Charles River Laboratories International, Inc.

Moat: 3/5

Understandability: 4/5

Balance Sheet Health: 4/5

Charles River Laboratories International, Inc. is a leading provider of drug discovery and development services to the pharmaceutical, biotechnology, and government industries. It assists its clients by conducting research, testing, and other services essential to bringing new medicines to market.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Explanation

Charles River operates within the life sciences sector, specifically focusing on the preclinical and clinical stages of drug discovery and development. They work with a diverse range of clients, including pharmaceutical, biotechnology, and government organizations. Here’s a breakdown of their key aspects:

  • Business Operations: CRL’s business is centered around providing a comprehensive suite of services that assist clients in drug discovery and development. This includes:

    • Research Models and Services (RMS): This involves breeding and supplying animal models used in research.
    • Discovery and Safety Assessment (DSA): This includes preclinical testing services which assess the safety and efficacy of new compounds, including toxicology studies.
    • Manufacturing Support (Manufacturing): This includes testing services related to GMP (Good Manufacturing Practice), such as testing a new drug or vaccine for impurities.
  • Revenue Distribution: Charles River’s revenue is broadly diversified across its various services with all three segments contributing similar levels of revenues. The primary driver of revenue is their customer base which is primarily made up of Biopharmaceutical companies, but it is also exposed to academia, and some government agencies.
  • Industry Trends: The overall biopharmaceutical industry is growing at a high single digit rate, fueled by an aging population and technological innovation which has created new therapeutic possibilities. There is increasing pressure to make drug development processes more cost effective, which has been leading to more outsourcing in recent years, which benefits companies like CRL. There is also a trend towards more biologics, gene, and cell therapy, which tend to require more complex preclinical research which also benefits CRL.
  • Competitive Landscape: The industry is competitive, and fragmented, with many mid-sized CRO’s. A few larger players are Labcorp, IQVIA, and Syneos. It is generally seen that large CROs provide more capabilities and a one-stop-shop for their clients. A differentiator amongst them is usually geographic, niche-focuses, and financial health.
  • CRL’s management indicates their value proposition to their customers is in: “access to broad range of capabilities, global scale, and high quality scientific expertise”.
  • What Makes CRL Different: A distinguishing feature of CRL is the breadth of their expertise, that is a capability across research models, discovery, safety assessment, manufacturing, and in multiple geographies across the world, all under one roof. This scale and scope are difficult for smaller competitors to replicate. The company also has more than 70 years of history with strong relationships in the industry and with their customers.
  • CRL highlights their innovation and focus on the latest technologies, such as genetic editing of animal models and new drug modalities such as cell and gene therapy. This constant development of new solutions for their clients is very crucial to their long term positioning.

Moat Assessment: 3/5

Charles River possesses a Narrow Moat based on its competitive advantages, although not a wide one due to the inherent commodification risk of its main business segments and its relatively unstable margins. Here’s why:

  • Intangible Assets: A notable aspect of CRL’s competitive advantage comes from its established reputation and brand recognition. Its 70-year history and deep ties in the pharmaceutical, biotech, and government sectors allow it to capture significant business. Also, they have many specialized expertise and technologies to handle complex new drug modalities and have built up specialized production capabilities that are not easily replicable by smaller players.
  • Switching Costs: Switching costs in preclinical research are high. The relationships built are long-term, often multi year projects, and the trust between both firms needs to be high to be able to have that level of scientific collaboration. Changing CRO’s during a trial would be costly and time consuming, with high switching costs for customers, as it requires retraining workers, restarting data collection, etc. This lock-in, particularly with larger pharmaceutical firms who seek a single vendor for all their research needs, creates a stable revenue source for CRL.
  • Scale and Efficiency: CRL also has a scale advantage where it can leverage resources and expertise across various geographies and different divisions within the company. This allows it to service the largest pharmaceutical and biotech companies across the world, which a new entrant cannot compete with.
*   However, this is not to be confused with a cost-based moat. *   **Limitations:** Although the above moat drivers are present, they are quite limited by the competitive nature of the CRO business. Preclinical and clinical CROs can be easily replicated by others with enough resources and financial backing. The services are more specialized but are still largely a commodity. Some customers also employ multiple CRO's. Their margins have generally been falling because of increased competition from smaller companies that want to underprice larger more established players. As more and more competitors emerge it is difficult to predict the moats durability.

Risks to the Moat and Business Resilience

Despite CRL’s established position, several risks could impair its moat:

  • Technological Disruption: Faster technological advancement in drug discovery and development could reduce reliance on traditional animal studies, which would affect the business model of CRL. They are, however, trying to mitigate this by investing heavily in new technology, but new breakthroughs could still make much of their current knowledge and expertise obsolete.
  • Increased Competition: The biopharmaceutical industry’s growth has been attracting more and more competition, with many small and mid-sized CROs offering similar services at lower prices. The emergence of new CRO companies is a constant risk that could lead to lower margins for the larger CROs.
  • Regulation: Stricter regulatory demands from government authorities could increase costs, and make it more difficult to gain regulatory approvals. But on the upside, it may also give a barrier to entry for other players.
  • Customer Dependence and Economic Risk: With a significant customer base in biotech and pharma, reduced investment in research from these companies will have a huge impact on their financials. Also if their clients do not successfully move forward in their drug pipelines, CRL will have fewer contracts to service. Also, economic downturns could reduce the number of research dollars available for drug discovery in general.
  • Execution Risk: Given the size of CRL, there is a huge risk of mismanagement or inefficiencies that are difficult to observe in these companies. Also, recent M&A activity could cause problems in integrating new cultures and operations, which could cause lower than ideal performance.

Despite these risks, CRL has shown solid business resilience. It has a high level of client retention, as well as diverse customer mix and diversified revenue across its different segments. The strong demand for drug development and limited regulatory approvals give a strong backlog.

Financials Analysis

  • Revenue: CRL has seen a history of steady revenue growth in the past, and this is expected to continue in the future with a projected growth of mid-single digits for the foreseeable future. Their growth is primarily driven by increased outsourcing from the larger pharmaceutical companies. As per 2022 annual figures, the revenue is broken down across all three segments with RMS generating $1.47B, DSA generating $1.82B, and manufacturing generating $634M
  • Their latest earnings calls (March 2023) indicate some slowdown in revenues as some customers reduce their spending.
  • Margins: Their margins have seen some decline in recent years due to increased competition. As per their latest 2022 figures, their Gross Margin is 36.6%, operating margin is 18.6%, and net profit margin is 8.9%.
  • This is a cause for concern, since they have stated many times that they want to be an operating margin of at least 20%. As per latest earnings calls, they have stated that they will maintain price increases this year, which might help margins to recover.
  • ROIC: Return on invested capital for CRL is around 13.4% as per their 2022 report, and has seen some decline in previous years.
  • Debt: CRL has around $3B in long term debt with an annual interest expense of $160 million, which constitutes a portion of their capital structure, and some debt was used in acquisition of newer companies. Their debt is not high, and is easily manageable, and they have a high credit rating.
  • Cash flows: As per their latest annual figures, they generated $584 million in operating cash flow, which has been increasing each year, and $318 in FCF. This is enough to pay for their yearly capex, interest payments, dividends, and acquisitions.
  • Capital allocation: Most of their free cash flow is geared towards acquisitions to expand their offerings and global presence. They also spend a decent amount on R&D and share buybacks.
  • Management’s View: In their latest earning calls, management has indicated that they are focusing on revenue growth through pricing power, as well as cost controls, particularly in their research departments. They are also trying to integrate recent acquisitions and find synergies across the company. They have also indicated an increase in their sales backlog and an improving sales pipeline.

Understandability: 4/5

Charles River’s business model is relatively complex and has a wide offering of services.

  • While each aspect of their service lines is well understood individually, the scale and scope of the company may be a little difficult for new investors to fully comprehend at first glance. Their income statements and balance sheets may require special attention due to the nature of their business and the presence of various non-operating and special items.
  • However, the overall industry and its dynamics are not overly complex, and most people can understand what their businesses do. It will be a more easy business to understand with some degree of accounting knowledge, which makes it a 4/5.

Balance Sheet Health: 4/5

  • CRL’s balance sheet is in a good health, with a good debt ratio that they can comfortably manage. Their interest coverage ratio is high with a lot of excess cash at hand.
  • Their latest credit ratings are BBB+ by Standard & Poor’s and Baa1 by Moody’s which is a sign of strong financial position.
  • They have goodwill and intangibles from a lot of acquisitions that they have done, which is something an investor should keep a watch on for write-downs down the road.
  • Overall, their balance sheet is in relatively good shape with very low risk of default, earning them a 4/5.