly after it became our first acquisition in the safety assessment space. With significant operational and finance experience, Shannon recently assumed responsibility of our Discovery Services in addition to Safety and was promoted to an Executive Vice President. I would like to congratulate Shannon and wish her continued success in driving the long-term growth of our Global Discovery and Safety Assessment segment. DSA operating margin increased by 190 basis points to 26.2% in the third quarter, driven primarily by operating leverage from the substantial quarterly increase in Safety Assessment study volume and pricing. RMS revenue was $180.1 million, an increase of 8% on an organic basis over the third quarter of 2021. The RMS business continued to sustain high single-digit growth, consistent with our outlook for the year. The RMS growth potential has trended upward recently from low to mid-single digits several years ago due to a combination of accelerating growth for research model services and research models. The CRADL initiative, or Charles River Accelerator and Development Labs including a recent Explora acquisition is a significant driver of the growth rate increase. In addition, our renewed focus on biomedical research has led to increased demand and share gains for small research models, particularly in North America and China. We are also benefiting from meaningful price increases, in part to offset inflationary cost pressures. These factors were the principal drivers of RMS revenue growth in the third quarter. In the Research Models business, North America continued to generate strong revenue growth and China rebounded following the impact from COVID related restrictions in the second quarter. There was no meaningful impact on client order activity from COVID related restrictions in the third quarter. We are also continuing to expand in China outside of Beijing and Shanghai regions to gain additional market share and believe the level of biomedical research activity, coupled with our expansion plans in China, will continue to generate robust double-digit growth in the region. Research Model Services also had another excellent quarter, led by the Insourcing Solutions business, particularly our CRADL and Explora operations. Clients are increasingly adopting this flexible model to access laboratory space without having to invest in internal infrastructure. Explora has continued to perform very well with the integration on track. We added five new sites over the last six months in California and Washington state and now operate 27 vivarium facilities totaling over 370,000 square feet of turnkey rental capacity. CRADL and Explora provides us with a new and unique pathway to connect with clients at earlier stages, enabling these clients to easily access additional services across our comprehensive discovery and non-clinical development portfolio. In the third quarter, the RMS margin declined by 260 basis points to 23.5%, driven primarily by the revenue mix and higher costs in China due in part to our regional expansions. We also experienced a modest margin impact from opening new CRADL and Explora sites this year for which the profitability will improve as client utilization increases in the newly open sites. Revenue for the Manufacturing segment was $189.6 million, an increase of 6% on an organic basis. Lower revenue in the CDMO business, the drivers of which we discussed last quarter, was more than offset by higher growth rates for both the Biologics Testing and Microbial Solutions businesses. The growth prospects for these legacy manufacturing quality control 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. Microbial Solutions benefited from broad based growth across SezendaSafe endotoxin testing and Accugenix microbial identification testing platforms. We are continuing to convert the marketplace to our more efficient and reliable quality control testing platform. The continued expansion of the installed base of instruments drives demand for the consumable cartridges and reagents which provides a healthy recurring revenue stream. The Biologics Testing business also had a strong quarter with virology, viral clearance and microbiology testing services driving growth in both the U.S. and Europe. Demand for traditional biologics remains strong, but cell and gene therapy clients are driving a disproportionate amount of recent growth. We have been continuing to add capabilities to our extensive portfolio to support the manufacture of biologics, including the addition of new cell and gene therapy assays. The initiatives that we have implemented to improve the performance of our CDMO business are beginning to gain traction and earn positive feedback from clients. It's still early, and we don't expect the financial performance to meaningfully improve until next year, but we're pleased with the initial progress. Our creation of Centers of Excellence for cell therapies, viral vectors and plasmids has been well received and coupled with our focus on CDMO business development efforts, we are generating new client interest. We recently announced a gene therapy manufacturing partnership with Nanoscope Therapeutics to produce plasmid DNA and viral vectors for their late-stage clinical trials of a therapy targeting degenerative ocular diseases. We have a number of other clients who are in late-stage clinical trials with their cell or gene therapies, and we are investing in our sites to ensure that we are commercially ready should our clients receive regulatory approval. As we mentioned last quarter, our Memphis cell therapy site received European approval from the EMA to commercially manufacture cell therapy products. We continue to believe in the long-term growth prospects for cell and gene therapies and are enhancing our service offering to generate new business and provide incremental opportunities for clients to streamline their biologics development workflows by utilizing Charles River for their analytical testing, process development and manufacturing activities. The Manufacturing segment's operating margin declined by 410 basis points to 28.6% in the third quarter of 2022, and similar to the second quarter, it was almost entirely driven by the CDMO business. As we announced this morning, we have signed an agreement to divest our Avian Vaccine business, which is part of our Manufacturing Solutions segment, for approximately $170 million in cash plus potential contingent payments of up to an additional $30 million. We routinely evaluate the strategic fit and fundamental performance of our global infrastructure. As we did at this time last year, we have sold or closed operations that did not meet our key business criteria. The decision to divest the Avian business was consistent with this evaluation process, as we determined the production of SPF eggs principally for Avian Vaccine manufacturers and researchers was no longer a core competency. Flavia will provide additional details on the financial impact of this transaction. We are confident that we will finish the year on a strong note and are encouraged by the solid growth prospects as we head into the new year. The economy will present challenges in the coming year, but we believe we are well positioned to meet these challenges and continue to deliver exclusive science, superior client support and greater efficiency to our clients. Our focus in recent years on enhancing our capabilities in biologics and cell and gene therapies, investing in our people and space, and continuing to build greater digital connectivity with our clients has further differentiated us from the competition and enabled us to forge even deeper relationships with our clients. We are the bridge between the biopharmaceutical industry and patients that enables innovation to move forward, and we will continue to distinguish ourselves scientifically and through our preclinical focus. To conclude, 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 our third quarter financial performance and 2022 guidance.

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 adjustments, costs related primarily to our global efficiency initiatives, gains or losses from our venture capital and other strategic investments 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. We're very pleased with our third quarter results with revenue and earnings outperforming prior outlook. Organic revenue growth of 15.3% resulted in earnings per share of $2.63. I will now provide some additional details on the non-operating items that drove our third quarter performance. Unallocated corporate costs increased in the third quarter, totaling $57.5 million, or 5.8% of total revenue compared to 5% of revenue last year. The increase was primarily the result of higher health and fringe related costs. For the year, we continue to expect unallocated corporate costs to be approximately 5% of total revenue. Total adjusted net interest expense for the third quarter was $27.3 million, an increase of $4.4 million sequentially and $6.6 million year-over-year, reflecting the Federal Reserve's interest rate increases this year and on a year-over-year basis, higher debt balances from recent acquisitions. For the year, our total adjusted net interest expense outlook remains unchanged in the range of $106 million to $110 million because we expect that more aggressive interest rate hikes will be offset by additional debt repayment. Our current interest expense guidance can accommodate an additional 75 basis point to 100 basis point increase, should that be the outcome of today's Federal Reserve meeting. Given the late timing of a potential December increase, we do not expect it would have a material impact on interest expense for 2022. This week, we entered into an interest rate swap agreement on $500 million of U.S. dollar denominated debt on our revolving credit facility. For the next two years, the swap will effectively fix the interest rate at 4.7% plus our current spread of 112.5 basis points for a total of 5.825%. With the swap, approximately two-thirds of our $2.9 billion in debt is now at a fixed rate. Of the remaining floating-rate debt, our revolving credit facility uses the one-month LIBOR rate or equivalents plus the current spread. Looking beyond 2022 and to help with modeling in light of the Federal Reserve's current policy of more aggressive interest rate hikes, a 100 basis point increase in rates is expected to result in incremental interest expense of approximately $9 million on an annualized basis based on our remaining floating-rate debt levels after the swap. Our gross and net leverage ratios were both approximately 2.7 times at the end of the third quarter. Over the longer term, we continue to believe that strategic M&A will generate the greatest shareholder returns and enhance our growth potential. But in the near term, we'll also focus on shorter-term initiatives like debt repayment. As Jim mentioned, we plan to divest our Avian Vaccine business by the end of the year. We'll receive gross proceeds of $170 million upfront and intend to redeploy that capital with a portion used to repay debt. The third quarter GAAP tax rate was 20.2%, representing a 320 basis point increase from the same period last year. The higher tax rate year-over-year was due primarily to a lower tax benefit associated with stock-based compensation related to the lower stock price, as well as higher discrete tax benefits in 2021 associated with the R&D tax credit. For the full year, we now expect the tax rate to be approximately 20% on a non-GAAP basis, slightly below the outlook provided in August, and at the low end of our longer-term target of low 20%. Free cash flow was $60.4 million in the third quarter compared to $119.2 million last year. The 49% decrease was primarily due to changes in working capital and higher capital expenditures. Capital expenditures were $72.4 million in the third quarter, an increase of nearly $17 million compared to the $55.5 million last year as we continue to make growth-related investments. For the year, our free cash flow and CapEx guidance remain unchanged at approximately $360 million and $340 million, respectively. As Jim mentioned, we have narrowed our revenue growth and non-GAAP earnings per share guidance to the upper end of the prior ranges. We now expect reported revenue growth in a range of 10% to 11% for the full year, including the 350 basis point foreign exchange headwind that we forecasted in August. Our organic revenue growth outlook was also narrowed to a range of 11% to 12%. We continue to expect that the consolidated operating margin will be essentially flat with 2021 and that we'll have narrowed our earnings per share guidance to a range of $10.80 to $10.95 or approximately 4.5% to 6% growth versus the prior year. Excluding an estimated foreign exchange headwind of $0.43 this year as well as a $0.20 headwind from interest expense compared to our initial outlook, earnings per share growth would be in the low double-digit range this year. By segment, our revenue growth outlook for 2022 remains unchanged. We expect organic revenue growth in the high-single digits for the RMS segment, mid-teens for the DSA segment, and mid-single digits for the Manufacturing segment. As noted in this morning's press release, the Avian divestiture will not have a meaningful impact on our 2022 financial results. In 2023, the transaction will reduce annual revenue by approximately $80 million and non-GAAP EPS by approximately $0.35. However, we expect to offset a portion of this dilution through the benefits of redeploying the proceeds towards other capital priorities. A summary of our updated financial guidance for the full year can be found on Slide 43. With one quarter remaining in the year, our fourth quarter outlook is effectively embedded in our full-year guidance. I'd like to remind you that this year includes a 53-week at the end of the fourth quarter to true up our fiscal year to a December 31 calendar year end. The 53-week historically has been characterized as a partial week of revenue and a full week of costs. For 2022, we expect the impact will be a benefit to reported revenue growth of approximately 550 basis points for the fourth quarter and a modest operating margin headwind in the fourth quarter, particularly in the RMS segment. For the fourth quarter, on a year-over-year basis, we expect reported revenue growth will be in the low to mid-teens and organic revenue growth will be at least in the low double-digit range. Earnings per share growth is expected to be in the range of approximately $2.65 to $2.80 in the fourth quarter based on our updated full-year guidance. In conclusion, we are well positioned to finish the year on a strong note. The second-half DSA growth acceleration is occurring as expected and our substantial backlog firmly supports our full-year financial guidance. As we look to the future, we're focused on continuing to drive growth, executing on our strategy and enhancing our position as the leading global known clinical drug development partner, working with our clients from discovery and preclinical development through the safe manufacture of their life-saving therapies.

That concludes our comments. We will now take questions.

Okay. First question, worst question. Probably one of the biggest debates this quarter is when are you going to give '23 formal outlook. I was hoping I could maybe put the pressure on for you just to tell us when that will be so we can end the debate?

We very much want to see the end of the year. We want to see how the following year begins. We moved away from that last year, but that's our normal cadence given the uncertainties and the complexities in the world. So we are highly likely to do this in February.

I appreciate your response, Jim. I have a question about the Avian divestiture. You mentioned it's no longer a core competency, but you've been involved with it for a long time and managed it successfully. It has been very profitable, and the divestiture does lead to some earnings dilution. This isn't the first time in the past year that you've sold something with similar characteristics of low or no growth but high profitability and earnings contribution. What insights can we take from this? I'm curious as to why it was considered no longer a core competency. What was the main factor behind that decision? Was it primarily related to the revenue growth rate, or was there something more significant at play? Or might this indicate a shift in focus towards higher-growth businesses? Thank you.

When we acquired this business, it exhibited significantly higher growth potential and played a more important role within the company. It was strategic and aligned closely with our core competencies. While the margins are healthy, it has transitioned into a low-growth phase, which is obviously not ideal and affects our overall revenue. Although the business has performed reasonably well, we have struggled to enhance its performance meaningfully despite attempts to expand into related areas since we acquired it in the mid-'80s. Therefore, we believe it's best to sell it and apply the proceeds, likely toward paying down debt, while reallocating our resources to more essential and relevant activities. Its diminished role in our core focus raises the risk that it won't receive the necessary attention and time, especially given our current emphasis on maintaining double-digit growth.

Yeah. Sounds good. I'll cease the floor here. So, thanks, Jim.

Thanks, Eric.

Hey. Good morning, everyone. Thank you for taking my question. So realizing that a lot has moved in the world since your 2021 Analyst Day. But can you talk a little bit about the margin cadence as we sort of think about going into 2023 and 2024? You have that roughly 22.5% off margin target for 2024. And I'm just sort of curious how we should think about it realizing you've got FX moving divestitures, just investment in the business, inflationary cost. Would love some thoughts on how you're thinking about the margin progression.

Sure. Hi, Derik. Good morning. It's Flavia. Since we provided our long-term outlook about 18 months ago, a lot has changed in the macroeconomic environment. We will take the time to finalize the 2023 budget, which will serve as an important starting point for reevaluating our long-term outlook. We continue to aim for healthy revenue growth and operating margin expansion in the long term. Our long-term goals remain intact, but we will need to revisit the data and examine the numbers in more detail since much has changed since our last update 18 months ago.

Got it. I have a follow-up question. One of the other CDMOs in the industry mentioned some challenges in their developmental services for biotech and pharma, which caught us off guard. I don't want to dwell on this given your discussion about biotech, but do you notice any unusual trends? Did the Discovery business decline? Did anything soften between now and August that would make you more cautious about the outlook? It doesn’t seem like it, but I'm trying to make sense of what some other companies have said. Thanks. I'll return to the queue after this.

We didn't see anything conservative slowdown anymore down the Discovery, growth rate has moderated, pretty much totally in line with our expectations. As we said on our last call, we've had a lengthening of decision-making. We've had no clients or very few clients really focusing on the reason for the delay relative to funding. But if they have to make those decisions of doing slightly less discovery in order to do more IND work, they're going to do that all day long. So we haven't seen any fundamental difference in the cadence since the last time we talked about this.

Thank you.

I have a question about pricing, and I'm not sure if this is for you, Jim or Flavia. When you mentioned strong pricing, should we expect that to be reflected in the model over the next four quarters or mainly next year? Is it only impacting this quarter? I'm trying to understand how the timing of these price changes affects the model and their sustainability moving forward. Thank you.

Yeah. We were very clear about the fact that the back half of this year, as exemplified by the third quarter, would have increased volume and increased price, which, of course, we just delivered and tightened up our guidance for the year, so that cadence is pretty clear. We have an unusually high amount of our safety assessment booked for next year at escalating and increasing prices, both related to inflation, but primarily related to the complexity, increased complexity of the work, the depth of the science that we do vis-a-vis our competitors and vis-a-vis big pharmaceutical companies. So we feel very good about our pricing power and some of the leverage we have with our clients. We feel really good about capacity utilization. We feel really good about headcount where we have it right now and our ability to do the work. And as we've been saying for a few years, as the work has gotten more complex, we really feel that we ought to be paid well for it. There were years historically, where we didn't think we were being paid well for it. I do think that that's changed. So as we look to next year without getting too granular, of course, we haven't even finished the plan yet, but we do have a lot of work booked at higher prices.

That's really helpful. Thanks and congrats on the quarter in a challenging environment.

Thanks, Sandy.

Hi, good morning. Thank you for taking my question. Jim, I would like to understand the relative movement within Discovery and Safety Assessment. You've mentioned this previously, and I’ve heard from various sources, including Derik yesterday, about slower decision-making. How do you differentiate between Discovery and Safety Assessment? If Discovery slows down, should we expect that to affect Safety Assessment as well? Additionally, you referenced the $6 million to $8 million in total costs associated with an IND enabling program. How much of that expense occurs after IND, aligning with clinical trial activities, and why is that significant?

We believe there are two different scenarios at play. Any company, regardless of size, that has a promising compound for an unmet medical need will do everything they can to reach an Investigational New Drug application and eventually bring the drug to the clinic, where they can potentially monetize their assets through sales or partnerships. This aligns with our growing backlog, rising prices, and unprecedented share volume observed in 2023, despite some similar trends in 2022. Discovery work typically occurs earlier in the process, and while a decrease in discovery work could eventually affect safety work, we believe we are still far from that point. We are noticing some cautious pauses from a small number of clients due to uncertainties related to capital access, particularly in the capital markets, leading them to prioritize their discovery assets. However, we are seeing improvements in capital market inflows, with the third quarter performing better than the second and overall venture capital inflows reaching record highs. Pharmaceutical companies are also experiencing better access to capital than ever before. We are confident that quality assets will continue to receive funding in various forms. While we have observed some clients adopting a cautious approach, we interpret it as strategic rather than a sign of financial distress. Discovery remains a relatively minor portion of our business, and we are pleased with our achievements in the third quarter, optimistic for the fourth quarter, and satisfied with our current backlog heading into fiscal 2023.

If I may add, Dave, we started sharing the DSA backlog earlier this year. And I know that there has been a slowdown in biotech funding going into this year. So we're now 11 months into the year. And every quarter, we have seen the DSA backlog increase sequentially and pretty substantially year-over-year. So we really haven't seen any slowdown on the DSA backlog that would point to any adjustments or anything being impacted by the biotech funding dynamics, which every quarter I know you all asked about. So we feel good, as Jim said, that we have a substantial portion of the backlog booked already for 2023.

Thank you for that. I wanted to follow up on your comments regarding pricing and complexity. You mentioned pass-throughs in your presentation today, which I believe is the first time that's been addressed. I would appreciate your insights on this matter because we have noticed a significant increase in the pricing of certain inputs for your studies. What I find puzzling is that if these are considered pass-throughs, they would likely negatively impact your margins, yet we're not seeing that effect. Could you provide some clarification on how this works?

Yeah. So Dave, you're correct that some costs have increased, and we are passing those increased costs to clients and keeping the same level of margin that we have whole. So they're neither dilutive nor accretive to margin, if that makes sense.

Hi, guys. Thanks so much for the question. I was wondering if you could comment on how Solaris HemaCare growing in the quarter. I know that you guys obviously did a lot of work to sort of make changes earlier in COVID to sort of increase the growth of that part of the business. How is that sort of panning out in these current days?

Panning out slowly. We've made a bunch of changes in that business. I think the two most fundamental changes in that business, the product line, the nature of the product line versus sort of off-the-shelf things and specialty items and also our access that social methodology to access donors. So all of that is now in place. We're optimistic that things will sequentially and continue to improve. But I would say it's improving slowly.

Got it. So it's more of a cross the like 2023 kind of dynamic is the way we should think about that?

We certainly hope so.

Okay. Got it. And then just in terms of the CDMO sales pipeline, we had heard that there were some sort of rebalancing efforts maybe between some biopharma sponsors in terms of having some internal capabilities for some of the CDMO work that they had developed during COVID and then potentially some dynamics in terms of using up some of that capacity versus starting to outsource as they grow. What have you heard on that front in terms of that? Are people sort of continuing to sort of outsource there? Is there any kind of residual internal capacity demand or maybe you haven't actually been seeing that at all?

I believe that capacity is currently limited and costly, and the capabilities required are complex, particularly regarding analytical work, process development, and scaling up. It seems unlikely to us that mid-sized or large biotech companies would even consider this. We know of a few major companies that have created their own facilities, not necessarily due to distrust of external providers, but out of concern for available capacity. As a result, I anticipate that a significant amount of work will be outsourced. Some projects may be done internally with facilities developed within the companies. It remains to be seen whether this internal work will be limited to clinical trial batches or if it will extend to commercial projects as well. Biotech firms have effectively leveraged external resources for their initiatives. We believe we have ample work and ongoing discussions, have increased our capacity, and feel confident about securing our share of the market.

Got it. That’s helpful. Thank you.

Hey, guys. Thank you for taking the questions. Jim, maybe on the DSA side, talked a little bit about the backlog there. On the staffing piece, you've heard this earnings season from some of your peers, you've seen some labor shortages out there that prevented other companies from converting over a pretty strong demand backdrop and your guys' backlog is growing, as you talked about, you seem to be ahead of the curve there, kind of prioritized hiring late last year into early '22. Are you better positioned here now? Is there potential for share gains, given you're able to take on more work? How capacity-constrained are you guys given the labor side, maybe just talk through that a little bit?

Yeah. We feel really good about our labor component. We've worked really hard at it for several years now, both in terms of starting wages, both in terms of numbers of recruiters, in terms of explicit career development opportunities so we can attract really talented people and keep them, I'm thinking about some of the cell and gene therapy folks that we've added over the last year or so. So in terms of numbers of people to initiate work or to continue to do work as we move into fiscal '23, we feel really good about where we're at. I think we got ahead and stayed ahead of the salary levels, both starting and otherwise for fiscal '22, and we had that embedded in our plan and in our guidance. While our '23 plan isn't done yet, we will do the same thing. We hope, I mean, yes. It's a little bit vague out there, but we will continue to be appropriately aggressive in terms of being able to bring in new folks. So we feel really good about our labor component. We feel really good about our capacity, available capacity at multiple sites. We feel really good about our pricing power. We feel really good about clients waiting a significant amount of time to initiate studies, getting in line and prioritizing what studies they want to do first, that's so new. We've been doing this for a long time, that sort of new the last couple of years. This is an industry that historically had some planned well, and there's lots of changes, but they really do have to plan well now, and that's, I think, holding us in good stead. So the labor component is in a good place.

Okay. That's helpful. And then maybe just on the capital deployment side. You guys obviously have some money coming in the door from the divestiture. Sounds like maybe near term, a little more priority on the debt paydown. But maybe just talk about, I guess, the M&A funnel. You guys are obviously executing on some of the more recent deals. Is it put a pause on that, pay down some debt? What's the right way to think about near-term priorities before you kind of get back to the normal kind of cadence there?

So both Flavia and I will answer aspects of that question. I would say a couple of things. Number one, that we're deep into the integration of our cell and gene therapy assets, which obviously it has been more complex and more challenging than we thought given the nature of the science and the newness of the science and some of the challenges. So going well, really pleased with the facilities, the staff, the sales organization, the regulatory folks and new clients and also on sort of a massive marketing initiative to make sure that people understand that we're in this business. I think I want to use the word pause because we did the Explora deal. And we would do a small tuck-in deal of a technology deal, depending on when it was available. We certainly don't always control the timing of these deals. But I would say that directionally, our balance sheet is increasingly in good shape to do some meaningful M&A. I don't want to say when that might be, except to say that we have multiple conversations going on right now with potential acquisition targets, almost all of which are owned by private equity. And we are always having conversations with them. I'll let Flavia answer what we're likely to do with the proceeds from Avian.

Thank you for the question, Patrick. We regularly assess our capital uses. As Jim mentioned, mergers and acquisitions have been beneficial and strategically important for our growth, helping us acquire the expertise needed to stand out to our clients. However, in the near term, we will likely concentrate our capital priorities on debt repayment. Therefore, I anticipate that a portion of the proceeds from Avian will indeed be used to pay down debt. We will continue to review our capital priorities and discuss them with our Board while considering other potential uses. But for now, a significant amount of the Avian proceeds will be directed towards reducing our debt, particularly in light of the current high-interest rate environment.

Appreciate all the color. Thank you, guys.

Hi. Thanks for fitting me in. Can you guys just talk towards the volume growth in DSA in the quarter? How much of that was just based on the increased capacity that you had come online? And then also just wanted to get a sense on if volumes are trending meaningfully higher than where maybe you had expected them to be heading into 2023, maybe at the time of the initial initiation of guidance and maybe versus even several months ago. And then just as a follow-up, I don't think I called a backlog growth number for DSA. I'm wondering if you could provide that. And if you have any line of sight towards double-digit growth in DSA next year, I think the Street has you at 9% in 2023 for DSA growth. Thanks.

We have dedicated significant effort over many years, likely close to a decade, to expanding our capacity at various locations each year. This growth has accelerated alongside our business size, requiring us to plan 12 to 24 months ahead. As a result, we are currently constructing additional space that we need for the end of 2023 and much of 2024. Our strong backlog and demand reflect our robust franchise, which is advantageous. We are definitely experiencing an increase in volume and achieving market share, which is essential for us. Each year, around 300 to 400 new companies will require safety assessments, and we aim to capture as much of that work as we can. We're also seeing an uptick in projects from major pharmaceutical companies and larger biotech firms, along with market share gains from competitors and new opportunities that haven’t been accessible before. We plan to maintain both pricing and volume as we expand our space while being cautious not to overbuild, which could negatively affect our operating margins. Particularly last year, where we surpassed our operational targets, having the additional space was crucial for accommodating new business.

Yeah. And Casey, just a couple of additional comments before I give you the backlog number. I think, as Jim pointed out, it's incumbent upon us to get it all right, right? We have to have physical capacity, expanding our facilities at the appropriate time, not too soon, not too late. We have to have the people. I think Patrick asked about that. We feel really good that we got ahead, if you will. And you saw, when we provided guidance earlier in the year, we talked about a stronger second half for DSA, which I think there might have been some skeptics out there, but we are seeing that materializing in the volume acceleration in the second half vis-a-vis the first half as all of those folks that we hire now become productive, they're out of training, and they can really be available to support the strong client demand that we're seeing and allow us to gain share, as Jim said. So I think we really have done a nice job of ensuring we had the available physical labor input capacity available to absorb the increase in demand. In terms of the backlog, the backlog in the third quarter was $3.2 billion. So it was about 7.5% sequentially growth versus the second quarter.

That’s helpful. Thank you.

Hey. Thanks. Good morning. Just one, on the CDMO business, you call out that you don't expect it to meaningfully improve until next year. So as we think about improvement into 2023 as Derik and Dave alluded to, there was CDMO talking about the funding environment impacting their development pipeline yesterday. I'm just curious any thoughts on kind of the demand backdrop for CDMO services as we think about kind of that business returning to growth next year? Thanks.

Yeah. So we are optimistic about next year. It's a business that has limited providers, both of the services or the products required. So that provides enormous opportunity for us going back to the previous question about clients doing it themselves. 3,000-ish molecules, at least two-thirds of which are in a preclinical domain. So there's an awful lot of work available. So we've been working hard to have the right staff, the right facilities and the right dialogue for the clients know that we're deep in this in concert with our biologics business, which gives us, I think, a competitive advantage, also in concert with our Safety Assessment business. So we feel really good about our portfolio and the ability to service a whole range of cell and gene therapy customers across the whole CDMO really paradigm.

Got it. Thank you.

Hi. Good morning. Could you give us a sense of what the growth was for the QC business and manufacturing? And then, gosh, I mean, I think it's been like eight to ten years since Todd and I went in depth on the Avian business. But if I recall, there is some seasonality to that. Can you just remind us of that as we just think about modeling?

Yeah. So we're not going to break out the growth rates and the specific pieces of manufacturing, except to say that we were pleased with the growth rate of Microbial, I'm pleased with the growth rate of Biologics. And not pleased with the growth rate of Avian, which is why we sold it. I don't think that business was particularly seasonal, by the way. We had a pretty consistent client orders sort of a long period of time for almost entirely Avian Vaccines, a little bit of human flu. So it was time to divest that business.

Yeah. And I would just add that the other component of manufacturing is obviously the CDMO business. And to Jim's point, while agent strategically, we have determined not to be the best fit with our strategic aspirations and ambitions. The biggest headwind, I would say, currently in manufacturing is CDMO, as we have talked about in the second quarter earnings.

I understand. I mistakenly thought there was a significant contribution in the first quarter, but that’s not accurate. Could I ask what the general rule of thumb is for how a one-point move in foreign exchange impacts operating profit over the year?

I think we can discuss that separately, Justin. We are exposed to various currencies, so it's challenging to provide a specific impact. Depending on which currency changes, the effect can vary, so it isn't a straightforward calculation.

Got it. I'll take the rest offline. Thank you.

Hi. Thanks for taking my question. Maybe just one on the CDMO and cell and gene therapy manufacturing and just the turnaround recovery next year. Do you see any areas of gaps or maybe areas that could be complementary within the portfolio there that invest in organically or inorganically that could help accelerate that turnaround into next year?

Not really. We likely have some settled gaps that we'll consider as this business matures and strengthens. While it is possible to achieve growth organically, there will probably be a modest amount of mergers and acquisitions involved. However, I don't believe any of these challenges are hindering business growth or development. We are confident that we are making the right moves to enhance our position, reach clients, differentiate our portfolio from competitors, and possess the necessary space, personnel, and regulatory expertise to advance projects, particularly into the clinic and, hopefully, eventually into commercial offerings.

Yeah. And I'll just add, I think in the second quarter earnings, we talked about, obviously, what we've learned in the CDMO as we took the assets, they're longer sales cycles. But I think actually, at this point, those longer sales cycles and the efforts that we have been doing and putting in our BT teams are very prudent us having good visibility into potential opportunities for next year. So we feel good, not only that we're going to have easier comps, but that we have line of sight to the underlying demand that Jim talked about.

Thank you. Just a question for you, Flavia. I just want to make sure I'm clear on how you're framing interest expense for 2023. Did you say that if rates go up by 100 basis points today, then the starting point for interest expense is $119 million for '23 or is there a different base on what you're calculating this sensitivity?

I tried to provide some guidance on how to model this. In 2023, a 100 basis point change in interest rates would lead to about a $9 million impact on our interest expense. Throughout this year, since the Fed has adjusted rates nearly every quarter, we've continually updated our interest expense outlook, making it challenging to identify a solid starting point. I wanted to clarify that for next year, a change of 100 basis points would be equivalent to $9 million.

Would the Q4 number be a good base, the Q4 run rate be a good base to calculate from?

You have different bases. So every quarter, it's going to be a little bit different. That's why it's challenging given what has been the escalating interest rate high this year.

Okay. I understand. Thank you.

Hi. It's Christine Rains on for Max Smock. Just one for me. So for the DSA business, if you're willing, how much of the 20.8% organic growth is coming from price increases? Assuming that you're not willing to quantify that, what do you currently view as the more normalized sustainable growth in demand for both Discovery and toxicology? Thank you.

Not going to give you the pricing and we really don't want to unpack it. So we're really pleased with both the volume growth and the pricing power in that business, which has improved pretty much sequentially year after year as the demand has increased as our competitive posture and capabilities have increased. So we're happy to be getting share, taking share and getting paid well for our business. We're very pleased with the improvement in operating margin in the third quarter. And particularly pleased with the volume of work that's already booked into fiscal '23.

Hey, guys. Good morning. So a quick one on safety assessment here. Is there any color you can share on proposal volume growth in the quarter? And Jim, if you can comment on lead times. I mean, do you see those sort of moderating at all sequentially or are they still where they were a couple of quarters ago for the business?

Proposal volume is high, with a lot of proposals and work being booked. I don’t see any reason, either structurally or in terms of demand, for things to slow down. We’ll provide more updates as we finish the year and continue through it. Our competitive position appears to be getting stronger. Our pricing power is also increasing, and there’s a significant amount of work. Clients are quite busy with various large and small molecules, as well as a lot of cell and gene therapy projects. What we’ve noticed most is that clients are prioritizing which drugs they want to advance sooner. We are trying to support that. Additionally, some clients have committed to dedicated spaces with us. This is an important development and reflects their recognition that they need a way to expedite their processes. I would be surprised if we don’t see more of these arrangements in the future.

Got it. That's helpful. And a quick follow-up on RMS, a near-term one and then sort of the medium-term one. So in the near term, Jim, can you just comment on thoughts on RMS margins in China and how you see those trending? And can you just pass out how much of the headwind there was from your expansion plans versus other factors? And then the medium-term question was related to this FDA Modernization Act. How are you thinking about that over the medium term for the animal model side of things? And are you starting to hear anything from your clients at all on that?

China has experienced strong growth and good margins, along with some pricing power. This is largely due to the availability of additional animals and various geographic locations in a vast country. We have continued to expand our capacity for both product and service in RMS in China and are very pleased with the outcomes. Although there is competition in the market, it mostly comes from local companies that are generally less sophisticated in terms of animal quality and veterinary expertise. The conversation around in-vitro technologies, 3D models, and AI is not new. At Charles River, we are committed to minimizing the use of animals and ensuring they are used appropriately in studies. Over the years, we have seen a shift in animal models towards more refined varieties with higher average selling prices, such as hypertensive, immunocompromised, and various inbred and hybrid models, as opposed to more generic outbred models. While there is a public desire for reducing or replacing animal models with new technologies, many of these alternatives do not offer a sufficient safety profile. For numerous drugs and diseases, scientists often do not fully understand the mechanisms of action. Attempting to replicate biological processes using computer models, cell cultures, or ex vivo systems is quite complex, making it improbable that drug companies will invest time in validating these technologies, nor would regulatory agencies find them acceptable. In the Discovery phase, safety regulation requires whole animal models to yield reliable results, typically involving two different species. Major pharmaceutical companies usually have their in vitro screening processes that they do not share. We are currently making investments in AI and machine learning and plan to invest more, anticipating that some early discovery processes could move in vitro and become more efficient before reaching animal testing. This represents a dual approach to innovation.

Got it. Super helpful. Thank you.

Sure.

Great. Thanks for the time. Just a quick modeling question for me. So the comps for DSA growth eased from 3Q to 4Q. And historically, there's been a bit of a sequential lift in the dollar revenues into the fourth quarter. So just curious, is there anything specific that you all are seeing today, which would limit quarter-over-quarter expansion in either the revenue dollars or the percent organic growth in DSA in the year?

No, I don't think so. Just remember, Tim, that there's also a 53rd week this year that I alluded to. So from a reported perspective, there's going to be that impact.

All right. Great. Thanks. That’s it from me.

Great. Thank you for joining the conference call this morning. We look forward to seeing you all at upcoming conferences. Thank you and have a good day.