Ladies and gentlemen, thank you very for standing by and welcome to the Charles River Laboratories Second Quarter 2020 Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. The instructions will be provided at that time.

[Operator Instructions] And as a reminder, this conference is being recorded. I’d now like to turn the conference over to our host, Vice President of Investor Relations, Mr. Todd Spencer. Please go ahead sir..

Great. Thank you. Good morning, and welcome to Charles River Laboratories second quarter 2020 earnings conference call and webcast. This morning, Jim Foster, Chairman, President and Chief Executive Officer; and David Smith, Executive Vice President and Chief Financial Officer, will comment on our results for the second quarter of 2020.

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 12:30 p.m. today and can be accessed by calling (866) 207-1041.

The international access number is (402) 970-0847. The access code in either case is 1730040. The replay will be available through August 18. You may also access an archived version of the webcast on our Investor Relations website.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.

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 results from continuing operations and 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 from 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.

In addition, today's remarks will also include estimates of the COVID-19 impact on the company. Certain methodologies and assumptions related to how we develop these estimates can be found on slide three. I will now turn the call over to Jim Foster..

Thank you. Good morning. As the COVID-19 pandemic continues to pressure the global economy and adversely affect so many lives, medical innovation has never been more critical.

The biomedical research community is rising to this challenge, resulting in an unprecedented level of investment, and Charles River has never been so essential to our diverse and growing client base.

Not only are we continuing to work on a wide range of drugs across multiple therapeutic areas, utilizing our unmatched suite of early-stage solutions, but we are also helping clients develop drugs to find treatments for, and ultimately, prevent COVID-19.

As anticipated, we experienced challenges related to COVID-19 in the second quarter, principally in the RMS segment. However, the resilience of our business model has enabled us to weather these challenges extremely well. This resilience is demonstrated by our second quarter financial performance, which widely exceeded our expectations.

The outperformance was due in part to the tireless efforts of our dedicated staff; the effectiveness of our comprehensive business continuity plans that enabled us to keep our operating sites open and adequately staffed; and the global scale, broad scientific capabilities and flexible outsourcing solutions of our unique early-stage portfolio on which clients are increasingly relying to move their programs forward in the face of disruptions or delays at their own sites.

We also benefited from persistent client demand across many of our businesses, driven by robust biotech funding and continued innovation that is generating scientific breakthroughs across multiple therapeutic areas, including for COVID-19 therapeutics.

Before I provide more details on our second quarter results, I want to update you on the impact that COVID-19 has had on the company. I'd like to start by thanking our employees around the globe for their hard work and unwavering commitment.

It's because of your extraordinary efforts that we have kept all of our operating sites open and continue to serve our clients throughout the pandemic. Because of your dedication to our mission, our clients are making progress on their critical research.

We believe that providing continued support to clients during the pandemic is leading to more outsourcing opportunities for Charles River.

Clients, large and small, are outsourcing work to us that they previously performed internally or outsourced to others because working with one large scientific partner like Charles River enables them to implement a more flexible and efficient R&D solution over the longer term and helps them navigate the evolving COVID-19 situation in the nearer term.

We are principally seeing the benefit of this outsourcing in our Discovery, Safety Assessment, biologics and GEMS businesses.

As we continue to perform these services, we believe clients will become accustomed to our faster turnaround times, superior science and cost effectiveness and therefore, we believe we will retain a meaningful amount of this incremental work. We are also experiencing favorable trends across most of our businesses, including through July.

In the RMS segment, which was most affected by COVID-19, academic clients are opening their facilities more quickly than anticipated around the world, particularly in Europe and Asia. And the services businesses continue to perform well. HemaCare's donor clinic reopened, and the business has largely returned to full operations.

The DSA segment continues to experience strong demand, with high proposal in booking volumes and only a small impact associated with COVID-19.

In the manufacturing segment, microbial did face some headwinds, but the biologics business continued to perform exceptionally well with significant demand, especially for cell and gene therapy products projects and, to a lesser extent, COVID-19-related activities. I'll now provide additional details on our second quarter results.

We reported revenue of $682.6 million in the second quarter of 2020, a 3.8% increase over last year. Organic revenue growth of 1.4% exceeded our prior outlook of mid-single digit decline because client demand has been resilient, and the impact of COVID-19 has been less severe than originally anticipated.

COVID-19 had a meaningful impact on the RMS segment, including RMS revenue by approximately $35 million in the second quarter. However, the impact of the DSA and manufacturing segments was quite small with both reporting healthy organic growth rates of 6.2% and 8%, respectively.

The operating margin was 17.3%, a decrease of 120 basis points year-over-year. The decline principally reflects the significant margin decline in the RMS segment as a result of the lower sales volume and the fixed cost nature of the business.

However, we were quite pleased that both the DSA and manufacturing segments reported meaningful operating margin expansion in the second quarter, reflecting the operating leverage in these businesses, as well as the benefit of operating efficiencies, including temporary cost reduction initiatives in response to COVID-19.

Earnings per share were $1.58 in the second quarter, a decrease of 3.1% from $1.63 last year, widely exceeding our prior expectation of a 20% to 30% decline.

Overall, we were pleased to be able to generate earnings per share nearly unchanged from last year, which demonstrates the resilience of our business and our continuity planning during this global crisis.

Based on the better-than-expected second quarter performance and our expectation that COVID-19 will be less of a headwind than originally anticipated, we are increasing our revenue growth and non-GAAP earnings per share guidance for 2020. We now expect organic revenue growth in a range of 4% to 5.5% or 175 basis point increase at midpoint.

Non-GAAP earnings per share are expected to be between $7.05 and $7.35, which represents a $0.275 increase at midpoint and a 5% to 9% year-over-year growth. The revenue loss from COVID-19 is now expected to be approximately $100 million, which is below our previous range of $135 million to $215 million.

We believe that we are beyond the worst of the COVID-19-related headwinds, but we understand that there may still be additional challenges ahead. We are assessing the situation on an ongoing basis, and we'll be diligent about addressing any new challenges just as we did in the second quarter.

Our guidance assumes that there will be additional recovery in client demand in the third quarter, principally in the research models business. David will provide an update on the assumptions that are included in our revised outlook shortly.

I'd like to provide you with additional details on our second quarter segment performance beginning with the RMS segment. RMS revenue in the second quarter was $116.5 million, a decrease of 18.4% on an organic basis.

As I mentioned earlier, COVID-19 reduced the second quarter RMS revenue by approximately $35 million, which was favorable to our initial expectation as clients began to gradually resume activities at their research sites earlier than anticipated, particularly in Europe and Asia.

On our last earnings call, we anticipated that demand for research models would improve in the third quarter as biopharmaceutical clients resume more normal research activities, and we expected that academic demand will begin to rebound by the fall.

However, this return-to-work process began in the second quarter with clients in Europe and Japan returning in the middle of the quarter in North America North American clients beginning the process in June.

Academic clients showed the most significant improvement by the end of the quarter as these clients were most adversely affected when institutions began closing abruptly in the first quarter. Overall, these reopening activities resulted in a significant improvement in client ordering trends in June.

We expect these favorable trends will continue in the coming months but believe it will take time for volumes in our research models’ business to return to pre-COVID-19 levels. For 2020, we expect RMS revenue to decline at a mid to high single digit rate organically, which is a notable improvement from our prior outlook of at least a 10% decline.

The research model services businesses continued to perform very well in the second quarter, experiencing very little impact from COVID-19.

We believe the strong performance reflects the value our clients see in outsourcing these critical services to us or in the case of insourcing solutions, or IS, the efficiency of using our people or capacity to manage their research needs.

As I mentioned last quarter, we are seeing evidence that some GEMS clients, who previously managed their model colonies in-house, have opted to outsource this work to us due to COVID-19 restrictions at their own sites. We continue to anticipate that much of this GEMS work will remain outsourced after the COVID-19 crisis subsides.

After a strong first quarter, HemaCare was negatively affected by a two-month closure of its donor clinic, which reopened in mid-May, as well as reduced cell therapy development activities at its clients' sites due to stay-at-home orders and associated disruptions caused by COVID-19.

Similar to our research models business, client demand improved meaningfully in June, and we continue to believe that beyond 2020, HemaCare will grow in excess of 30% annually as more clients start their cell therapy discovery programs at Charles River and remain with us through discovery, early stage development and the manufacturing support process.

Today, we also announced a signing of an agreement to acquire Cellero for approximately $38 million, which will complement HemaCare by enhancing our supply of critical biomaterials including a wide range of human-derived primary cell types to further support discovery, development and manufacture of cell therapies.

The acquisition will expand our access to high-quality human-derived cellular products with Cellero's donor sites in both the Eastern and Western United States.

Cellero will enable us to provide a more comprehensive cell therapy solution, allowing clients to work with us through the cell therapy development and manufacturing process, which will accelerate their speed to market and enhance client retention.

Following the acquisition of Cellero, we expect to continue to generate revenue growth for human-derived cellular products, including HemaCare, of at least 30% annually over the next five years, beginning in 2021. The transaction's expected to close in August.

The RMS operating margin declined from 25.5% last year to 9.1% in the second quarter, driven almost exclusively by the impact of COVID-19.

The segment operating margin benefited from the temporary cost reduction initiatives that we implemented, but due to the fixed cost nature of the business, these savings could not offset the sharp short-term decline in research model volumes.

We believe the RMS operating margin will improve meaningfully in the third quarter as research model volumes continue to increase. DSA revenue was $442.6 million in the second quarter, a 6.2% increase in an organic basis over the second quarter of 2019.

There was a much smaller impact from COVID-19-related study slippage and product project delays than we originally expected due to strong demand across the Discovery and Safety Assessment businesses, as well as our efforts to ensure both business and resource continuity.

Biotechnology clients was a primary driver of DSA revenue growth, which is not surprising, given the capital available to fund scientific innovation and the industry's focus on finding a cure for COVID-19. The Discovery Services business had another excellent quarter of broad-based growth, particularly in Early Discovery and oncology services.

In May, we commented on indications from a small number of discovery clients that they would slow the initiation of new programs because of COVID-19.

There was only a very limited impact in the second quarter as we believe our integrated discovery portfolio, scientific expertise and track record for delivering clinical candidates encourage clients to move their programs forward by partnering with us to overcome challenges at their own sites.

With continued strength in bookings, we do not foresee any change in the robust business environment for our Discovery Services in the second half of the year. Safety Assessment business performed well with sustained growth in study volume.

As we mentioned at our investor conference in June, proposal activity and bookings continue to be strong throughout the second quarter. We believe both biotechnology clients and large biopharmaceutical companies are compensating for reduced on-site activities with increased outsourcing of their IND-enabling safety programs.

We believe our integrated early stage portfolio spanning target identification through nonclinical development uniquely positions us to enable clients to work with one trusted partner to ensure business continuity amidst the challenges of the COVID-19 crisis.

We believe this has and will continue to be will continue to translate into additional outsourcing opportunities as we collaborate with our clients to navigate today's challenges as well as those that arise in the future.

Given the limited impact of COVID-19 today and our expectation that the robust outsourcing trends will persist in the second half of the year, we now expect DSA revenue to increase at a high single-digit rate in 2020, which is effectively the same as our original outlook before the spread of COVID-19.

The DSA operating margin improved 210 basis points year-over-year in the second quarter to 23.2% with improvement in both Discovery and Safety Assessment businesses, greater operating leverage on the healthy revenue growth as well as the benefits of operating efficiencies drove improvement.

Revenue for the manufacturing support segment was $123.5 million or an 8% increase on an organic basis over the second quarter of last year. The Biologics Testing Solutions and Avian businesses had excellent quarters. However, the revenue growth rate in the Microbial Solutions business was constrained by COVID-19.

For the year, we continue to expect organic growth in the high single-digit range for the manufacturing segment. Microbial Solutions was affected by reduced client activity and delayed instrument installations in the quarter as certain client sites were inaccessible due to COVID-19.

This was a challenge but one that we expect to overcome as more of these clients allow access to the sites and activity at these sites accelerates, which is already beginning to occur. In addition, we are serving our clients via remote instrument installations.

As a result, we expect the Microbial Solutions growth rate will improve in the second half of the year.

Overall, we continue to firmly believe that our ability to provide clients with a comprehensive, rapid and efficient microbial testing solution as well as the quality and accuracy of our testing platform are key differentiators from the competition, which will lead clients to continue to choose Charles River for their critical quality control testing requirements.

The biologics business reported another exceptional quarter. Revenue growth was driven in part by the sustained rapid increase in the number of biologics in development, as well as new opportunities such as cell and gene therapies and COVID-19 therapeutics that continue to propel market growth.

We believe the biologics market opportunity is expanding at a low double-digit rate annually, which is why we continue to modestly add capacity to accommodate demand. Revenue growth was also driven by our successful efforts to gain new business.

Clients see the value of our extensive portfolio of services to support the safe manufacture of biologics, and we will continue to enhance our abilities to support clients by developing new services such as additional assays for cell and gene therapy.

The Manufacturing segment's second quarter operating margin was 37.4%, a 650 basis point increase year-over-year. The significant improvement was related to enhanced operating efficiency in the Microbial Solutions business, primarily from process improvements and operating leverage from higher revenue in both the biologics and Avian businesses.

In biologics, the elimination of duplicate costs related to last year's transition to our new Pennsylvania facility also drove the improved operating margin. The demand for our leading portfolio of early-stage and Manufacturing Support solutions remains robust.

Biotech funding levels continue to increase and are expected to reach record levels again in 2020. And biotech IPO activity is accelerating. FDA drug approvals remain healthy. Fewer clients have delayed or canceled work due to COVID-19 than we anticipated just three months ago.

Clients are essentially business-as-usual across most of the company as they emphasize investment in their preclinical pipelines to move their programs forward.

We believe this underlying strength in our markets and the resilience of our business model have enabled us to withstand the challenges of the COVID-19 pandemic better than many other companies to date. Because of our strength and stability, we feel confident in our ability to move forward with the execution of our M&A strategy, albeit cautiously.

Today's announcement of the Cellero acquisition is consistent with that strategy. It's imperative that we continue to expand our portfolio of essential products and services to enhance our ability to comprehensively support our clients' drug research efforts. Strategic acquisitions have always been our preferred use of capital.

And after a pause in the second quarter, we are continuing to evaluate new opportunities using our disciplined and mindful approach. There continues to be an abundance of M&A candidates available, and we will evaluate a number of opportunities, including unique research tools, discovery capabilities and manufacturing support activities.

We will also increasingly employ our strategic partnership strategy to stay current with new technologies and modalities and add innovative capabilities and cutting-edge technologies with limited upfront risk. We continue to closely monitor the risk that COVID-19 poses to human health as well as to our clients' operations and our own.

The crisis is far from over globally, particularly in the U.S. and there will likely be a prolonged recovery until the world returns to some semblance of normalcy. But as I mentioned earlier, we will continue to assess the situation and be diligent about addressing any new challenges.

We believe Charles River has weathered the challenges of the COVID-19 pandemic better than many other companies to date because of our clients' increased reliance on our outsourcing across a wide range of therapeutic areas, resilient biotech funding and as always, the efforts of our dedicated staff.

As a result, we are confident in our ability to operate in the current environment and execute our strategy. We fully anticipate this new normal environment will be with us for the rest of the year and likely well into next year, if not beyond. But we believe the worst is behind us.

Barring any widespread changes in the COVID-19 recovery, we believe that our two year financial targets of high single-digit organic revenue growth and a 20% operating margin in 2021 remain intact.

Before I hand the call over to David, I'd like to update you on some of our social initiatives to support our people as well as the communities in which we operate. COVID-19 has affected us all, and it's our responsibility to be good corporate citizens and to lead by example.

Our immediate priority was to address the needs of our employees and fully support them during these challenging times through initiatives like enhanced workplace safety measures where necessary, flexible work hours and scheduling and other forms of assistance as needed.

Beyond the immediate COVID-19 priorities, we are firmly committed to the need for equality in our world. We will not stand for racism, inequality, discrimination or harassment of any kind at Charles River and are dedicated to supporting those values in our communities. It's more important than ever to support each other.

We have a culture that celebrates and supports our differences. And we realized it's more important than ever to support each other in our communities through a posture of respect, listening, learning and empathy. At Charles River, this is our obligation and part of our core values.

As part of our commitment, we launched a $2 million charitable donation campaign in the second quarter aimed at supporting our local communities through a range of initiatives and organizations that promote equality and social justice and support local food banks, first responders, youth and family organizations, STEM education and scientific causes.

As a company and a corporate citizen, I want us to be able to reflect on this extraordinary period and be proud of our contribution to life-saving medicines, be proud of how we treated each other, and be proud of how we supported our communities.

In conclusion, I'd like to thank our clients and shareholders for their support and once again, our employees for their commitment to our mission. Now I'll ask David to give you additional details on our second quarter results and updated 2020 guidance..

Thank you, Jim, and good morning.

Before I begin, may I remind you that I'll be speaking primarily to non-GAAP results on continuing operations, which exclude amortization and other acquisition-related charges, costs related primarily to our global efficiency initiatives, our venture capital and other strategic investment performance and certain other items.

Many of my comments will also refer to organic revenue growth, which excludes the impact of acquisitions and foreign currency translation. As Jim mentioned, we are very pleased with our strong second quarter results with revenue and earnings outperforming our prior outlook.

The second quarter performance and accelerated return of our research model clients gives us greater confidence in our outlook for the second half of the year, and these collective factors contributed to the increase in our revenue and earnings per share guidance for 2020.

We believe that the company will see a more normalized level of business activity by the end of the year. Our updated guidance takes into consideration several key assumptions for each of our businesses that vary based primarily on the timing of the recovery, particularly for the RMS segment.

These assumptions are consistent with those provided in May and can be summarized by our expectations for additional improvement in the research models business in the third quarter, particularly with regard to academic clients in North America and that we do not foresee a notable change from the current robust trend in our DSA businesses.

We continue to believe that our essential personnel will be able to work on site and that we will have the adequate supplies and resources to support our businesses. We also have not assumed any widespread stay-at-home orders will resume for the remainder of the year.

As we discussed in May, we implemented several cost reduction initiatives to mitigate the near-term margin impact resulting from the expected COVID-19 revenue loss, principally aimed at reducing compensation expense and discretionary costs.

We are pleased to report that we have already reinstated merit increases on 401(k) contributions earlier than expected in the third quarter, given the stronger financial performance, and to appropriately recognize the extraordinary efforts of our staff during this challenging period.

Although the benefit from our temporary cost reduction initiatives is expected to be below our prior target at approximately $40 million for the year, the better-than-expected results are more than offsetting the difference, enabling us to meaningfully increase our earnings per share guidance for the year.

Based on our outlook for lower cost savings, offset by additional top line recovery in the third quarter, we expect the second half operating margin to be similar to our prior expectations but to improve meaningfully from the first half level, particularly for the RMS segment.

For the full year, we believe that we are well positioned to generate some expansion in the operating margin compared to the 2019 level of 19% despite the headwinds associated with COVID-19. Our updated revenue growth guidance for the year is a result of a more favorable outlook for both the RMS and DSA segments, particularly in the second quarter.

For RMS, we now expect a more moderate mid- to high single-digit decline in organic revenue growth and low single-digit reported revenue growth. For DSA, we now expect high single-digit organic revenue growth and low double-digit reported revenue growth.

Our outlook for the Manufacturing Support segment is unchanged from May, with high single-digit organic revenue growth. Our financial position remains very healthy. At the end of the second quarter, we had an outstanding debt balance of $2.3 billion, with a gross leverage ratio of 3.2 times and a net leverage ratio of 2.6 times.

We continue to target reducing our gross leverage to below three times. As the COVID-19 situation stabilizes, we intend to continue to evaluate acquisition candidates after a brief pause in the second quarter as we've demonstrated through today's announcement of the proposed Cellero acquisition.

As Jim said, M&A has always been our preferred use of capital as we believe that investing in strategic assets will support our long-term growth strategy and generate the greatest return to shareholders. Our solid financial standing puts us in a strong position to begin to add to our early-stage portfolio again through strategic M&A.

Free cash flow was $135.5 million in the second quarter, an increase of 29.3% over the $104.8 million for the same period last year and bringing us to a record level for the first half of the year.

The primary drivers of the increase were our strong operating performance and the timing of working capital, including the deferral of cash tax payments due to recent legislation. As a result, we have increased our free cash outlook by $20 million at midpoint to a range of $350 million to $365 million for the year.

CapEx was $26.8 million in the second quarter, an increase of $2 million over the prior year. We now expect CapEx will be approximately $130 million for the full year, above our prior outlook of $120 million as we ramp up our capital investments in expectation of our needs in 2021 to support growth.

Unallocated corporate costs for the second quarter was 6.1% of revenue compared with 5.3% last year. The increase was primarily the result of initiatives related to our COVID-19 response. We continue to expect unallocated corporate costs to be approximately 5.5% of total revenue in 2020.

Total adjusted net interest expense for the second quarter was $19.1 million, essentially flat on a sequential basis from the first quarter level. For the full year, we now expect adjusted net interest expense to be slightly lower in the range of $76 million to $78 million, reflecting our expectation for reduced debt levels.

The second quarter tax rate was 21%, representing a 110 basis point decline from 22.1% in the second quarter of last year. The decrease was due to a 220 basis point excess tax benefit associated with stock-based compensation, resulting from higher stock price levels and the impact on equity exercise and award activity during the quarter.

As a result of this favorable excise tax benefit, we are lowering our full year tax rate outlook to a range of 21% to 22% from our prior outlook of 22% to 23.5%. A summary of our revised financial guidance for the full year can be found on slide 44.

For the third quarter, while we continue to expect the revenue growth rate to improve sequentially from the second quarter level, based on client conversations and demand with respect to the COVID-19 recovery, we do so with greater confidence as clients have already begun to resume their research activities.

Accordingly, we expect organic revenue growth in the mid- to high single-digit range on a year-over-year basis and reported growth to be in the high single-digit range. We expect high single-digit earnings per share growth when compared to last year's third quarter level of $1.69.

In closing, we are very pleased with our second quarter results, and thanks to the efforts of our colleagues around the world and the critical nature of the work that we do, we continue to demonstrate to our clients that we can and will fully support their research efforts, both during the current extraordinary environment and in the future.

In the face of the challenges presented by the COVID-19 pandemic, we continue to successfully demonstrate our commitment to our clients, employees, communities and shareholders.

We are focused on the continued execution of our strategy, which includes the resumption of M&A activity, as well as achieving our financial and operational target, including the two-year targets that we set last September, of high single-digit organic revenue growth and a 20% operating margin in 2021. Thank you..

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

Thank you. [Operator Instructions] And we'll go first to the line of Tycho Peterson with JPMorgan. Please go ahead..

Thanks. Jim, I'm wondering if you could just give us any rough guidance on the bookings [Technical Difficulty].

Does anyone hear, Tycho? He totally cut out on me..

No, he did cut out..

You're still with us. Hey, Jim.

Can you hear me now?.

Yes. You just totally cut out so.

Okay. So let me just sorry about that. The question was just on the bookings from COVID and any anticipated COVID tailwinds, both for vaccine and therapy work.

Are you able to put any numbers around the opportunity?.

No. We need to be careful not to overstate that. So we're delighted with the COVID work from large to small clients. We're proud to be participating. We prioritize that work whenever possible. We're happy to have it. I just don't want you to think of that as a material number that's going to significantly drive our financials..

Okay. And then you're taking up CapEx. You talked about maybe a faster recovery, increases in outsourcing, yet at the same time, you're kind of reiterating your two-year financial targets.

So can you maybe just talk to those dynamics? And are the incremental CapEx investments tied to the increases in outsourcing? It sounds like everything is trending in the right direction in potentially getting you to a higher point than where you're guiding to for the next two years. But I'm just curious if you can kind of talk to those dynamics..

Yes. I mean is that you, David? Go ahead..

Yes..

Go ahead..

Well, I was just going to say, Tycho, that we actually brought the CapEx down in the last quarter because of the COVID situation. What we're really kind of conveying is we're getting back to a sort of a normal position again.

And so it's more thinking about the future, thinking about 2021 and basically rebuilding up those capital demands and making sure that we can meet the demands we expect in 2021..

And I would just add, Tycho, that even though we took it down, as David said, we're continuing to be extremely diligent, as I mentioned actually in my prepared remarks, and vigilant about having sufficient capacity, incremental capacity at multiple sites and multiple businesses, biologic, safety, discovery, I mean, pretty much across the board, China, to ensure that we can accommodate increasing demand from our clients.

And it's impossible to have the capacity on a just in time basis when you get to work. So we have to stay ahead of it. I think we've done a good job for the last, I don't know, almost decade doing that.

And we do that very thoughtfully, very strategically, being very, very careful about spending our cash, but knowing that it's essential in order to safeguard the business and provide access to clients to our services..

Okay. And just one last one quickly, just on the resumption of M&A activity since you highlighted it.

Obviously, you've got Cellero teed up, but should we assume similar type deals? Or are you telegraphing an appetite to do something maybe more meaningful?.

I don't think we're trying to telegraph anything specifically with regard to scale. What we want to impart is the fact that the business is solid. We feel really good about the balance of the year and, preliminarily, quite good about next year. We have a fair number of targets out there that we're speaking to real time, as we always do.

We kind of resumed those conversations, which we had paused in Q2. They cut across a pretty wide swath of our activities. They are a variety of sizes. I would say that nothing real soon would be very, very big. But there are a few things that I would say are sort of modest-sized and certainly bigger than Cellero, which we're very pleased to do.

It's highly strategic and a very critical field, but obviously, a very small deal..

Okay. Thank you..

Sure..

And next, we'll go to the line of Eric Coldwell with Robert W. Baird. Please go ahead..

Thanks very much. First question is hoping to get a little more distinction between the performance in research models and academic accounts versus biopharma accounts. If you could give us some sense on the decline in magnitude in academic versus pharma would be helpful..

Sure. The big hit, Eric, was academic accounts. Yes, we had some closures of pharmaceutical sites and some closure of some biotech sites, but the most profound impact was academics. And the closures were really fast. I think we feel and they feel, in retrospect, way too fast.

And they should have decoupled research activity in labs where people are PPE-ed with students, the risk associated with students, which they didn't, so very big, very sudden impact.

And obviously, nobody's buying research models to use in an academic setting or any setting, but in this case, an academic setting, when the sites are closed and the people aren't there because the work is being done and the animals are going to grow out of spec. So they pulled back on the lever pretty quickly to sort of stop buying those folks.

We had anticipated a return because we were talking to all these academic institutions at pretty high levels, so the provost level. And they were saying, yes, we're sorry, we did it. We're making plans to get back open. And we had anticipated they would open more slowly than they have, even though they're not all open yet.

So Europe and China in the middle of the quarter and a lot of things opening in June for the U.S. So pleased with that.

I don't anticipate sort of regardless of whatever the next wave is or isn't with COVID that they would do that again, given the fact that people are ground-up in these facilities, often working under hoods, often have positive pressure in the labs. And of course, they're doing critical work across a whole host of diseases and particularly COVID.

So we're quite confident that they will continue to open. They will continue to buy animals. We scaled up in preparation for that. We prepared for that. And so we're being able to service the clients pretty quickly as they open because they want to get right back to work. So mostly academic and very little pharma..

Yes.

So safe to say, 70%, 80%, 90% of your 18% decline was due to academic?.

I don't think I know that number off hand. But yes, I would say that the significant impact was academic and very much secondarily was some pharma closures, so yes..

Fair enough. If I could ask one more on HemaCare..

Sure..

We did notice in the middle of the quarter, you had your donor site reopen in California. I'm curious what contingency plans you have in place if it's forced to close again. How much of your frozen or preserved inventory you might have worked through during the quarter, if you did so.

And then any sense on what's going on with donor activity, interest levels? Has that picked back up now that the site is open? Or are there still challenges given the I think still concerned by a number of citizens about moving about and the number of states that are seeing increased incidence of COVID.

I'm just I'm curious how that business dynamic looks in the short term..

Yes. Donor activity looks good. There's a lot of repeat donors that we know well, and they understand the importance of donating. And it's a really first-rate facility. So I think most of them feel safe there. Obviously, we've made accommodations with regard to social distancing within the donor clinic to accommodate for that.

So we would hope that we would be able to continue to work. Work's pretty essential. And in retrospect, had there been better plans, we might have been able to keep it open. So we would be able to do that just parenthetically. Cellero, which we're in the process of owning, kept their donor site open during the pandemic. So it's quite possible.

So we feel pretty good about that. Inventories are strong. So in the, I think, unlikely event that we have another closure, we could still ship frozen product from that side. And there's a second site as well. So we would anticipate this business is getting back to the kind of growth rate that we had anticipated when we bought it.

Obviously, it won't do it for this year. But as we said in the prepared remarks, that business is going to grow at, at least 30% on a forward going basis probably for the next five years or longer as cell therapy drugs are developed and process improvements are made and are manufactured.

So we look forward to having a bigger footprint to be able to provide these critical tools to the companies in the drug business..

Thank you, Jim..

Sure..

Our next question here comes from John Kreger with William Blair. Please go ahead..

Hi. Thanks very much.

Jim, just sticking with that concept, can you talk a little bit more about how Cellero and HemaCare differ? Are you just adding sort of a broader donor base? Or what other capabilities are you gaining from this deal?.

So it's a little above. So we're adding scale, which is just important given just the growth rate of cell therapy investments in those companies, minting new companies and the rapid nature of drug development by these companies. So we wanted scale, number one.

Number two, you may recall, John, that when we bought HemaCare, which was only in January, I understand, but we did talk, at the time, about geographic expansion. That it's a California company, so we're talking about doing something in the Boston area. Because having more than one site helps the clients to sleep better.

And with some of the cell types, you want to be really in close proximity, so they can get the cells to the client quickly. So these guys have something in the south, in the west and in the greater Boston area. So we love that, we love the scale.

They have more disease-state cells, so clients with who have diseases, both orphan diseases and other diseases. And they have immobilized cells, which is immunocompromised cells from immunocompromised patients and some stem cells. So we have added some scientific capabilities that we probably would have had to do on a greenfield basis.

So we have that now. We have overall capacity, and we have very important geographic expansion..

Excellent. And then a follow-up, we've heard reports that some of the COVID work is moving forward at unprecedented rates.

I'm curious, are you getting that sort of request from clients within the tox work that you would do on these programs? And is there even a way for you to accelerate time lines?.

Yes. We definitely have more work pretty much across our portfolio. Obviously, the safety testing, safety assessment of these drugs is going to be the most critically important thing as they fast-track the therapeutics and the vaccines. Particularly the vaccines, the safety profile is going to be critical. So we do have a healthy book of business.

We are trying to prioritize it. We're doing everything we can.

We've been doing everything we can generally pre-COVID, but we're certainly doing everything we can to take white space out of the process and do things more quickly with regard to reporting time lines and just having a client be ready to accept the data when we're ready to give it to them and vice versa.

So I think the iterative process, communication process and responsiveness on both sides is really there because this is obviously so important to the society. So yes, we're really pleased and proud with that role..

Great. Thank you..

And our next question here will come from Ricky Goldwasser with Morgan Stanley. Please go ahead..

Hi, good morning. First question on the margin.

When you think about the margin structure, what kind of volumes do you see for margin to return to historical levels? And when do you think how long do you think it's going to take to recapture?.

So you broke up at the beginning, Ricky. So you're talking about margins being restored in RMS specifically? Or.

In RMS, particularly.

What type of volume do you need to see for margins to go back historically? And how long do you think can take?.

I don't think it takes long at all. Remember, I mean, RMS unit volume in RMS in the U.S. and Europe has been, I don't know, the last few years, anywhere from down a couple of percentage points to flat to up a couple of percentage points. We always get price.

And so this is nothing more or less than clients literally being closed and not being able to take the animals that they need for the research as they open. So they're opening nicely, as I said earlier.

We would the services business has been strong, not only strong in the COVID world, but in some ways, stronger because it's instigated more outsourcing. We continue to build capacity in China. And there's a little bit of pent-up demand by the academic institutions who are closed and are now opening.

I don't want to overstate that, but pent-up demand being in as much as they want to get right back to work, so our ability to provide them animals is important.

So I don't think it's obviously not mathematically possible to deliver the margins that we did, let's say, last year this year because of the - it's kind of a huge diminution in revenue and profit in the second quarter, but it'll continue to build back in the third and fourth quarters very nicely towards historical levels.

And I would imagine that next year would be fine, barring some unforeseen bizarre COVID-related event..

Okay. And the next one is just on supply sourcing a little bit. Last time we spoke, you mentioned that you're actively reevaluating outsourcing strategy and also reducing dependency on Asia.

So any updates there in how it impacts the business and opportunities for the future?.

Yes. We're working really hard at our supply chain and critical tools that we need to do our work.

And I think we've done a very good job ensuring that we have sufficient products to do our work, both living and in inanimate from a variety of sources, some new, many increases from where they were historically and some reduced from where they were historically.

So we feel really good about supply chain for the balance of this year, and we'll be very well prepared for next year as well..

Thank you..

Sure..

And next, we can go to the line of Dan Brennan with UBS. Please go ahead..

Great. Thanks. Jim, I think earlier in the call, maybe I missed it. I know there was a question on maybe sizing the COVID opportunity for Charles River, whether in the quarter as we look out.

Could you just reiterate kind of what you indicated there? And then related to that, I'm just wondering, given the improving trend in your base business, how are you planning from a capacity standpoint to the extent this COVID work continues..

Yes. So what I said was that we're delighted to have the work. It's coming from large and small clients. We're doing our best to prioritize it when we get it because everyone's in a rush. We're doing our best to take time out of the process. We're not going to give a specific number. Just we just don't do things like that.

And we'd have to update it every time we speak to you, and I'm just not sure that's helpful. So we're delighted to have the work. It's obviously going to be beneficial to our financial results, but it's not going to be a huge number in the scheme of the cosmos. I think it's beneficial. So we don't want you all to over read that..

Got it. And then I think your full year guide, while it's impressive you're raising it, I think if you do the math, it implies a decent deceleration in 4Q.

Is that just conservatism on an organic growth basis that you're baking that in?.

I'm going to let my colleague, Mr. Smith, respond to that..

Well, I wouldn't say it's conservative, it isn't. [indiscernible] I think we've got a sensible forecast here. Remember, there's a lot of puts and takes. The downside scenario isn't as draconian as we thought it might be when we spoke last quarter. So we've taken that downside risk off the table.

We certainly feel that we've passed over the full beat for Q2, and we've increased the revenue a little bit for the second half of the year. Remember, the way that RMS is building back up, it's very it had a big fall in Q2. It's beginning to build up in Q3.

It's not going to get quite to the same level as we would expect from normal Q4, but we're getting towards that. So it's too early, I think, to go to that "RMS is going to fully recover in this year," to some of the comments that Jim said earlier. So again, still six months of the year to go.

We think we've got something that protects us for a sensible COVID headwind. We haven't assumed, in our forecast, there will be a complete worldwide sort of stay-at-home order that we saw a few months ago.

So I'm trying to get some sort of sense here between passing on the beat, catching on a little bit of upside, but at the same time, there's still some uncertainties with COVID. And therefore, we don't want to get too far ahead on our skis and get something that's sensibly balanced, and I think that's what we've got in front of you today..

Got it. And then David, if I could sneak one more in. Just on the operating margin, we can do the math and triangulate back in.

But could you just kind of walk us through maybe a little bit like what in the expected range could be on operating margins as we look on a full year basis?.

Yes. So we've said that we would have some margin expansion from last year. Last year was 19%. We, again, going back to the comments I've just made, we've hesitated from narrowing that margin range at this stage of the year. What I could give you is a bit of color, of course.

The first half of this year, we've done 18.2% margin, which is a nice comparison to last year of 17.4%. So an 80 basis point increase despite the heavy headwind that we had in research models in Q2. So we've the first half of the year has gone up very well. So we're pleased with that.

You can expect, as Jim mentioned, some further improvement in the research models margin as we go through the year. But as I said a moment ago, it won't get to the same margins that we've had historically. We won't get a full recovery until next year. Manufacturing, we're already in the mid-30s, which is where we promise.

So if I were in your position, I wouldn't read in much more of an expansion in manufacturing. And of course, DSA is where, we've always said we'd get the lion's share of our expansion as we go into 2021. You've seen a nice uptick in the DSA margins in the first half of this year, even at the end of last year.

So we would expect to see some continuing improvement year-over-year on DSA..

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

Hi. Thanks for taking my question. Jim, on a couple of people have come at this in different ways.

But thinking about, I guess, the timing of the COVID opportunity for Charles River in light of your specific kind of category killer position in early development, is are your services ones that should be in demand for developers of COVID vaccines throughout the development life of those vaccines? Or are they heavy in the early going such that kind of the real opportunity for Charles River's portfolio of services is, say, in 2020?.

No, I think that we'll play, I think, an important role in the development of both the therapeutics and the vaccines, as I said earlier, particularly on the safety side. It's impossible to predict what the size will be. So we're just trying to give you all a sense of what it's like now. There's a lot of activity. We're happy to have the revenue.

I wouldn't certainly wouldn't say it's dramatic at the current time. But I think our role is critical.

And given that we're the biggest tox company in the world and given the race to market and given the necessity of safety profiles to provide a drug and particularly, a vaccine for a disease that nobody there's no historical data, nobody understands, is really high stakes. So I think that our work is going to be critically important.

And since I don't think that a vaccine is around the corner, even though we all hope it is, and while we may have some short-term drugs, I think there's a significant opportunity for more to come down the line and be increasingly refined that we should continue to play a role here..

Great. Yes, there's certainly an intellectual challenge between the societal hope for a vaccine and what we know about failure rates. So my other question is around kind of a theme throughout your comments about additional outsourcing. You mentioned it in GEMS. I think you kind of covered my question there in terms of the persistency of that.

But you also mentioned in DSA and maybe even in some other areas where there's been a prompting to more outsourcing when clients' facilities were not as readily accessible. And so my question is, how do you assess the permanency of those outsourcing shifts by those clients in the various areas of your business..

We have to assess it by living it, Dave, but we're seeing it everywhere. So we're seeing a lot of it in RMS services, particularly IS and GEMS.

We're seeing it in discovery for people that have begun to develop drugs that they had done the very, very earliest of discovery, and then they were shut down, whether it's a large or small client and they couldn't depend on themselves, or they were using somebody with side Charles River that didn't have a good business continuity plan and they couldn't depend on them or they did safety.

For some of the big clients, they did some safety work internally or used a competitor ours and again, couldn't depend on them. Of course, there's a huge need to be testing these drugs from a biologics point of view, and there's going to be an increasing need to test them from microbial contamination point of view.

Once they manufacture it, it's either to go into the clinic or the end-use market. So as I think I said in the last quarter's call, this is very interesting to see our very large portfolio really benefit clients who, for whatever reason, might have historically like to do things internally or works with somebody else or both who now is utilizing us.

And they may when we got to work, they may have thought, "Okay, so we'll use Charles River because they're the only ones that are open." And then I think over time, they'll be I think they'll be very pleased with the pricing and the speed and the quality of the work, and I think they'll be thinking, why would I bring it back house? I also think the time frame to bring it back house is going to be substantially elongated.

I don't think this COVID situation's going away anytime soon. And I think the longer they work with us, the greater the propensity and the opportunity is for them to stay with us and like it and decommission their space or utilize their space for something else. So all we can do is live it.

And all we can do is do great work, and all we can do is demonstrate we don't have to even say anything, just demonstrate that this is a better value proposition for them and a better business continuity proposition for them because even for big pharma, they can't depend some of them couldn't depend on themselves, depending on the geography that they were in.

So we're really pleased with the outsourcing business that we've gotten. We think that a meaningful amount of it will stick. It's impossible to predict that or size it at the moment, but we're really pleased with what transpired to date and what we think will continue..

That's great. Thank you for the answers. I'll leave it with that..

Sure..

And next, we'll go to the line of Robert Jones with Goldman Sachs. Please go ahead..

Great. Thanks for taking my question. This is Jack Rogoff on for Bob. I wanted to ask about Manufacturing Support margins. How sustainable are the margins that you're seeing in that segment? This is the fourth quarter in a row that you're at or above your long-term guidance.

And throughout this time, you've had some facilities transfers and then now you saw the Microbial Solutions revenue impact. So just trying to understand how sustainable the margins that you're seeing are..

You want to take that, David?.

Yes. I mean we signaled some years ago that we want to be in mid-30s. We've been as you've just seen, we are operating in the mid-30s. We've often commented that rather than drive the margin up, we want to continue to invest in that business so that we can continue to get sort of double-digit growth rates on the top line.

In the preprepared remarks, Jim called out that we are continuing to or we plan to expand biologics as the moment needs the capacity. So that's an example of where we will continue to invest in the business. There are some process improvements that we have been making in microbial as well.

But again, at the end of the day, we're not prepared today to talk about increasing the margins for the sort of the future, but to continue to replow some of that profit back into the business to make sure we can get that top line growth of double-digit continuing..

Makes sense. Thank you..

And next, we can go to the line of Juan Avendano with Bank of America. Please go ahead..

Hi. Thank you. My question is also on the Manufacturing Support segment. It seems like the Microbial Solutions business was moderating in growth even before COVID-19 due to a one-timer in the first quarter of last year. And then obviously, this quarter, you noted that there were some delays in the installations.

So my question on the Microbial Solutions business is what level of confidence do you have that you may be able to regain and sustain the low double-digit growth in this business, specifically? And I'll leave it there..

Yes. So yes, you phrased the question well. And I think you identified the areas and the issues that are causing lower growth, Juan, and pretty much no growth this quarter. We had a massive preorder with a client that causes the year-over-year comparisons to be out of whack.

And we have a lot of demand for new systems, and we haven't been able to get into the clients to install them. It's the RMS and that directly are the big COVID impacts. As I said in my prepared remarks, it's beginning to loosen up. We've installed some systems remotely, which is not surprising.

Clients need them and we've been able to walk them through it, and that may stick and increase. But clients are beginning to open up slowly. What happens this year if we were going to sell them, let's say, a system in the second quarter, and let's say it's one in the Endosafe systems.

This is an associated number associated amount of reagents or cartridges that go along with that and even some of the Celsius systems. So we don't just sell the equipment, we have the razor blade to go along with it, right? So we have that hit as well.

So we're entirely confident that, that business, when the clients are open, then we can install the systems, which clients very much want and like, particularly some of the Celsius systems in the COVID world with bacterial contamination, we should get back to low-digit double-digit levels.

We're continuing to convert our own clients from conventional methodologies to more sophisticated systems. And we're continuing to take share by having competition, by having clients convert from the competition's technology to ours because they get an answer much faster. So it's an odd sort of air pocket here, Juan.

And I'm happy that you asked the question because we really want people to see through the business. As we said, we're not going to give you the exact margins.

But as we said in my prepared remarks and in David's, part of the reason that the manufacturing margin is over 37% is because the margins are better in microbial because of process improvements we made in the manufacturing process. So in addition to, I think, a more robust top line going forward, we continue to drive efficiency in that business.

So it's contributing very nicely to total Charles River operating margin..

Thank you..

Sure..

And next, we can go to the line of Patrick Donnelly with Citi. Please go ahead..

Thanks. Jim, maybe one for you. Last quarter, you called out the complex integrated drug discovery projects on the discovery side, an area you were seeing some delays.

It sounds like you saw some normal [indiscernible] in small biotechs, how quickly things normalize and just the general tone there?.

Okay. You cut out, but I think I got the question. So I think we had some small clients, biotech clients really pulled back and paused when COVID hit because they just didn't know how it would impact them or impact their access to capital or ability to get their work done, number one.

Number two, they were considering very complex, multiyear, pretty expensive integrated projects with us, and they thought, "Well, if we're going to be conservative, that's a good place to be conservative." So we had a couple of those a few of those. And they paused.

And while I don't think the ones that pause necessarily have reinstituted those studies, we have had others, other biotech companies and pharma companies’ kind of pick up the slack.

So I think everyone's kind of figured out what COVID means to them in terms of the drug development processes, in terms of the really complex discovery work they're doing and in terms of the impact that we can have, hopefully, helping them solve some really complex problems.

These integrated studies are really complex and help solve some problems that somehow are big mysteries to the clients. So sort of move right through that relatively quickly later in the second quarter, and we think that business will continue to be.

It's not a huge part of our business but will continue to be an increasingly important one and one that distinguishes us from the competition..

Helpful. Thanks..

Sure..

And next, we can go to the line of Vijay Kumar with Evercore ISI. Please go ahead..

Thanks for taking my question. I had two quick ones. Maybe I'll roll them into a single question. Jim, on the reiteration of the LRP here, high singles organic, the 20% margin target.

One, on the top line, why wouldn't we see RMS snapping back perhaps at high singles, even perhaps touching low doubles? I'm curious, you made some comments around in a new normal extending well into 2021, perhaps put that into context for us.

And second, on margins, the 20% for 2021 target implies a big step-up versus the comments relative to some margin expansion for 2020. Curious what drives the step up..

So we just don't want to get ahead of ourselves here. We would be very pleased, and we hope you all would be very pleased if we were to deliver high single-digit revenue growth next year and meet our articulated operating margin target of 20%.

We obviously will do everything we can to always have our numbers be better, but it just would be way premature just given the vagaries in the world right now, notwithstanding the fact that we're performing well to do better than that. And specifically, your comments about RMS. I mean, RMS has been low to mid-single-digit grower.

With the cell therapy product businesses growing at 30%, that's going to stimulate a larger growth rate. I don't think the math gets you to where you're directing. But I think directionally, hopefully, the growth rate will exceed low to mid, but we're not ready to articulate that. We just bought those businesses, and we want them to perform.

And as we saw in the second quarter, HemaCare was impacted somewhat by COVID. So we'd be delighted to hit those targets. We're always driving to push them higher. So I'm not saying it's impossible that they could be better. I'm just saying that that's not something we're willing to guide to at the current time..

And that's helpful. And....

I get sorry. I get your point about the year-over-year comps from a low base for research models for 2020 compared to 2021, yes, it's still an organic growth. But to Jim's point, we're still a long way of seeing what COVID is going to do in 2021. But I take your point about the year-over-year comps.

If we get research models back to a normal way of working in 2021, then you would see a one-off year-over-year benefit because we had a low base in 2020. But we'll start signaling that math and that structure when we get closer to 2021..

Understood. Thank you, guys..

And next, we'll go to the line of Stephen Baxter with Wolfe Research. Please go ahead..

Hi, thanks for the question. Hopefully, you can hear me, okay. I wanted to ask a bigger picture question about doing acquisitions in the current environment. Obviously, you have a deal you're announcing today.

Can you talk a little bit about how you're handling the integration process when, obviously, traveling, for example, is a difficult thing to ask people to do? And would you be able to integrate a larger deal in the current environment? Or is the ability to integrate in any way a rate-limiting factor for you over the next couple of quarters as you think about larger deals?.

That's a good question. We have a pretty large sophisticated integration team. And so I think our ability to do much of the integration, the vast majority of the integration can be done remotely. Certainly, any of the system stuff, all the back-office stuff is not a problem.

Facility issues, to the extent that we have to get involved, obviously, somebody has to go there, and we will. We have local people. So we've seen the facilities we're buying, although we didn't do that en masse.

Ability to help companies who we buy from a sales point of view, I think we can do remotely, and we can educate sales organizations by video, et cetera. So no, it doesn't strike us that, that's a headwind doing deals, large or small. I think integration is something we've got increasingly better at. It really doesn't matter the size of the deal.

We wouldn't be hesitant and there's going to be some opportunities. And I, for one, think that the COVID situation will be prolonged, and we're not just going to sit and wait for things to change to be able to get on with our business. So we have strong balance sheet. We have a lot of targets.

We've seen that adding and enhancing the portfolio is the key competitive differentiator between Charles River and all of our competitors. So we want to continue to advance that. There are targets out there. And we have a team ready, willing and able to do additional deals. So I think we'll be able to integrate them just fine..

All right. If there are no further questions, I'd like to thank everyone for joining us on the conference call this morning. We look forward to speaking with you during several upcoming investor conferences in September. This concludes the conference call. Thank you..

Thank you very much. Ladies and gentlemen, that does conclude the call for today. Thanks for your participation for using AT&T Teleconference. You may now disconnect..