Charles River Laboratories - Q1 2023

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by, welcome to the Charles River Laboratories First Quarter 2023 Earnings Conference Call. This call is being recorded. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. To ask a question during this period, you will need to press star one on your telephone. If you want to remove yourself from the queue, please press star two. Lastly, if you should need operator assistance, please press star zero.

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

Todd Spencer (Corporate VP of Investor Relations)

Good morning, welcome to Charles River Laboratories first quarter 2023 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 first quarter of 2023. Following the presentation, they will respond to questions. There is a slide presentation associated with today's remarks, which is posted on the investor relations section of our website at ir.criver.com. A webcast replay of this call will be available beginning approximately two hours after the call today and can also be accessed on our investor relations website. The replay will be available through next quarter's conference call. I'd like to remind you of our safe harbor.

All remarks that we make about future expectations, plans, and prospects for the company constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated. During 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.

James C. Foster (Chairman, President, and CEO)

Good morning. We had a strong start to the year with organic revenue growth of 15.4% and non-GAAP earnings per share of $2.78, both wildly exceeding the outlook that we provided in February. The year began with a continuation of the strong demand and pricing environment in our DSA segment that we experienced through the end of last year. This was expected based on the strength of the backlog, which supports more than a year of DSA revenue. Clients continue to choose to partner with Charles River for our industry-leading scientific expertise, for the breadth and depth of our portfolio, and for the flexible, efficient outsourcing solutions that we are able to provide to them.

We are a large, stable scientific partner focused on holistically supporting our clients' drug discovery, non-clinical development, and manufacturing efforts, which we believe is increasingly important in the current market environment. The biopharmaceutical end market seems slightly less robust than last year, which we had anticipated and factored into our initial guidance in February. Clients appeared to be more thoughtful about their spending and have prioritized their programs at the beginning of the year. This is not surprising in light of the changing macroeconomic factors that are present today and the unprecedented level of biomedical research activity that occurred over the past several years. We still believe that our client base remains adequately funded, with one sell side analyst recently estimating that public biotechs still have about three years of cash on hand.

Although we continue to watch the market closely and are seeing a normalization of demand trends towards pre-pandemic levels, our clients are continuing to move thousands of their critical programs forward with us, so we believe these trends and current business development activity firmly support our financial guidance for the year. Before I provide more details on our first quarter financial results, I would like to provide a brief update on the non-human primate, or NHP, supply situation. As you know, we suspended shipments of Cambodian NHPs into the U.S. in February. We took this action so that we could develop and implement new testing procedures that would reinforce our confidence that the NHPs we import from Cambodia are purpose-bred.

We have made advancements towards identifying a new testing platform and implementing the new testing procedures and are engaged with the relevant government agencies in furtherance of the needed resolution. We have also been working in parallel to accommodate our clients' NHP-related study starts by utilizing our global safety assessment site network. Our global scale is one of the key factors which we believe differentiates us from the competition. We believe that these efforts will mitigate some of the NHP supply impact on our clients' programs that we expect during the second half of the year and afford us greater confidence in our 2023 financial guidance.

Our wider guidance range continues to accommodate a number of scenarios related to the success of our mitigation efforts since our plans have not yet been fully implemented and NHP supply remains a fluid situation. As a reminder, biologic drugs cannot be approved for commercial use without NHPs, and it is critical that we work diligently with industry and government agencies to resolve the NHP situation and restore this important supply chain so that life-saving therapies can continue to move forward. I'll now provide highlights of our first quarter performance. We reported revenue of $1.03 billion in the first quarter of 2023, a 12.6% increase over last year. Organic revenue growth of 15.4% was driven by the robust DSA performance as well as solid RMS growth.

The manufacturing growth rate was impacted by a challenging year-over-year comparison, as well as a lower than anticipated biologics testing volume to start the year. By client segment, global biopharmaceutical companies, small and mid-sized biotechs and academic and government accounts all made significant contributions to the growth rate. The operating margin was 21.2%, a decrease of 20 basis points year-over-year. The decline was driven by the manufacturing and RMS segments. Earnings per share were $2.78 in the first quarter, an increase of 1.1% from the first quarter of last year. Strong, low-double-digit operating income growth was mostly offset by increased interest expense and a higher tax rate compared to the prior year, as well as the impact of the avian vaccine divestiture.

Based on the strong first quarter performance and expectations for the remainder of the year, which remain largely consistent with our initial outlook, we are narrowing our organic revenue growth guidance to a range of 5%-7.5% and our non-GAAP earnings per share guidance to a range of $9.90-$10.90 for 2023. We've increased the lower end of the ranges by 50 basis points and $0.20 per share, respectively. As I mentioned, our outlook continues to reflect the anticipated financial impact of the Cambodian NHP supply constraints, which will have a greater impact on the second half results.

I'd like to provide you with additional details on our first quarter segment performance, beginning with the DSA segment's results. DSA revenue in the first quarter was $662.4 million, another significant increase of 23.6% on an organic basis. The safety assessment business continued to be the principal driver of DSA revenue growth, with significant contributions from study volume and base pricing, with NHP passthroughs also adding to the growth rate. Although revenue for discovery services increased in the quarter, the growth rate continued to modulate, which we believe is reflective of the current market environment, coupled with the shorter-term nature of both discovery projects and the business's backlog. The DSA backlog decreased modestly on a sequential basis to $3 billion at the end of the first quarter from $3.15 billion at year-end.

As previously mentioned in February, this trend is reflective of the normalization of booking and proposal activity that we experienced at the end of last year and in the first quarter. Clients are not booking work as far out as they did over the past few years, and we believe this is the result of their evaluation of pipeline priorities and scheduling with a nearer term focus. That said, we believe these trends in the current market environment, coupled with the strength of our current backlog, which still affords us 14 months of revenue coverage in our safety assessment business, will drive the expected DSA revenue growth this year. Our client base remained stable and resilient. Our biotech clients continued to send us new programs and generated healthy double-digit revenue growth in the first quarter.

It was also encouraging to see that biotech funding levels increased year-over-year by more than 20% in the first quarter to approximately $15 billion. The public markets had a better quarter. We believe this higher funding demonstrates that venture capital remains a reliable source of funding to enable biotech clients to spend on their promising molecules. Large biopharmaceutical companies continued to move programs forward with vigor, with first quarter revenue growth outpacing biotechs and demonstrating the strength and balance of our client base. Through the first four months of the year, 14 new drugs were approved by the FDA, which is on pace to exceed last year's total. Since we have worked on over 80% of the FDA-approved drugs over the last five years, we believe the pipeline of new drugs supports ample future growth opportunities for us.

After three consecutive quarters with extraordinary revenue growth above the 20% level, the DSA growth rate is expected to moderate over the course of this year due to three primary factors. The normalization of the demand trends, as just discussed, more challenging year-over-year comparisons as 2023 progresses, and the impact of NHP supply constraints, mostly in the second half of the year. We expect less of an impact from NHP supply constraints in the second quarter than originally planned because of our ability to collaborate with our clients, optimize study schedules, leverage our flexible global infrastructure, and also due to our extensive backlog coverage across multiple study types. As I said earlier, the strong first quarter results and our progress with regard to additional mitigation efforts around the NHP co-supply constraints over the course of this year have also improved our confidence in our full-year financial guidance.

We are moving forward with plans to reconfirm NHP study starts that are already scheduled for the second half of the year. Based on communications with our clients, we are confident that we remain the preferred partner for their preclinical development activities because of our global scale, scientific differentiation, exceptional quality, and the value that we bring to the research and development efforts. Even in this time of disruption in the NHP supply chain, we do not believe the competition can provide a better value proposition to clients than we can. The DSA operating margin was 29% for the first quarter, a 610 basis point increase from the first quarter of 2022. The increase continued to be driven by operating leverage associated with a meaningfully higher revenue in the safety assessment business, as well as price increases.

RMS revenue was $199.8 million, an increase of 6.8% on an organic basis over the first quarter of 2022. The RMS segment benefited from broad-based demand for small research models in all geographic regions, for research model services, and for the cell solutions business. The RMS growth rate was below the high single-digit target for the year, due primarily to RMS China. While demand for small models remained strong, the timing of NHP shipments to clients in China impacted the first quarter growth rate. Since exports from China were shut down at the beginning of the pandemic, we have been selling a relatively small number of NHPs locally to clients since we were unable to utilize these models in our global safety assessment operations.

We expect the RMS growth rate to meaningfully improve in the second quarter as the NHPs are shipped in China, and we continue to expect RMS to deliver high single-digit organic revenue growth in 2023. Outside of China, revenue growth for small research models in North America and Europe remained strong, driven by healthy volume increases in North America and continued pricing gains globally. We believe demand for research models is an excellent indicator of the health and stability of early-stage research activity. The demand and pricing trends this year demonstrate that clients are continuing to move their research programs forward, which will drive solid RMS revenue growth. From a services perspective, revenue growth was also broad-based, with the Insourcing Solutions and GEMS businesses leading the way.

Insourcing Solutions, or IS growth, continued to be primarily driven by our CRADL operations, which offer flexible vivarium rental space at Charles River sites to both small and large biopharmaceutical clients. Having expanded significantly last year through both the acquisition of Explora BioLabs and by adding nine CRADL and Explora sites, we are now focused on ramping up utilization of the new sites, as well as continuing to moderately add new sites. This will generate a runway for continued robust revenue growth and margin enhancement opportunities for CRADL. Our traditional IS model, which provides staffing and vivarium management at our client sites, still resonates with clients. It has historically had a larger academic and government client base. However, commercial clients are also seeking the benefits of driving cost savings and greater operational efficiency by allowing us to manage their internal vivariums.

We were pleased to add a new meaningful commercial biopharmaceutical contract in the first quarter. We also continued to expand our GEMS business in North America to accommodate increasing demand from both biopharmaceutical and academic clients as they partner with us to maintain their proprietary genetically modified model colonies. These models are playing an increasingly critical role as drug research becomes more complex with the shift to oncology, rare disease, and cell and gene therapies. In the first quarter, the RMS operating margin decreased by 650 basis points to 23.4%. Most of the decline was driven by the temporary headwind related to timing of NHP shipments within China. Revenue mix was also a factor due in part to the Explora acquisition in April of 2022 and the ramp-up of utilization at our CRADL and Explora operations, which were expanded last year.

We expect the RMS operating margin to meaningfully improve in the second quarter as these headwinds subside. Revenue for the manufacturing solutions segment was $167.3 million, a decrease of 1.8% on an organic basis compared to the first quarter of last year. The decrease was driven by the CDMO and biologics testing businesses, partially offset by a solid performance for the microbial solutions business. We mentioned in February, we expected the segment's year-over-year revenue comparison would be challenging due to commercial readiness milestones in the CDMO business and COVID vaccine testing revenue in the biologics testing business, both of which occurred in the first quarter of last year. We believe these factors will be largely anniversaried beginning in the second quarter.

In addition to these factors, the biologics testing business experienced a slower start to the year. Testing volume tends to be seasonally softer in the first quarter, with lower sample volume reflecting reduced client manufacturing activity over the holidays. This year, we also experienced lower than anticipated volumes, particularly for viral clearance and cell banking services. Clients seem to be prioritizing their programs and more budget-focused at the beginning of the year. Microbial Solutions delivered a solid first quarter performance, led by the continued strength of the Accugenix microbial identification platform due to both instrument placements and demand for our testing services. Our advantages as the only provider who can offer a comprehensive solution for rapid manufacturing quality control testing continues to resonate with our clients. The cell and gene therapy CDMO business continued to make progress towards its targeted growth rate goal.

As expected, the growth rate was affected by the comparison to the commercial readiness milestones paid in the first quarter of last year. The initiatives that we have implemented to improve the performance of our CDMO business continue to gain traction and earn positive feedback from clients. We believe that the success of these actions and an increasing sales funnel will result in a marked improvement in the CDMO growth rate in the second quarter, and we expect the CDMO business will drive a rebound in the manufacturing segment organic growth rate over the course of the year. Manufacturing segment's first quarter operating margin was 13.7%, a significant decline from 33.1% in the first quarter of last year. The decline was primarily related to lower operating margins in each of the segment's business units, particularly CDMO and Biologics Testing.

This was driven largely by the prior year headwinds and the slower start in the Biologics Testing business that I discussed, as well as an asset impairment in the segment. As anticipated, end market dynamics have moderated somewhat in 2023. It is important to reiterate that our client base remains stable and resilient, particularly biotechs. These companies have now become the innovation engine for the entire biopharmaceutical industry, with a number of biopharma companies with active pipelines doubling over the past 10 years. We believe the early-stage research that we conducted is instrumental to our biotech clients' achievement of the important milestones that enable them to secure additional funding. Therefore, they will continue to partner with Charles River for our flexible and efficient platform that accelerates their therapeutic innovation.

These factors, coupled with the strength and scale of our DSA backlog and the substantial visibility that it provides, will enable us to better withstand any near-term fluctuation in the market. We believe the power of our unique portfolio differentiates us today more than ever from other companies that provide R&D support services to the biopharmaceutical industry. We are continuing to further distinguish ourselves scientifically by adding capabilities in biologics and cell gene therapies, by investing in technology partnerships to bring cutting-edge tools to our clients, and by building greater digital connectivity with our clients, including through the launch of Apollo in March. Apollo will revolutionize client access to real-time study data, planning and cost estimates, and other self-service tools.

To conclude, I'd like to thank our employees for their exceptional work and commitment and our clients and shareholders for their continued support. Now, Flavia will provide additional details on our first quarter financial performance and 2023 guidance.

Flavia H. Pease (EVP and CFO)

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, and foreign currency translation. We're pleased with our first quarter results, which included revenue and earnings per share well above the outlook that we provided in February. We delivered strong organic revenue growth of 15.4%, wildly outperforming our prior expectations.

Higher revenue and a solid operating performance contributed to earnings per share of $2.78, a 1.1% increase over the prior year compared to the outlook we provided in February of a mid-single-digit decline. As Jim mentioned, we have narrowed our previous revenue growth and non-GAAP earnings per share guidance to reflect the strong first quarter performance. We now expect to deliver reported revenue growth of 2%-4.5% and organic revenue growth of 5%-7.5% for the full year, as well as non-GAAP earnings per share in a range of $9.90-$10.90 for the full year.

Our 2023 revenue guidance ranges continue to reflect the estimated impact from the NHP supply constraints, resulting in wider guidance ranges to account for multiple outcomes with respect to our mitigation plans. We're expecting stronger revenue growth rates in the first half of 2023 due to both the comparison to last year, when growth accelerated throughout the year, as well as the anticipated gating of the NHP supply impact, which will principally impact the second half. Our segment outlook for 2023 revenue growth remains largely unchanged, as noted on slide 34. We'll also continue to expect that the consolidated operating margin will be flat to lower versus prior year, depending on the ultimate success of our plans to mitigate the NHP supply constraints.

Unallocated corporate costs were favorable in the quarter, totaling 4.3% of total revenue, compared to 5% of revenue in the first quarter of last year. The decrease was primarily the result of timing of health and fringe costs, which are expected to normalize over the course of the year. Despite the favorability in the first quarter, we expect unallocated corporate costs to total approximately 5% of revenue for the full year, which is similar to 2022. The first quarter tax rate was 21.7%, approximately 490 basis points higher year-over-year as anticipated. The increase was primarily due to a lower benefit from stock-based compensation. We continue to expect our full year tax rate will be in a range of 22.5%-23.5%, which is unchanged from our previous outlook.

Total adjusted net interest expense was $33.6 million in the first quarter, essentially flat on a sequential basis. The significant year-over-year increase from $20.4 million in the first quarter of 2022, which compressed earnings growth in the quarter, primarily reflected meaningfully higher interest rates as a result of the Federal Reserve's monetary policy actions since March of 2022. For the year, we continue to expect net interest expense of $133 million-$137 million. As a reminder, nearly three-quarters of our $2.75 billion debt at the end of the first quarter was at a fixed rate. With regards to the remaining variable rate portion of our debt, our outlook can accommodate an additional 50 basis point increase in rates by the Federal Reserve during the remainder of 2023.

At the end of the first quarter, our gross leverage ratio was 2.2x, and our net leverage ratio was 2.1x. Free cash flow was $2.5 million in the first quarter, compared to $22.2 million last year, with higher capital expenditures driving the decrease. As a reminder, the first quarter is a seasonally softer period for free cash flow generation. Capital expenditures were $106.9 million in the first quarter, compared to $80.5 million last year, due primarily to ongoing expansion projects to support continued growth across our business. Today, we're initiating 2023 guidance for free cash flow and capital expenditures.

We expect free cash flow to be in a range of $330 million-$380 million, which is flat to a 15% increase from $330 million in 2022. CapEx is expected to be slightly below our recently stated target of 9% of revenue at $340 million-$360 million this year. The lower capital intensity reflects our disciplined approach to capital deployment. We are investing in our business based on the growth potential of each business unit and are modifying certain projects in light of the temporary disruption from the NHP supply constraints. Normalizing demand trends will result in less capital required than we previously anticipated.

A summary of our 2023 financial guidance can be found on slide 40. Looking ahead to the second quarter, we expect year-over-year reported revenue growth in a high single-digit range and organic revenue growth of 10% or better. Reflecting, we expect the NHP supply issue will have only a limited impact on the second quarter DSA growth rate, as we're able to schedule flexibly and expect to leverage the strength of our backlog to slot in other studies when necessary. Earnings per share are expected to decline at a mid-single-digit rate compared to $2.77 in the second quarter of last year, as the higher tax rate and increased interest expense will continue to restrict the year-over-year earnings growth rate. In closing, we're pleased with our first quarter performance and are confident about our prospects for the second quarter as well as our ability to achieve our full year financial outlook.

Even as macro--[audio distortion]

Operator (participant)

We do ask that you limit yourself to one question. Once again, that is star and one to ask a question. We'll take our first question from Eric Coldwell with Baird.

Eric Coldwell (Senior Research Analyst)

Thank you. Good morning. Wanted to just clarify, last quarter you highlighted the 200-400 basis point potential impact from NHPs this year. I may have missed it, but I didn't see an update on that commentary. Looks like Q1 probably did a little better than the street expected. 2Q looks better than the street expected. I'm just curious if your range of potential impact has changed or if it's just shifted totally out to the third and fourth quarter? That's the first question. I have another. Changed any policy, or are all of your actions to this point, very much proactive and, you know, internally driven decisions to just be as safe as possible?

James C. Foster (Chairman, President, and CEO)

Hi, Eric. Certainly it's prudent for us not to bring NHPs at least from Cambodia into the U.S. You know, I would say that the U.S. government is fine with that strategy. They're certainly not supportive of us doing otherwise. We're gonna cooperate, and we're gonna run our business with multiple supply sources, doing the work at multiple sites, and try to work hard to have new testing. A little bit difficult for us to have much impact on the cadence of how quickly that goes, and what the receptivity will be. You know, we feel good about the science behind that. We actually feel good about all of our supply sources.

You know, we're doing the best we can to accommodate for the situation. You know, as a result of that, we should, you know, have slightly better performance in the second quarter than what's embedded in our guidance. It's still fluid and, I would say the fact that you know, I think we have good program and plan to satisfy the needs and demands of our clients. There's, there are things that continue to be out of our control, which is why we continue to have a guidance range. Of course, we did not get animals from all of the suppliers there, you know, only one principal one. We don't categorically know, but I would doubt that.

You know, China has lots of NHPs themselves, which is how this whole thing started. You know, we're doing the best we can to accommodate the demand by doing work in multiple geographies within CRL. We're, you know, we're as confident as we can that, you know, we can show parentage if we, as the discussion continues and we have clarity and sort of cooperation with the various, I would just wanna reiterate for the record that, you know, we're not a, you know, we're cooperating in an investigation, providing information. I think we're cooperating really well. We're not a target of investigation. We, you know, we don't know whether our supplier is, but we can just tell you that, we've been there.

We think the place is well run pursuant to the sort of CITES oversight that's required for purpose-bred breeding. We, you know, we also think that the veterinary oversight and nutritional oversight and transportation oversight on the farm that we utilize is done really well. You know, given our experience with farms all over the world, including farms that we had ourselves years ago and started on our own, we've been responsive on a timely basis with the folks that are asking us for information. We have very little control over the pace and response and how we move forward. I would be surprised and disappointed if Cambodia doesn't continue to be a source of supply.

As you know, really well, given your scientific background, not doing a sufficient amount of large molecule work, including these drugs through the FDA without using NHPs. It's not optional. Since this is the largest supply source, it's something that needs to be rectified, you know, in as timely a basis as possible.

Eric Coldwell (Senior Research Analyst)

Great. Thank you. I'll stick to one question. Thanks, Jim.

James C. Foster (Chairman, President, and CEO)

Sure. Thanks, Eric.

Speaker 13

[audio distortion] Thanks very much. I guess maybe just thinking about the quarter, obviously strong quarter total, but sort of looks like we as well as the Street sort of mismodeled. DSA was much stronger than we expected. RMS pretty much in line, manufacturing lower. I'm just curious, I know you don't give quarterly guidance by segment, but was this type of result generally in line? Sounds like maybe you're a little bit surprised by DSA. Just trying to think about how these results compared, and so how we should be thinking about your commentary on full year growth rate by segment. Are those still appropriate or based on the first quarter results, should we be sort of rethinking stronger DSA but lighter manufacturing and RMS? Thanks.

James C. Foster (Chairman, President, and CEO)

We'll both answer this. I would say we were not surprised at Factor. RMS has been growing really nicely for several years now. I don't know whether anybody remembers, I hope you did, but if not, we've reminded you. We knew that manufacturing would be behind the prior year because of some substantial milestone payments we had in the first quarter, with our CDMO business and COVID work for Biologics. Quarter track pretty much as we anticipate. We're obviously pleased with that level of growth. Safety assessment business is a very large part of what we do, as you know. It, you know, has had a really meaningful impact in our results.

I'll let Flavia answer the rest of the year question.

Flavia H. Pease (EVP and CFO)

Yes. Sandy, I think we always talked about how our business is not linear, and it's not linear. We affirmed our full year guidance of high single digits. We talked a little bit about some timing events in RMS in the first quarter that will normalize in the second quarter. DSA was very, very strong in the first quarter, as Jim pointed out. Continued strength following the second half of 2022. I also commented that the growth will modulate throughout the year, both given the comp, as the growth accelerated in 2022, you'd have a comp dynamic that will impact 2023. We reaffirmed our guidance of low to mid-single digits for the year.

In manufacturing solutions, as Jim pointed out, had a couple of headwinds in the first quarter with COVID vaccine volumes that are no longer existing, as well as the CDMO milestones. We talked a little bit about a slower start in biologic solutions. We expanded the guidance range a little bit to now include high single-digit to low double-digit for the year. The previous guidance was low double-digits, we just extended that range.

James C. Foster (Chairman, President, and CEO)

Sandy, it's worth reminding you and everybody else listening what the cadence was last year to Flavia's point, right? We had a slow first half of the year and a really strong second half of the year. I think some of our shareholders didn't think that that was gonna happen. We had, you know, 26% growth rate, I think, in the third quarter. We're gonna have these year-over-year comparisons, less tough in the first half, tougher in the second half. Some impact from the NHPs, we'd have that cadence anyway. Linearity is impossible for us to design or even predict. Studies sort of start when they start and end when they end. As always, you wanna listen to our guidance for a full year, particularly in the safety business.

Speaker 13

Great. That's really helpful. Thanks so much for the comments.

James C. Foster (Chairman, President, and CEO)

Yeah.

Operator (participant)

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

Speaker 14

Good morning. You have Lizzie on for Patrick. Just one more on the NHPs. It sounds like you're making progress on the test to determine parentage. I guess, how long do you anticipate the rollout of that test once you have it will take throughout your supply? You know, anything that we can expect there. I'll leave it at that. Thank you.

James C. Foster (Chairman, President, and CEO)

No more NHP questions. Just kidding. It's real-really difficult to say what the rollout is. The science is not trivial, but relatively straightforward. It's not all that complicated. We, you know, we have several places that we could do it or people could do it for us or all of the above. And we're quite confident from what we know that our supplier is purpose-breeding these animals, you know, according to all of our expectations, and that we can demonstrate that. The communications is just as I said a couple of times earlier, is a little bit slower than we would like. We understand that, and, you know, we'll do the best we can. We'll give you clarity when we have it.

I would say we don't. We've been very responsive in terms of coming up with a program, providing that to the various authorities. They've looked them over and, you know, we just continue to go back and forth. As a parallel strategy, you know, we're using our international infrastructure and will continue to. You know, it's always held us in good stead in all of our businesses, but in this case, particularly in safety, that we do the work in so many geographic locales that it really helps with the current situation when things are a little more complicated in the U.S. We're confident that we can prove it and demonstrate it scientifically without a shadow of a doubt. At some point, that will be kind of standard.

As I said earlier, would really like to come up with something that works for the whole industry and maybe not necessarily just for CRL.

Flavia H. Pease (EVP and CFO)

If I can just add, to Jim's point, we made progress on scientifically, identifying how the test can be done. It will take some time to operationalize given obviously the supply logistics and everything. It is, as we continue to work with the government, authorities, it will take some time to get this off the ground.

Speaker 14

Great. Appreciate the color there. Thanks.

Operator (participant)

We'll take our next question from Max Smock with William Blair.

Max Smock (Research Analyst)

Hi. Thanks for taking our question. I wanted to drill down on a decrease in DSA backlog, 'cause I think there's been a fair level of concern around some of the perhaps lower book-to-bills we've seen here in this part of the business. What are you seeing in terms of proposals and bookings so far here in the second quarter? Are you expecting backlog to continue to get worked down here over the next couple quarters given the tougher macro environment? Thinking ahead, where do you think you need to see backlog in this year in order to support double-digit organic growth for the DSA segment in 2024? Thank you.

James C. Foster (Chairman, President, and CEO)

We'll both comment on this. Proposals and bookings, you know, continue to be strong. Less strong than last year, which was a very unusual year. Enjoyable but unusual. You have a combination of factors, but I would say the principal factor is you have clients that at a certain level of waiting to start their studies, it just becomes problematic for them to plan their business and to get drugs into the clinic and ultimately into the market. We're seeing a normalization, kind of a pre-COVID normalization of that level of demand. Still healthy, still a lot of price, still not everybody, but almost everybody comes to Charles River for the really complex work and our geographic footprint. You know, we think this is in the process of normalizing.

We think the demand will-- I'm not gonna talk about 2024, but the demand will remain strong this year. If you didn't have the sort of primate overhang, you know, I think we would have a very strong year in the safety business, not to the level of last year. We're not concerned by that. You know, we got a very big denominator in this business. It's a big business now. We're having nice growth rate, taking share, getting good price. We don't see any amelioration of that.

Flavia H. Pease (EVP and CFO)

I think if you look at our book-to-bill on a trailing 12-month basis, which is how many clinical CRs look at their book-to-bill, we're still above 1x, excuse me. That firmly supports our DSA revenue growth outlook for 2023. We got a question earlier around the NHP supply impact, I commented again on the 200-400 basis points. You kind of do the math, you would be able to back into what would the DSA growth be had we not had that disruption. It would support a high single digit, low double digit growth in 2023. I think that answers your question, Max.

Max Smock (Research Analyst)

Got it. Thank you.

Operator (participant)

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

Dave Windley (Senior Equity Research)

I do have a brother named Dave Windley, so, hi.

James C. Foster (Chairman, President, and CEO)

Hey, Dave.

Dave Windley (Senior Equity Research)

Hi. Good morning. I actually my brother is actually Dave Windley. Jim, I'll redirect a little bit. I know you already said no more NHP questions. I'm gonna try to ask a positive--

James C. Foster (Chairman, President, and CEO)

It's okay.

Dave Windley (Senior Equity Research)

Yeah. In your proxy, you put a kind of a commitment to 2024, broadening out your supply chain diligence and how, you know, you work around your sourcing of these animals that are needed for research. Appreciate that. I'll look forward to the information in that. I guess I'm thinking in that context, certainly the, you know, if we go back to November when the indictments were first unsealed, certainly kind of a big shock to the industry. How has that influenced-- Your proxy calls it risk-based due diligence and risk-based supplier, you know, oversight. How has the environment changed the way you go about evaluating the situation?

At SOT, there was a suggestion-- I thought I understood that you were not importing Cambodian animals into any part of the business, international or the U.S., and you're saying U.S. today, so I wanted to understand that. Just kind of the risk management around this situation, how has, you know, the changing environment changed your risk management?

James C. Foster (Chairman, President, and CEO)

It's a good question, Dave. You know, our methodology hasn't changed very much. We believe we deal with suppliers who are certainly producing purpose-bred animals under strict veterinary oversight and complying with CITES permitting procedures. Of course, as we talked about for the last two or three years, we have multiple sources of supply, in other words, multiple countries, in some cases, multiple providers in those countries. We own some farms. We own pieces of some farms. We have long-term supply agreements with, I would say, almost all of them. We go, and we audit them. We had a little disruption in that audit because of COVID, those audits because of COVID, but we go and audit them. We are familiar with the situation.

Just to use your parlance, I think we were more shocked with the indictments because that's not the nature of the work that we're doing, of the people that we're working with. You know, that's obviously concerning, any sort of allegations like that. We'll continue to get closer to our suppliers, and I mean that in every way, in terms of ownership, people on the ground, constant audits, the testing that we talked about, you know, 10 minutes ago, with all of them, and dealing openly and appropriately and professionally with the various oversight bodies in a variety of countries.

For competitive and security and a whole bunch of other reasons, we wanna not be too granular on how we're For the situation right now, except to underscore the fact that we have multiple sources of supply, and we're using the entire Charles River portfolio, which is worldwide. I know you've been to a lot of sites, and the ones you haven't been to, I think you know where they all are. We think that, yeah, that's always been a competitive advantage for us, and being able to use those sites has really been beneficial.

The last thing I would say, which we haven't said yet, although I think it's in the earlier materials, is that, you know, we've had extensive conversations with the clients who have been terrific, and we've said, "Okay, here's the situation. We don't know exactly how many animals we'll be able to bring in, so you need to prioritize studies that you do in terms of what you need to start and when." They're doing that. You also have to be flexible about where you do it. You know, as you know, some of our clients, less all the time, but some of our clients are like, "You know, I only wanna do the work at wherever, 'cause I've always done it there.

I did a postdoc with the guy or gal that runs this site. They've been terrific. I'd say our client base has really been very collaborative, working hard with us, being open to getting the work done. They just want the work to start in the most timely fashion. I would say we're doing a very good job so far disrupting as few clients as possible. We had a strong Q1. We will have a, you know, a better Q2 with regard to the NHPs than we originally thought. The back half of the year will be more challenging because of the comps. You know, we, it's a fluid situation. You know, we hope it's a positively fluid situation.

You know, we'll, when there's something granular that we think is permanent and beneficial for you all to know, we'll tell you, but it's too changeable and, you know, we don't wanna be providing very, very detailed information that may not be sustainable. We're very pleased with the way we're handling it and the way our clients are accepting the current situation.

Dave Windley (Senior Equity Research)

Appreciate that. If I could, you know, that was a long question and answer. If I could attempt to clarify one thing in the prepared remarks. You talk about these NHPs and use the term pass-through. The pricing on the NHPs has gone up a lot. I just wanna make sure I understand, 'cause DSA margin was very good, you know, maybe the best of all time. That rising price on NHPs, if it is only pass-through, would be a pretty significant headwind to your margin. I was hoping maybe, Flavia, if you could clarify that for us. You know, are the NHPs contributing to margin, or are they a detriment to margin? Thanks.

Flavia H. Pease (EVP and CFO)

Thanks, Dave. A couple things. Yes, the DSA margin was very robust in the first quarter, and primary source of that continues to be underlying strong demand, especially volume and also price outside of NHP. We're very pleased with that. The NHP impact on margin, specifically as you're saying, at a macro level, as you pointed out, it's a pass-through, so it should be neither accretive or dilutive to the percentage margin. The timing on when we start NHP studies can have an impact on the mix that they have that they contribute towards or not to the margin. Depending on that and how we ended up the year and how many new NHP studies we're starting or not in each quarter can have a modest impact on the margin.

What I would focus all of you on is the strength of the margin in the first quarter in DSA is primarily behind volume and underlying price.

Dave Windley (Senior Equity Research)

Okay. Thank you. Thanks for the extra question.

Operator (participant)

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

Casey Woodring (VP of Equity Research)

Hi. Thank you for taking my questions. As a follow-up to the DSA backlog question from earlier, by our math, it looks like bookings were down over 40% on the year in the quarter. Was that step down in line with your booking normalization expectations in DSA? Just on manufacturing quickly, appreciate the commentary around the tough comps from last year, but curious as to the rationale for widening that growth range for the year. You know, wondering if there's any cushion baked in for a more volatile cell and gene therapy demand environment, you know, just given some of your peer commentary in the CDMO space from earlier this week. Thanks.

Flavia H. Pease (EVP and CFO)

Yeah. I think we talked about the normalization of the demand trends to more pre-pandemic levels. We had pointed out throughout all of last year that the backlog had extended meaningfully in terms of the length of it, with people booking really ahead as we had never seen before. That has definitely normalized. I think our clients are focusing on study starts that are sooner rather than a lot into the future. As they do that, they also look at studies that were booked before and whether they're ready to initiate them or not.

As we said, it's, we see this as a normalization from extraordinary levels in 2022. And then just on the manufacturing solutions, I think we had commented and expected a lighter first quarter vis-à-vis the overall guidance for the year that originally was low double digits. We not only saw the first quarter impact of the tough comps with the CDMO milestones and the COVID volume in biologics, but we also talked about a slightly slower start of the year for testing. And there might be some comments around the industry on bioprocessing. We widened our guidance range a little bit on manufacturing to accommodate for that.

James C. Foster (Chairman, President, and CEO)

I think we're ready for the next question.

Operator (participant)

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

Tejas Savant (Executive Director and Senior Healthcare Equity Analyst)

Hey, guys, good morning. Jim, since you've, you know, told us not to ask about NHPs, that is exactly what I will do. Just one clarification actually to that first question from Eric. Flavia, you mentioned sort of the 200 to 400 basis points range being the same, but at the same time, you also talked about how some of your ongoing efforts should mitigate some of the impact here. Is it fair to assume that at the midpoint, things have moved a little bit towards the lower end of that 200 to 400 bps range? Jim, one for you in terms of just dealing with the competition here, more tactical rather than structural long term, because I know you're very competitive here.

You know, given some of these Chinese CROs and NHPs being an abundant supply there, also some of your U.S. competitors perhaps acquiring NHPs from some local suppliers, which you may or may not have wanted to deal with, how do you think about the near-term sort of tactical competitive landscape, in the market at the moment?

Flavia H. Pease (EVP and CFO)

Maybe I'll just take the first question. you know, we had provided a wider guidance range, obviously this year, given the NHP supply situation. To your point, it included 200-400 basis points of impact. As Jim commented, the second quarter is certainly a little bit better than we had planned, given the collaboration with our clients to work and schedule flexibly. We continue to include the 200-400 basis points in our guidance range, given also what Jim talked about, which is it continues to be a fluid situation. We're working very hard to be at the lower end of that range, but it's still early in the year, I'll leave it at that.

Jim, do you wanna?

James C. Foster (Chairman, President, and CEO)

On the NHP competitive scenario, I'd say a couple of things. One is, there's obviously a significant number of NHPs in China to be utilized by Chinese CROs to both support their current industry, I mean, their internal China industry and perhaps some U.S. and European companies. The scale of the industry there is still relatively small. Obviously, that's subject to change over a period of time. Some Western clients may have gone there. It's difficult for us to tell, but not too many. I think there's a reluctance for a whole bunch of obvious reasons to be taking your new drug, newly patented drugs and doing the work in China. Having said that, I think they'll get the work done wherever they can.

With regard to our domestic competitors, you know, I'd remind you that number one, they're smaller, way smaller. Number two, they, you know, I think they have very limited supply sources. Number three, I think they're also not bringing animals in from Cambodia. Number four, they may be using suppliers that we might not use. We are constantly trying to take the high road in terms of quality, consistency and volume of supply, and we think we're in a very strong competitive position.

Tejas Savant (Executive Director and Senior Healthcare Equity Analyst)

Thanks, guys. Appreciate it.

James C. Foster (Chairman, President, and CEO)

Sure.

Operator (participant)

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

John Sourbeer (Managing Director)

Morning. Thanks for taking the question. I guess just looking into the CDMO, could you just talk about some of the backlog building there? I know there's been some announcements over the last several months, and just the maturity of some of these programs, and you still see the potential for commercial products this year or into next year. Then just one follow-up, too, on unrelated subject. You know, there's been some press reports on bans of harvesting of horseshoe crabs. Just any comment there on or what the size of that business is for Charles River? Thanks.

James C. Foster (Chairman, President, and CEO)

On the CDMO business, you know, has three parts. We have a cell therapy manufacturing business, which is our largest business in Memphis. It's doing quite well, certainly compared to the prior year. I was just down there. Fabulous new facilities, new management team, new sales organization, significant number of new clients, both large and small. We are producing our first commercial products. Can't divulge it, but we are. And we have other clients that are moving in that direction. By that, I mean, you know, either filing with various government agencies in the U.S. and Europe, and/or telling us to get ready for audits by either the FDA or the EMA.

Moving in the commercial direction, we have new production suites which are available. Some of those have been reserved by clients that are either commercial now or think they will be soon, because obviously they don't wanna have a product approved and not get this. We're pleased with the way it's progressing. We also have a viral vector business in Rockville, Maryland, that it also has been enhanced facilities and management team and sales organization, which is strengthening nicely. We have a plasmid DNA business in the U.K., which again, has been somewhat transformed. We have centers of excellence in both of those sites now where they used to do multiple things. CDMO business will have nice growth rate this year, notwithstanding the predetermined and expected difficult comps for Q1.

That business will continue to strengthen through each quarter, both on the top line and the bottom line from a comparative basis. The horseshoe crab thing, you know that's the reagent that we use for our endotoxin test. I'll remind you that that test is used for medical devices and injectable drugs required by law as a lot release test. I'll also remind you that that was our first major foray into in vitro systems. That's actually considered an in vitro system, even though it uses the blood of horseshoe crabs. Those crabs are harvested in a variety of places. We have a little bit of pressure in one of our locations in South Carolina. Had some lawsuits related to that.

I won't get into all the details, you know, the punchline is we have some restrictions in fishing those waters. We also have new locations to harvest crabs in other parts of the U.S., which should hold us in good stead. We're also building the inventories nicely. I guess the last thing I would say is that our technology, as opposed to the conventional technology, which is 96 well plates, and we still sell lots of that, our forward-looking technology is a more sophisticated device which uses 95% less crude. You know, our need for a crude, which is the blood from the horseshoe crabs, is actually, as we transfer the clients to new technology, is actually decreasing all the time. We're in good shape there.

Elizabeth Anderson (Senior Managing Director)

Thanks for taking the question.

Operator (participant)

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

Justin Bowers (Research Analyst)

Hi, good morning, everyone. Just sticking with the CDMO and the improvements there sequentially, you know, I think in the deck or the prepared remarks too, you talked about returning to those targeted growth rates. Can you just remind us what those are? Then maybe qualitatively is, you know, for 2023, are you thinking that that business is sort of above or below the segment growth rates for the year?

James C. Foster (Chairman, President, and CEO)

We're expecting those businesses in the aggregate, again, with Memphis being the by far the largest piece, will grow at 20%-25%, which is what we had anticipated when we bought them. That's a great growth rate. Obviously accretive to the growth rate of the manufacturing segment. And at a certain scale, you know, obviously somewhat accretive to the core company as a whole, but as it grows, it will be increasingly more accretive. Lots of demand, limited competitive scenario. I mean, some clients are doing it themselves, but I'm talking about on a contract basis. We have good competitors, but not a lot of them. Lots of drugs in development that we're working on in the preclinical sector. And then obviously lots of those moving into the clinical domain.

Only a few have been approved. I still think it's 13% or 14% totally. We're now making one of those gene-modified cell therapy products, so we're very pleased and proud of that. Early days from a volume point of view, so it's not transformational necessarily from that point of view. I think reputationally, with regard to other potential client, current clients being comfortable with our capability and also the regulatory agencies having audited us and being pleased with what they saw, holds us in good stead. We're happy with our infrastructure, with the growing client base, with our scientific capabilities, with our ability to sell more effectively. It's a pretty long sales cycle, so you know, we're out and about well in advance.

I think there's a fair amount of price power in this business because it's complicated and expensive to set it up. While you may have some very big companies set their own shop up, small and medium-sized biotech is not gonna be able to afford it. Like in safety, well, like in all of our businesses, we're gonna need to be paid well for our current and future investment in this space. We're pleased with the way it's going. We learned a lot last year. We made a lot of fundamental changes in the physical plant and in the scientific and the G&A staff. And just getting the word out that this is something that we do as we go to more scientific meetings and present more papers.

We should hit the growth rates that we originally anticipated in our acquisition model.

Justin Bowers (Research Analyst)

Great. Congrats on the commercial production there in Memphis. Maybe just a quick follow-up on RMS and NHPs in China. Is the messaging there, was there a blip in 1Q and then it's back to normal in 2Q or has something changed in the way that you're sort of going to market there with RMS and NHPs in China?

James C. Foster (Chairman, President, and CEO)

You know, we have supply sources in China that have to stay in China. We sell the animals to clients in China. Usually, we can predict the timeframe, so this just slipped out a little bit, so nothing's fundamentally changed. It's not a huge part of the business, but it's meaningful certainly to our Chinese business and slightly less meaningful, but still meaningful to our RMS. Margins are good. Animal quality is good. Yeah, that will continue to be part of our situation over there. Nothing's fundamentally changed, just slid out a little bit.

Flavia H. Pease (EVP and CFO)

Yeah, it's purely timing, I would characterize.

Justin Bowers (Research Analyst)

Okay. Got it. Thanks so much.

Flavia H. Pease (EVP and CFO)

Sure.

Operator (participant)

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

Elizabeth Anderson (Senior Managing Director)

Hi, guys. Thanks so much for the question. If you could comment on sort of backlog cancellations in the first quarter, is that something that you're sort of seeing as broadly steady sequentially? Are you seeing any sort of changes in the characterization of that at all? Thanks.

Flavia H. Pease (EVP and CFO)

Elizabeth, we've been talking about cancellations and slippage throughout last year as we also continued to talk about the size of the backlog, which had expanded to significantly higher than historical levels. We talked about the elongation of that backlog, which as one might expect, would drive additional cancellations or slippage. First, cancellations and slippage are a normal part of the business, as clients, you know, do not have the test articles ready or continue to negotiate design study with the appropriate regulatory agencies. That normally happens in the business. As the backlog elongated in time, that certainly becomes more pronounced as it's harder to predict things that much into the future. We had seen that elongate throughout 2022.

I think we're getting back to, I would say, maybe more normalized pre-pandemic levels. I think those things will work, or will adjust, together. The backlog is not gonna be perhaps as long, and the cancellations and slippage will lower accordingly.

Elizabeth Anderson (Senior Managing Director)

Got it. That's super helpful. Just one other follow-up. Like, I obviously, the margin in manufacturing support was impacted a bit by the lower revenue growth, I would imagine, in the quarter. The OpEx growth in general seemed a little bit higher than your usual kind of run rate on that. Can you just talk to maybe like the cadence of that in the back half of the year and sort of, how much was sorta specifically a function of maybe some of the deleveraging in manufacturing support versus, how you're seeing any kind of, cadence changes in the spend over the rest of the year? Thank you.

Flavia H. Pease (EVP and CFO)

Let me comment first on the Manufacturing Solutions margin in the quarter. As Jim talked about, we had some of those prior year headwinds with the milestones in CDMO and the biologics COVID volume that we no longer have. We also had a lighter start in Biologics Testing this year. I think we also talked about we had an asset impairment in that segment in Q1. All those things contributed to a, I'll say, unusually low Manufacturing Solutions margin in Q1. I think for the overall margin for the company, you know, we were about 20 basis points lower year-over-year.

We continue provided an update on the guidance for the full year of flat to lower versus 2022, given the continued fluidity of the NHP situation that we talked about earlier.

Elizabeth Anderson (Senior Managing Director)

Got it. Thank you.

Operator (participant)

We'll take our next question from Tim Daley with Wells Fargo.

Timothy Daley (Senior Equity Research Analyst)

Great. Jim, just moving away from all these near term factors here, wanted to clarify some comments made at a broker conference in March around the RMS segment long-term growth rate. Over the past two years, you guys have formally up-indexed long-term growth forecasts in RMS from low single, mid-single to mid-single, high single, and DSA from high single to 10%. You know, where we sit today, are those still the official goalposts or any further updates here on that framework on a segment level?

James C. Foster (Chairman, President, and CEO)

Certainly, for this year, we feel good about RMS growing at high single. You know, the constituent parts of that business continue to strengthen. We're actually gaining share in the U.S. and Europe, which we haven't seen in a long time. We always get price in that business.

Chinese business is growing nicely, both on the small animal side and then NHP business. Service businesses which have great margins are growing very nicely. Obviously, we did an acquisition last year, which is Explora BioLabs with all of these new cradles and very important geographies. Really great receptivity in a tough economy for these sites. Surprisingly, clients are both very large and very small, and we thought they would be only small clients. And the cell supply business, which was in the prepared remarks, but we haven't talked about that much. Altogether, small business really had probably the only business in the portfolio that really had a tough time as a result of COVID and had a very nice first quarter.

You know, I'd say, you know, without getting into 2024, obviously, that the outlook for that business continues to be stronger. Capacity is extremely well utilized. Competition, while we always respect notwithstanding what I'm about to say, I would say is, continues to be financially less strong and more fragile and more siloed. I think it's difficult for them to compete with us. We're feeling really good about that. You know, on the DSA side, with some moderation from an extremely strong 2022, and assuming the NHP situation gets resolved permanently as we hope it does, yeah, we think that's gonna be a DSA should be a strong business for us. Our current guidance, given the vagaries, is, what is it? Low to mid-single digit.

You know, the current long-term guidance out there is what? Low double, I think. We'll, we'll give updates on all of those growth rates sometime this year when we have our investor conference. Things, you know, things are a little bit fluid, as I said, on the NHP side, but we'll give guidance assuming that that's clarified, or hopefully it will be clarified by the time we have our investor conference. You know, I think we have pretty much across the board, very good demand for what we do.

I think we're providing an extraordinarily valuable service and products, with very strong competitive position and great connectivity across the various parts of our business that should only be enhanced, given the current portfolio and hopefully as we continue to add to with very small and perhaps some mid-sized deals.

Timothy Daley (Senior Equity Research Analyst)

Great. Thank you. A quick one for Flavia. You know, what's the overall China exposure as a percent of revenues, you know, an update on that? Are any business, businesses or segments over or under indexed to China? Thanks for the time. Appreciate it.

Flavia H. Pease (EVP and CFO)

Yeah. I think, the only business really that we have a China presence is RMS, you know, with obviously our models business there, but also the services business. As you can imagine, we also have microbial, which is part of the manufacturing solutions business, be distributed and available in China. Our largest business, excuse me, our largest segment, which is DSA, has no presence in China. As a result of that, China is a fairly modest portion of overall Charles River sales.

James C. Foster (Chairman, President, and CEO)

I think it's still less than 5% of total revenue, probably 3% or 4%. The last time we updated, it was like 10% or 15% of RMS revenue.

Timothy Daley (Senior Equity Research Analyst)

Great. Thank you.

Operator (participant)

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

Todd Spencer (Corporate VP of Investor Relations)

Great. Thank you for joining us on the conference call this morning. We look forward to seeing you at upcoming investor conference in June. That concludes the conference call. Thank you.

Operator (participant)

Thank you. That does conclude to today's Charles River Laboratories 1st quarter 2023 earnings call. Thank you for your participation, you may now disconnect.