The Cutting Edge in Drug Development

02/01/2012 7:15 am EST

Focus: STOCKS

Taesik Yoon

Editor, Forbes Investor and Forbes Special Situation Survey

Health care will be a growing sector and an increasingly important issue moving forward, which is great news for this pioneering drug discovery firm, writes Taesik Yoon of Forbes Investor.

Charles River Laboratories International (CRL) is a leading global provider of products and services that aid and advance the drug discovery and development process.

Customers include pharmaceutical and biotechnology firms, government agencies, hospitals, and academic institutions. CRL operates two segments.

Research Models and Services (RMS), which produced 61.4% of net sales through the first nine months of 2011, supplies purpose-bred rats, mice, and other biological specimens (in approximately 150 strains) for use as research models in drug development.

RMS also provides services related to the maintenance and monitoring of research models, and the implementation of efficacy screening protocols. Additionally, it offers in vitro products, such as testing kits, reagents, software, accessories and instruments, designed to test medical devices and injectable drugs for endotoxin contamination, and supplies specific pathogen-free (SBF) chickens and eggs used in vaccine applications.

CRL’s Preclinical Services segment (PCS), which generated 38.6% of net sales, provides outsourced drug discovery and development services. This consists of both in vitro and in vivo studies, such as toxicology studies; pathology testing; bioanalysis, pharmacokinetics and drug metabolism evaluation; and specialized testing of biologics and devices.

The segment also offers supportive laboratory services, and strategic preclinical consulting and program management. Outsourcing these non-core activities allows CRL’s customers to focus on more important tasks, such as innovation and early drug discovery.

Third-quarter net sales from continuing operations rose 2.5% year-over-year to $277.6 million. RMS sales climbed 7.7% to $171.5 million, boosted by growth in its in vitro and avian businesses. PCS sales fell 4.9% to $106.1 million, due to the ongoing trend towards shorter-term, less complex studies by customers.

The adjusted operating margin, which excludes acquisition-related expenses and other special items, remained largely unchanged at 16.2%. Adjusted net income was flat from a year ago at $28.7 million. Due to the benefits of aggressive share buyback activity, net income climbed 23.9% to 57 cents per share.

Results for the third quarter came in slightly below expectations. One of the main reasons for this underperformance was due to shifting business priorities by CRL’s biopharmaceutical customers.

Weak economic conditions and uncertain business outlook has resulted in these customers emphasizing shorter-term efficacy studies that eliminate non-viable molecules earlier in the drug development process in order to focus on those offering the most promise. This has resulted in less business opportunities for CRL’s development-phase preclinical services.

The lower demand environment likely continued through the fourth quarter. Indeed, the company expects adjusted earnings of $2.40 to $2.45 per share for 2011. This implies fourth-quarter adjusted earnings of 53 to 58 cents per share, which is lower than the 60 cents earned in the same period in 2010.

However, prospects for the new year are more optimistic. During a financial update provided last month, CRL stated that market conditions have stabilized with better visibility regarding future outlook. As a result, it expects constant currency sales growth of 1% to 3%.

CRL also expects adjusted earnings of $2.60 to $2.70 per share. At the midpoint, this implies growth of 9.3% from the company’s estimate for 2011.

Yet we believe this guidance could prove conservative for several reasons. For example, it does not include any accretion from potential acquisitions, which has been a meaningful contributor to CRL’s growth in prior years. Additionally, because its customers are emphasizing shorter-term efficacy studies, discovery services such as non-regulated testing and in vivo pharmacology have become increasingly more important to their needs.

In order to make informed decisions as to which molecules are viable, they also need to conduct a larger number of screens. As such, CRI has seen greater outsourcing of discovery activities by customers.

At the same time, these customers are reducing the number of providers they purchase from by partnering with those large enough to support the broader level of outsourcing needs within the drug discovery pipeline they now require.

CRL’s global scale and established expertise within in vivo biology provide strong competitive advantages, and should allow it to capture a significant portion of this growing outsourcing business.

This was the case last November when a leading global pharamceutical customer expanded an existing preferred provider agreement to include non-GLT pharmacology services for multiple therapeutic areas. This was in addition to the drug metabolism and pharmacokinetics services, and safety assessment services CRL already provided.

Yet despite the likelihood of additional benefits from these favorable customer trends and expectations for a more stable marketplace, CRL’s shares continue to trade near their lowest levels in more than two years. As such, we believe the stock presents a good opportunity.

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