Susan E. Hardy - Charles River Laboratories International, Inc. James C. Foster - Charles River Laboratories International, Inc. David R. Smith - Charles River Laboratories International, Inc..

Steven Reiman - JPMorgan Securities LLC Ross Muken - Evercore ISI Jon Kaufman - William Blair & Co. LLC David Howard Windley - Jefferies LLC Sara Silverman - Wells Fargo Securities LLC Mark Rosenblum - Morgan Stanley & Co. LLC George R. Hill - Deutsche Bank Securities, Inc. Greg Bolan - Avondale Partners LLC Jonathan Groberg - UBS Securities LLC.

Ladies and gentlemen, thank you for standing by. Welcome to the Charles River Laboratories Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. As a reminder, this conference is being recorded.

I'd now like to turn the conference over to your host, Susan Hardy, Corporate Vice President of Investor Relations. Please go ahead..

Thank you. Good morning, and welcome to Charles River Laboratories' third quarter 2016 earnings conference call and webcast. This morning, Jim Foster, Chairman, President and Chief Executive Officer, and David Smith, Executive Vice President and Chief Financial Officer, will comment on our third quarter results and update guidance for 2016.

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 replay of this call will be available beginning at noon today and can be accessed by calling 800-475-6701.

The international access number is 320-365-3844. The access code in either case is 403827. The replay will be available through November 16 and you may also access an archived version of the webcast on our Investor Relations website. I'd like to remind you of our Safe Harbor.

Any remarks that we may make about future expectations, plans and prospects for the company constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by any forward-looking statements as a result of various important factors, including but not limited to those discussed in our Annual Report on Form 10-K, which was filed on February 12, 2016, as well as other filings we make with the Securities and Exchange Commission.

During this call, we will be primarily discussing results from continuing operations and non-GAAP financial measures.

We believe that these non-GAAP financial measures help investors to gain a meaningful understanding of our core operating results and future prospects, consistent with the manner in which management measures and forecasts the company's performance.

The non-GAAP financial measures are not meant to be considered superior to or a substitute for results of operations prepared in accordance with GAAP.

In accordance with Regulation G, you can find the comparable GAAP measures and reconciliations to those GAAP measures on the Investor Relations section of our website through the financial information link. That said, I will now turn the call over to Jim Foster..

Good morning. We believe that the trend that drove revenue growth for the first half of the year continued in the third quarter and will continue in the fourth quarter.

As a result, we expect that reported revenue growth in 2016 will be in a range of 21% to 22%, and that growth for the legacy businesses will be between 7% to 8%, approximately 100 basis points higher at the midpoint than in 2015.

The strength of our unique portfolio and the success of our strategic acquisitions, targeted sales strategies and our initiatives to increase operating effectiveness and efficiency, are the foundation for our growth in 2016 and in the future. I'd like to provide you with the highlights of our third quarter performance.

We reported revenue of $425.7 million in the third quarter of 2016, 21.8% increase over the third quarter of 2015. The negative impact of foreign exchange was 1.5%. Acquisitions contributed 18% to third quarter revenue growth and our legacy business generated 5.3% organic growth.

The growth rate for our legacy businesses was below the first half of last year, due primarily to the Discovery and Safety Assessment segment, which was moderately below our expectations. This was due principally to Early Discovery, which I'll discuss in more detail in a moment.

From a client perspective, biotechnology clients were the primary driver of revenue growth. Sales to these clients increased at double-digit rate, as they continued to invest in their pipelines.

The operating margin declined 80 basis points year-over-year to 19.7%, but improved sequentially by 20 basis points, due to both sales volume and efficiency initiatives, particularly in the DSA segment.

The year-over-year decline was due primarily to the acquisition of WIL, which as we have mentioned, has an operating margin below our DSA segment level. Our goal to achieve $17 million to $20 million of cost synergies over two years will improve WIL's operating efficiency.

I'm pleased to say that we are making excellent progress on synergies and fully expect to achieve our goal in 2017. Earnings per share were $1.18 in the third quarter, an increase of 14.6% from $1.03 in the third quarter of 2015.

The improvement was due to a combination of higher revenue generated by our legacy operations and the benefit of our acquisitions, particularly WIL. Our investments in venture capital funds contributed just $0.01 in the quarter. In general, we were pleased with the performance of our portfolio in the third quarter.

Although revenue growth was moderately below our expectations, most of our businesses continued to perform very well, and we reported growth for each of our business segments.

From a guidance perspective, we now expect constant currency revenue growth for 2016 to be in a range from 22% to 23%, which is at approximately the midpoint of the previous range. Adjusted for foreign exchange and acquisitions, the organic growth rate would be between 7% and 8%, in line with our high single-digit target.

We are increasing our 2016 non-GAAP earnings per share guidance to a range of $4.44 to $4.49, which is towards the higher end of our previous range, and $0.13 higher at the midpoint of the range than our original guidance in February.

Based on our strong organic growth, the contribution from acquisitions and the benefit of our efficiency initiatives, we are confident that we will achieve our full year revenue and earnings per share guidance. I'd like to provide you additional details on our third quarter segment performance, beginning with the RMS segment.

Revenue was $120.9 million, an increase of 2.1% in constant currency over the third quarter of 2015. Like the second quarter, growth was driven by higher sales of Research Models in Asia and Research Model Services. The third quarter growth rate was lower than the first half of the year, due primarily to the acquisition of WIL Research.

As a result of our ownership of WIL, sales of Research Models to WIL are now accounted for as an intercompany transaction. Had those sales been reported as revenue, as they were in the third quarter of last year, the RMS segment revenue growth rate would have been approximately 3.5%, in line with our targeted low to mid-single-digit growth rate.

RMS operating margin declined slightly in the third quarter to 27.3% from 27.5%, but remains in our high 20% targeted range. Revenue for the Manufacturing Support segment was $89 million, a 21.8% growth rate on constant currency over the third quarter of last year.

The acquisitions of WIL's CDMO business, Celsis and Blue Stream contributed 10.5% to growth. On an organic basis, growth was 11.3%, driven by the Microbial Solutions and Biologics businesses. Microbial Solutions reported a robust third quarter, with revenue growth for the legacy business above our 10% target.

As a result of adoption of our rapid testing products, we sold more PTS, MCS, and Nexus machines than in the third quarter of 2015, which in turn drove greater demand for cartridges.

The enhancements that we made to our manufacturing capacity are enabling us to produce more cartridges to meet the demand, and providing operating margin benefits as well. Growth was also driven by demand for our microbial identification services, due to both increased outsourcing and synergies with Celsis' clients.

We are continuing to focus on expanding our footprint in the market for rapid testing and microbial identification.

We are investing in research and development for Microbial Solutions business to enhance the functionality of our rapid testing platform, and drive greater adoption of our products in order to capitalize on this moment in time when we have the opportunity to set the standard for rapid testing and identification.

We are optimistic that our ability to provide a total microbial testing solution for our clients will be the driver for Microbial Solutions to continue to deliver at least low double-digit organic revenue growth for the long-term foreseeable future. The Biologics business reported a very strong year-over-year performance in the third quarter.

Robust revenue growth in the legacy business was driven in part by strong demand for our virology services, particularly in the U.S., where we expanded capacity at the beginning of the year.

We are experiencing greater demand for our services due in part to the fact that the number of biologic drugs and biosimilars in development continues to increase and also to the broadening support that we can provide for our clients' manufacturing activities.

As we mentioned on our second quarter earnings call, the ability to provide broader support was the primary reason for the acquisition of Blue Stream, which was strategically important because it expanded our portfolio with protein characterization and other capabilities required for biologics and biosimilars testing.

As a result of the acquisition, we can now provide a comprehensive portfolio of both bioanalytical and biosafety testing services, with the ability to support biologic and biosimilar development from discovery through clinical phases and commercial manufacturing.

We are continuing to execute our integration plan, which has proceeded on target in the first 120 days. The Manufacturing segment's third quarter operating margin was 33.8%, a 60 basis point increase year-over-year. The improvement was driven primarily by the Microbial Solutions and Biologics businesses.

In both cases, increased volume and the benefit of efficiency initiatives contributed. The 160 basis point sequential decline was due primarily to unusually high PTS cartridge volume in the second quarter, when we shipped the backlog which occurred as a result of the manufacturing enhancements.

Revenue for the DSA segment was $215.8 million in the third quarter, an increase of 39.8% in constant currency over the third quarter of 2015. The acquisitions of WIL and Oncotest contributed 35% to the segment's third quarter growth.

Organic revenue growth of 4.8% was driven primarily by the Safety Assessment business, which reported a high single-digit revenue increase over the same period last year.

The fact that third quarter revenue growth for Safety Assessment was below our low double-digit target was due to studies being delayed to the fourth quarter and not because of a reduction in bookings.

We are continuing to attract business on the basis of our strong portfolio, scientific expertise, and flexible and customized working relationships, which enable our clients to improve the efficiency and effectiveness of their early-stage drug research efforts.

I remind you that low double-digit revenue growth is an annual target, and that there may be quarterly fluctuations above or below. However, we expect that the Safety Assessment business will achieve low double-digit revenue growth in the fourth quarter and meet our target for the full year.

The Discovery Services business performed below our expectations in the third quarter. As I mentioned, this was due primarily to Early Discovery. We continued to see strong demand from biotech clients, but demand from large biopharma clients has had greater fluctuations.

We believe this is due to the fact that large biopharma companies have significant internal capabilities on which they rely. As we demonstrate that our services can augment and accelerate their discovery capabilities, clients will increasingly appreciate the benefits of outsourcing more work to us.

And as we continue to build our capabilities and market them more effectively, large biopharma clients should utilize our services more consistently.

To address the near-term implications for our business, we have made changes to our management team, assigning Birgit Girshick, a Senior Vice President and one of our most experienced operating managers, to lead Discovery Services business and reorganizing certain operations.

We are also realigning our Discovery sales strategies, first by enhancing the sales organization in order to increase our focus on Discovery, and, second, by establishing a therapeutic area focused, integrated drug discovery team which will be responsible for collaborating with the broader sales organization and our operating units to ensure that we maximize the value of our unique early-stage portfolio and deliver exceptional service to clients.

We are focusing on both large biopharma and biotech clients because each is a key driver of growth; biopharma because (14:45-14:49) relationships, and biotech because, without certain internal capabilities, they have consistently outsourced.

With the maturation of the biotech industry, these companies are discovering effective drugs that cure diseases, which is leading to more robust pipelines. Biotech investments in its pipelines has been a primary driver of our growth in the last few years.

And we have recently been awarded a number of new projects for Early Discovery work, as well as the three-year extension of our longstanding integrated drug discovery alliance with Genentech.

The relationship with Genentech began in 2005 with a single project involving medicinal chemistry and has evolved over the ensuing 11 years to a multi-disciplinary collaboration drawing on our leading researchers in chemistry, biology and pharmacology.

I want to be clear that the fluctuations in Early Discovery outsourcing did not change our view of the importance of our early-stage drug research portfolio. Our In Vivo Discovery business is performing well, and Safety Assessment has had an exceptional year in 2016.

Clients increasingly rely on us because of the breadth of our portfolio and our scientific expertise.

We believe it is critically important that we continue to strategically expand our portfolio, both through internal development and targeted acquisitions, so that we can continue to expand our ability to support our clients' early-stage drug research efforts.

Our view has been reinforced by positive client response to our broader portfolio and we were very pleased to see two analyst surveys published in October, both of which ranked Charles River as the preferred CRO for early-stage work.

We are optimistic that the business changes we implemented will enable us to generate growth and improve our operating margins as the Discovery outsourcing market evolves. Despite softer revenue, third quarter operating margins in our Early Discovery business improved as a result of efficiency initiatives.

The DSA segment's operating margin was 22.7%, a sequential incremental improvement of 150 basis points, due in part to the changes and efficiency initiatives in Early Discovery. The 150 basis point year-over-year decline was due primarily to the addition of WIL, which as you know, has operating margins below our DSO segment average.

We continue to make excellent progress on the WIL integration and targeted cost synergies and expect WIL's operating margin will improve over time. I will also note that because the integration has progressed so well, we were able to transition Birgit from her WIL integration role in order to lead the Discovery business.

Integration of the WIL operations is effectively complete and the exceptional team that Birgit has established will carry on the remaining integration activities. The tasks that remain are longer term in nature and plans are underway for their completion.

From a client perspective, biotech technologies continued to be the primary driver of revenue growth in the third quarter. Whether biotech has one drug or a more robust pipeline, each company is focused on making the go and no-go decisions about whether a drug should progress further through development.

With our broad early-stage portfolio, biotechs can rely on Charles River to provide them with the scientific expertise and experience they need to bring a drug to market as quickly and efficiently as possible.

We maintain our belief that these companies have ample funding for the next few years, and that as their drugs demonstrate efficacy, additional funding will be available. It's notable that biotech funding from the capital markets improved significantly on a sequential basis in the third quarter.

However, our revenue from biotech clients increased even when funding was weaker earlier in the year. This is in part because the capital markets are not the only source of funding for biotech. As large biopharma increasingly relies on biotech for discovery of new molecules, large biopharma is providing funding to those organizations.

Combined with funds already raised in the capital markets and consistent support from venture capital, we believe that our biotech clients will continue to have the capital they need to invest in their pipelines. Increasingly agnostic to where molecules are sourced, large biopharma is also providing funding to academic institutions.

Over time, we have seen academic institutions become more focused on extending their efforts beyond basic research and like our global and biotech clients, academic clients are relying on Charles River for their research models and services needs.

We are beginning to see them work with us in Discovery and Safety Assessment as well, as they focus on moving molecules through early-stage research. Supported by stable to improving funding from the institutions themselves and the NIH, and funding from large biopharma, we believe that our academic clients will contribute to our revenue growth.

We believe that the continued expansion of our portfolio and our scientific expertise, superb execution, and our flexibility relative to decision making, speed, and relationships are the basis for long-lasting relationships with our clients and our future growth.

Our recent acquisition of Agilux Laboratories, a CRO that provides a suite of integrated small and large molecule discovery bioanalytical services, and DMPK and in vivo pharmacology services, supports our strategy to offer clients a broader, integrated portfolio that enables them to work with us continuously from the earliest stages of drug research through the non-clinical development process.

Agilux reinforces the linkage between our Discovery and Safety Assessment capabilities, enhancing our ability to provide clients with a comprehensive testing solution that spans their discovery and regulated drug development needs.

As we make progress on our goal to maintain and enhance our position as the premier non-clinical CRO, we have become the go-to partner for an expanding number of clients who recognize our expertise, scale, and deep commitment to them.

We've increasingly become part of the solution to more efficient and productive drug research, which we believe is demonstrated by the fact that we worked on more than 55% of the drugs approved by the FDA in 2014 and 2015.

The value that we provide to clients is the basis of our position as the premier early-stage contract research organization, and the reason we believe we will achieve our long-term growth goals and enhance shareholder value. In conclusion, I'd like to thank our employees for their exceptional work and commitment, and our shareholders for the support.

Now, I'll ask David to give you additional details on our third quarter results..

Okay. Thank you, Jim, and good morning. May I remind you that I'll be speaking primarily to non-GAAP results from continuing operations, which exclude amortization and other acquisition-related charges, costs related primarily to our global efficiency initiatives, and certain other items.

The corresponding GAAP results and the reconciliation of the non-GAAP items can be found in the associated slide presentation, as well as on our Investor Relations website. Overall, we are pleased with our third quarter performance.

Our financial results demonstrated continued growth across our three business segments, as well as our ability to continue to make progress towards achievement of our stated goals.

Jim has already discussed the factors that effected DSA revenue growth in the third quarter, so my initial comments will focus on two areas that led third quarter non-GAAP earnings per share to exceed our prior outlook; a sequential improvement in operating margins and a lower tax rate.

The strength of our operating margins was primarily driven by a 150 basis point sequential increase in the DSA segment to 22.7% in the third quarter from 21.2% in the second quarter.

This improvement occurred despite the sequential decline in DSA revenue, primarily as a result of efficiency initiatives and other cost benefits, including lower direct study costs due to the study delays in the third quarter and the mix of those costs. Our tax rate was also more favorable than we had expected.

After the significant increase in the second quarter, the third quarter tax rate declined sequentially by 240 basis points to 27.5%, as a result of a more favorable earnings mix and the benefit from a tax rate reduction in the UK associated with the passage of the Finance Act in September.

As a result, we now expect our 2016 non-GAAP tax rate to be at the lower end of our previous outlook in a range of 29% to 29.5%, compared to the 29% to 30% range that we provided in August. I will now comment on other non-operating components affecting our third quarter results and full year outlook.

Unallocated corporate costs decreased by $1.2 million sequentially to $28.4 million, or 6.7% of third quarter revenue, due primarily to lower stock compensation expense. For the year, we continue to expect unallocated corporate costs to be approximately 7% of total revenue.

Third quarter net interest expense of $7 million was similar to the second quarter level. We repaid $105 million of debt during the third quarter and as a result, I am pleased to announce that we have already achieved our goal of reducing our pro forma leverage ratio below 3 times.

At 2.8 times as of the end of the third quarter, we exceeded our original 18-month goal of debt repayment following the WIL acquisition by a full year. As a result of lower leverage, we reduced our interest rate spread by 25 basis points to LIBOR+ 125 basis points.

For the full year, we expect net interest expense to be at the lower end of our prior outlook of $26 million to $28 million, reflecting both the lower interest rate and debt balances in the fourth quarter, partially offset by a small amount of interest expense associated with the Agilux acquisition.

We expect to continue to focus on debt repayment in order to reduce a portion of the $64 million we borrowed at the end of the fourth quarter to fund the Agilux acquisition, with a goal of maintaining our leverage below 3 times at year end.

Year-to-date, free cash flow is continuing to track above last year's level, despite the significant cash acquisition and integration costs associated with WIL. Year-to-date free cash flow was $156.5 million, higher than the $150.9 million for the first nine months of last year.

For 2016, we now expect free cash flow to be in a range of $245 million to $250 million, an increase of $7.5 million from the midpoint of our prior outlook of $235 million to $245 million. Both the year-to-date and full year increases are due primarily to lower capital expenditures.

Year to date, CapEx was nearly $30 million, $5 million below last year, and is now expected to be in a range of $60 million to $65 million for the full year, compared to our prior outlook of less than $80 million. The decrease in our CapEx outlook is due primarily to the timing of projects.

For the year, we narrowed our revenue guidance to a range of 21% to 22% on a reported basis and expect organic revenue growth to be in a range of 7% to 8%, including approximately 1 percentage point from the 53 week. We expect non-GAAP earnings per share of $4.44 to $4.49, which is at the higher end of our previous range of $4.40 to $4.50.

This implies a fourth quarter outlook of reported revenue growth in a range of 23% to 27% on a year-over-year basis, and non-GAAP earnings per share growth in a range of 8% to 13% on a year-over-year basis.

Fourth quarter revenue growth is expected to improve from the third quarter level, reflecting high single-digit organic growth and the contribution from the Agilux acquisition, which we expect will add approximately 2% in the quarter.

Higher organic growth will be primarily driven by greater than 10% growth in the legacy Safety Assessment business and the addition of the 53rd week.

These growth drivers will be partially offset by normal seasonal trends in the RMS business, which are expected to result in a sequential decline in RMS revenue associated with the slower activity through the holiday season.

As you know, the 53rd week will be added to the fourth quarter of this year to true-up to a December 31 year-end, as a result of our 13-week, or 4/4/5, quarterly reporting structure. The 53rd week is characterized by a light week of sales due to the holidays, but a normal week of costs.

This year, the 53rd week is expected to contribute approximately 1% to full year revenue growth and be essentially neutral to operating income and earnings per share.

Foreign exchange is expected to reduce fourth quarter revenue growth by approximately 1% to 1.5%, similar to the third quarter, as both periods reflect the impact of Brexit and reduce full-year revenue growth by slightly more than 1%.

The expected impact of Brexit has not changed materially from what we discussed on our second quarter conference call, despite the weakness of sterling in recent weeks. With regard to our fourth quarter earnings per share outlook, we expect a small headwind related to a health status issue at one of our Avian sites.

This is expected to reduce fourth quarter non-GAAP earnings per share by approximately $0.02 to $0.03, primarily as a result of inventory and payment charges, and will also affect the Manufacturing Support segment's operating margin.

Before I conclude, I would also like to remind you of the Quebec tax law change that was enacted in the fourth quarter of last year. I am highlighting this because it will affect the prior-year comparisons in the fourth quarter of this year, even though the impact has been consistent throughout 2016.

The substance of the change was to increase our fourth quarter non-GAAP tax rate by 280 basis points.

However, the legislation provided a one-time retroactive benefit in the fourth quarter of 2015 associated with the treatment of R&D tax credits claimed between 2012 and 2014, which contributed a net 230 basis points to the DSA operating margin and 100 basis points to the consolidated operating margin in the fourth quarter of last year.

We have said that demand in our market segments is not always linear on a quarter-by-quarter basis. However, we believe that the annual growth prospects for our businesses are firmly intact.

On the basis of our strong results for the first nine months of the year, we believe we are well positioned to deliver 2016 revenue growth that will be within our original guidance range for the year and non-GAAP earnings per share that will exceed the guidance that we provided to you in February.

We remain committed to our focus on enhancing the relationships with our clients, deploying capital effectively, driving global efficiency, and investing in initiatives to support future growth, and believe this focus will help us achieve our targets for this year and over the longer term. Thank you..

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

Thank you. And our first question will go to Tycho Peterson with JPMorgan. Please go ahead..

Hey, guys. This is Steve Reiman on for Tycho. Thanks for taking my question. So NIH outlays are down pretty significantly in September. So with that in mind, did you see any NIH-funded clients maybe holding back on spend in the quarter? And did this dynamic have a negative impact at all on DSA or RMS? Thanks..

We would not have seen that expressly. We have a relatively modest amount of our revenue that's government and academic related. That sector for us has pretty much been holding its own throughout the year, so not an issue for us..

And we'll go to the line of Ross Muken with Evercore. Please go ahead..

Good morning, guys. So, Jim, when you look at some of the behavior in DSA and what happened, particularly amongst large pharma on the Discovery side, there's a lot of moving parts for pharma right now. There's a lot of political scrutiny. We've seen some pipeline failures.

As you step back and you look at some of the turbulence going on relative to maybe the last 12 months or 24 months, how do you put that in the context of what we've seen in some of these prior periods where you've had some temporal distractions there at pharma? And then, how do you think about it relative to the bigger picture? Because it doesn't seem like anything they're doing, whether it ends up being M&A or something else driven, will change the ultimate outsourcing discussion.

But it certainly feels like in the interim it's causing and we're seeing it in other places a little bit of choppiness quarter-to-quarter in terms of demand..

Yeah. I don't really think that that's the issue here, and we don't want to overstate or have you folks over-read the Discovery results for this quarter. So I would say that by and large pharma continues to be a continual outsourcer for us, pretty much across most companies throughout the world.

But I would say that our relationships have become more strategic and the breadth of services that they buy for us is increasing. And I would say that that's pretty much across the board.

And as the suite of services gets larger, that improves, and certainly that's the case in Safety, where we have a very large business that's the direct beneficiary of that.

I interface with senior people at most of these accounts and talk to them about their concerns about the political situation and competition, and they seem to be pretty sanguine about that. And I don't think we're seeing that in their actions. I think the Discovery piece for us is, first place it's a relatively modest sized business, number one.

Number two, it's what the drug companies do. So when you first have a conversation with them, their initial reaction is typically that's what we do. I would guess, even though we weren't in the business then, that that was the reaction relative to safety 30 years ago.

I'm not sure it's all that different, although Discovery is kind of the essence of the drug companies. And whether they do well or not, or some of them do better than others, they still feel that a lot of that's proprietary, particularly the in vitro stuff. It's really early.

So I would say that we're seeing slightly more of our large drug companies either keep stuff in-house or take it back in-house. I'd say it's more keep than take back, but it's a combination of both. It's a little less pronounced with the in vivo part of Discovery, which is later, just further down that path.

It's pharmacology based and it's after the pure discovery. And I think that even the clients have been keeping stuff in-house, there are opportunities for us as we expand our portfolio, and particularly if we describe to them things like the fact that we've discovered 66 development candidates, that always gets their attention.

So, I think that pharma is acting the way we had anticipated that they would. They're outsourcing more work, we're using biotech more as a discovery engine, some of the discovery they do internally, which is why they're holding on to some of the work that we were hoping to get.

And I think on the Discovery side, the changes that we made in our sales organization and this team that's doing these integrated therapeutic area based activities plus just additional knowledge on their parts that we're in this business will help generate additional work for us..

And, Ross, if I can just help size the Discovery for you. Total Discovery as a percentage of our total revenue is less than 10%, and of course Early Discovery will be a smaller component still..

That's helpful. I guess, Jim, just quickly just following up on pharma. I mean, there is a lot of debate, particularly if we get repatriation of what we'll see on the M&A side. Prior cycles it was always a concern that would cause some disruption.

Is it possible, given the unique business model and the breadth you guys have today that you actually become a key synergy partner for them if we do see an uptick in M&A amongst your client base?.

That's always been the thesis of our portfolio, right.

That if there is additional M&A as they merge and drive efficiency because there's always a huge cost synergy component to that, that we're able, in our growing services business, to accommodate more and more of their needs, which is why we've invested so aggressively and built up this big portfolio through M&A.

So, I would say that that's been driving growth in large measure to this point and it's likely to continue to do so, but hopefully on an even more aggressive basis..

Thanks, Jim..

Sure..

And we'll go to the line of John Kreger with William Blair. Please go ahead..

Hi. This is Jon Kaufman on for John Kreger. Thank you for taking the question. Can you just provide an update on Shrewsbury? I guess are the first 40 rooms there still on track? And do you have any plans at this point to open additional rooms in the facility? And what should we expect in terms of CapEx investments in the coming year? Thank you..

So, Charles River, Massachusetts, or our Shrewsbury operation, we continue to work hard getting it ready to do GLP work. We've, I would say, essentially hired our workforce. There's probably a few more people to hire. They're being trained. We're doing non-GLP work for our range of clients principally in the Cambridge, Mass area.

We're doing some bioanalytical testing and we're doing some DMPK work for those clients as well.

We announced a meaningful deal with Moderna, which I think is indicative and demonstrative of types of deals we will do with various biotech companies who want the proximity, so their study monitors can spend time with our study directors in close quarters and really participate in the work themselves.

We hope to have a healthy suite of business, I would say Q2 of next year. We'll have clients in there testing our activity probably at the beginning of next year. So, yeah, we're on track.

What the mix is going to be between GLP and non-GLP will be entirely dependent on what the demand is and what clients are doing at other sites of ours and what the pipelines look like. We have the ability to bring on more space if we want to, so it's one of the nice things about having built that large facility and now reopening it.

So, we built out 80 rooms initially so we can double the capacity. I hope we have that opportunity. I'll let David answer the CapEx question..

And to your CapEx question, most of the CapEx that was needed to be spent on the Shrewsbury site has been incurred this year and maybe a little bit needed next year, but the bulk of getting that unit online has already been taken place..

Great. Thank you..

And we'll go to the line of Dave Windley with Jefferies. Please go ahead..

Hi. Thanks for taking my questions. Good morning. I guess I wanted to ask a question around DSA. Strategically in thinking about your realignment of sales and cross-selling opportunities there, Jim, I'm interested in understanding a little more deeply how you drive more activity into Discovery.

Is it still more standalone? Or do you see the opportunity being leveraging your Safety Assessment relationships with clients back into Discovery? And then to what extent is it the completeness of the portfolio in Discovery that might be needed to attract more business into there? It is an area where after Argenta, BioFocus, you had a client, I think, exit that business or pull some business in-house.

It's been a little bit more choppy. I'm wondering what it is that gets that to a more stable and larger run rate. Thanks..

Sure. So, we've always thought that scale is important. So one of the reasons that we've continued to do acquisitions in this space is that, just to go back to the comments I made a few minutes ago, Discovery is the sort of essence of the drug companies, right.

So in order to get their attention to outsource sort of industrialized aspects of the Discovery process or some things that they do intermittently and we do consistently, we have to have greater scale and we have to just be able to tell the story. And I think we're doing that, notwithstanding the fact that we're disappointed with this quarter.

It's a much, much bigger market than the Safety business. So while it eventually may have less of it outsourced than Safety will, it's going to be a big opportunity for us. I do think that our portfolio, the breadth of our portfolio, provides a competitive advantage to everybody that we're competing with in the Discovery space.

And so just telling that story more effectively and more consistently and just having the advent of time, I do think is necessary. So we have a very sophisticated, targeted, restructured sales organization that's Discovery-deep.

And there's a critical evaluation that goes on when you first meet clients where they're really sizing you up to see whether the depth of your science is significant enough for them to work with you. And I think we have that, and I think this organization will show that.

The additional group that we've set up, the sort of integrated drug discovery group across multiple therapeutic areas, is set up to bring all of our Discovery sites together, work both with the broader sales group and the Discovery sales group and the operational folks in Discovery that interface with the client to design very creative deals, and I think that's going to hold us in good stead.

And to the other part of your question, we should see historical Safety Assessment clients who are happy with our work and haven't used us or anybody, let's say, for external discovery work, taking advantage of that, and having us understand the molecule as well or perhaps better than they do, and having this sort of continuity of services run from Discovery through pharmacology into toxicology.

So, we feel very strongly about the strength of the strategy. We think that the portfolio is a very strong one, and we need to just continue to engage with our clients so that they understand our capabilities. What tends to happen, and it's happened in Safety is you talk to the clients about your capability and when they need it.

And that's typically when they have financial need to restructure something or to work in a different way, they reach out to us. And we've seen that countless times in Safety and we're seeing it in various aspects of Discovery already, and I think that will become more pronounced over time..

Okay. Thank you..

And we'll go to the line of Tim Evans with Wells Fargo. Please go ahead..

Hi. This is Sara Silverman on for Tim. Just wanted to touch a little on Asia. You noted strength in Asia helping drive growth in the RMS business.

Can you comment a bit further on what you're seeing in Asia and maybe China in particular?.

Yeah. We're continuing to see very strong demand for our Research Models business as the Chinese government continues to pour money into more life sciences at rates higher pretty much than any other place in the world.

And the quality of our animals becomes clear to researchers just opposed to some of the other lower quality government-based organization. The demand is increasing nicely. We are continuing to expand geographically by getting closer to current marketplaces and additional marketplaces that are springing up.

Some of the ancillary cities in China are bigger than most of the cities in the United States. So being proximate has always been important in the animal business. You want to often be able to deliver on a daily basis.

So we're seeing very – we're not going to give the exact number, but very high growth rates in that business consistently quarter-after-quarter, with very strong operating margins and really positive reaction from clients who are using these animal models.

So, we think it's still very early days for this business given the maturation of the marketplace and the investment in it. And we should continue to see this sort of growth rate for a long time to come..

Great. Thanks..

And we'll go to the line of Ricky Goldwasser with Morgan Stanley. Please go ahead..

Yeah, hi. This is Mark Rosenblum on for Ricky. I just wanted to ask about biotech. So you mentioned that it was the primary source of growth in the quarter. When you guys look at your pipeline going forward, is that the case there as well? Just trying to get a sense of the mix of biotech versus large pharma and academics..

Yeah. We have a very big footprint with all of the drug companies. We're a major supplier to all of them, some slightly more than others, but it's a really critical part of our demand curve. We've stopped teasing it out because so much of pharma's – so much of biotech's money comes directly from pharma.

And so much of the line between those two is sort of graying and not really all that relevant, frankly. Having said that, we have more revenue to biotech companies, which makes a lot of sense because there's a proliferation of them.

They're actually doing a fabulous job at discovering novel technologies and novel compounds, many of which are large molecule. And so we're continuing to see just an increase in business with them. And, of course, they are net outsourcers.

Very few biotech companies do much internally except very, very early discovery, and even some of them don't do that. They find a molecule and they license it in from some academic institution.

So, we would expect biotech to continue to be a very strong client base for us, and we should continue to see our revenues be heavily weighted or weighted towards biotech, but pharma will continue to be an important source of revenue for us.

There's still a lot of work that's being done internally by the big drug companies that we're quite confident will come outside given the need for them to reduce their cost structures..

Okay. Thanks. That's helpful. And then, I know you mentioned that government was a small piece.

Is that true going forward in the pipeline as well?.

Well, we hope it's a less small piece. So, yeah, we're working hard at increasing our revenue with academics, not just in Research Models where we've typically engaged with those clients, but in the Discovery and Safety Assessment business because many major academic medical centers discover their own molecules, just like drug companies.

They have R&D budgets that are either their own or money is coming in from a whole host of sources, including big pharma, and they're looking for a way to develop them. And so we're engaging with those academic institutions the same way we've engaged with big pharma. So we hope it becomes a more important resource for us. Historically, it hasn't been.

Historically, it's been primarily a client base that's bought animals and they've been very price-sensitive. We tended to do much better, let's say, in Europe than in the U.S. because of the client. There's just a larger number of clients. So, working hard on it, but still a relatively small part of the whole..

Okay. Thanks. That's very helpful..

And we'll go to the line of George Hill with Deutsche Bank. Please go ahead..

Yeah, good morning. David, I just want to circle back on something in the prepared comments. Did I hear something? I guess, could you provide a little more detail on the headwind in Q4 as it relates – I thought you called it the Avian issue? I just wanted to be sure that I heard you correctly..

Correct, yes. It's a health site issue with one of the flocks and that essentially means a need to write that flock down, and that's going to have a $0.02 to $0.03 charge in Q4. In terms of next year, it'll be smaller, maybe a couple of cents..

Okay. And....

It's a discrete issue and once we've dealt with that, that charge is finished with..

Okay.

And I guess is that something that you guys plan to include in operating results or exclude from operating results?.

No, that'll be an operating result performance. That's why we've called it out as part of our non-GAAP guidance..

Okay. All right. That was all I had. Everything else I had has been addressed. Thank you..

And we'll go to Greg Bolan with Avondale Partners. Please go ahead..

Thanks. I'm about to throw my phone. I'm having some technology issues. So, I understand what you're saying, Jim, on the Discovery side. Obviously, non-clinical from in vitro all the way through in vivo is an inherently lumpy business.

Getting to the Discovery side of the equation, as we think about what happened this quarter relative to where your mindset was at the Investor Day last quarter, could you maybe – I know you've already talked about it, but maybe if you could just qualify what's happened. Obviously, this is a sizeable addressable market; it's going to be lumpy.

We should be looking at it from a year-over-year perspective. I totally get that. But, from the Investor Day to here, you've changed management. Obviously, there's some weakness there.

But, if you could maybe just kind of walk through exactly what happened there? And then on the RMS side, as you think about just the competitive dynamics, have you seen one of your peers on the academic side start to fight back a bit? Or are they still kind of floundering, if you will, from the standpoint of their rodent business? Thanks..

I'll take the easier one first. I would say it's a competitive universe and the Research Model business is – we want to always take our competitors seriously. So we would never disparage them, but I would say that they're certainly not becoming stronger in competition.

So I think they have some issues, and we've done such a good job on a quality basis, on an international scale basis, and actually from a price point. The major competitive tool that our competition had was price, and we've pretty much taken that off the table. So, we feel good about our position there.

We feel good about how we've driven efficiency there and gotten the margins up. And I think we're in a particularly strong position to take advantage of what additional business there is in the U.S. and Europe, and for sure, the large amount of work that's in China.

I would remind you, since I don't think anyone's ever asked and perhaps we've never said, that none of our major competitors have any presence in China. So, we're dealing with Chinese governmental institutions, and, while the Chinese clients may like certain aspects of that, the products aren't particularly great. Discovery, it's a complicated one.

So, it's a business that – and just to nuance it and to keep it in perspective – so just to repeat what David said, number one, the whole Discovery business is less than 10% of the whole, and the in vitro piece is less than that, less than 10%. So, we're talking principally about the challenges in the in vitro piece. It's very early.

We purposefully went into this business because we want to engage with the clients as early as possible. We wanted to have chemistry capability. We wanted to have target identification capabilities. We wanted to be more important to the clients than we were before we did this acquisition.

And so we feel as strong or stronger about the basis of the thesis, and I would say that we, I don't know, that we perhaps did not understand fully the challenges that we would face in getting clients to part with that work, or to having them say, yes I'm, why don't you try this for us? And so, I do think as I said earlier that some of the comparisons with early Safety Assessments are good ones, probably times two because I do think that these are sort of the pearls of the companies and I think that sort of instinctively resist into outsourcing some of this work.

So, maybe the simplest way to phrase it is, I don't think we recognize the time that it would take to tell our story thoroughly to have the clients really pause and look at the totality of our portfolio and embrace it. And so, I do think – I think the science is fabulous. I don't think we're disappointing anyone.

We don't have clients saying, oh, my God, you guys don't know what you're doing. To the contrary, clients who use us think we're great. Biotech, obviously, it's easier. I won't overstate that either.

Most biotech companies have some proprietary discovery capability, but while some of them let us do the earliest work, even if we're not able to do the early work, we can do work immediately following that. So we think we've gotten the right things that we're focusing on a more tightly managed ship.

By the way, we drove a whole bunch of operating margin in that business notwithstanding not very good sales, so I think we can continue to drive margin as we originally said.

We have a enhanced and much more creative and much more complex sales effort with very senior people, most of whom have PhDs, interfacing with the clients, and we have to tell the story more consistently to pull work through from Discovery into Safety and vice versa.

So, I don't really think our view of the business hasn't changed at all since the Investor Conference except to say that it continues to be a challenge. We don't shy away from challenges. We think that the size and scale and importance of the market is enough to keep us not only interested, but to keep investing in this business.

The portfolio continues to be unique and unusual and competitively distinct and we're going to continue to drive it that way. So, we're going to just have to continue to work hard at this business. Obviously, since we've called it out, we'll be talking more about it in the future.

You need to keep its size in mind and not sort of over-react to it this quarter. And also, you can't over-react to any quarter because if there's no linearity in Safety, there's certainly no linearity in this business. It's going to have some choppy aspects to it which we can ameliorate by a larger client base and a larger suite of services..

Totally fair. Thanks, guys..

And we have time for one last question and we'll go to Jonathan Groberg with UBS. Please go ahead..

Great. Thanks a million. Just two quick ones. On pricing in 2016, can you maybe talk about what you expect to get for the full year given what happened in the third – where you are in the third quarter here? And any early thoughts for 2017? I know you made some mention around pricing with competitors a second ago.

And then just wanted to clarify on the tax rate. I think previously you talked about maybe some upward pressure on the tax rate or at least keeping it stable in 2017, but don't know if that's changed here given what you announced in this quarter. Thanks..

So, I'll take those. On pricing, there's not much changes really in terms of what we've already signaled to everybody at 5% on Safety Assessment and about 2% on RMS. And nothing in that has changed. The shifting of the work hasn't had an impact on how we've priced the work in terms of Safety Assessment.

In terms of the tax rate, the Q3, our guess is slightly lower than you would normally expect because when the UK surprised us and changed the tax rate from 18% to 17%, you essentially take the future reserves and you basically restate them at the 1% lower rate, and you take that benefit into the quarter. So it came into Q3.

So the way to look at the tax rate for the year is as we said it and we've given you some guidance for the year. When we get to 2017, we will nuance that to give you a bit more flavor as to what that might do for 2017..

Thanks..

Thank you for joining us this morning. This concludes the conference call..

Thank you. Ladies and gentlemen, that does conclude your conference. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect..