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|  | JUNE 28, 2005
 FOCUS STOCK By Jeffrey Loo, CFA Charles River Keeps on Rolling[Page 2 of 2]GOOD GOVERNANCE. We believe the shares, which currently trade at about 20 times our 2005 EPS forecast of $2.37, with a p-e-to-growth (PEG) ratio of 1.0, below peers, are attractively valued. Although we anticipate integration risk with Inveresk, we believe Charles River is undervalued at current levels in light of its superior earnings-growth and revenue potential. In our view, it is well-positioned as a leading provider in a healthy and growing industry. The stock recently traded about 25% below our 12-month target price of $63, based on our discounted cash flow and PEG analysis using a PEG ratio of 1.3, slightly below peers as we take potential integration issues into account. We believe that Charles River has excellent corporate governance practices. Among those that we view positively: Every director is elected annually; the board is controlled by a supermajority (over 75%) of independent outsiders; the nominating, compensation, and audit committees are each comprised solely of independent outside directors; the company has a stated policy on auditor rotation; and average options granted in the past three years as a percentage of basic shares outstanding has been equal to or less than 3%. UNDER PRESSURE. There are several risks to our recommendation and target price, in our opinion. Essentially all of Charles River's revenue is generated from pharmaceutical and biotechnology R&D spending. The trend of these companies increasing their outsourcing drug-discovery and development needs may slow or even decline. Pharmaceutical R&D spending has grown at an average annual rate of 10% for the past decade. But if R&D budgets are reduced, Charles River would most likely be adversely affected. Currently, there is limited pricing pressure from competitors and clients due to robust demand. However, should demand decline, we believe pricing pressure would increase. HIRING LINE. Charles River depends heavily on its RMS segment for both sales (currently around 47% of net sales) and operating profits (about 70% of overall operating profits). Potential contamination in its animal population could significantly damage its inventory and reputation. Also there is ongoing research for alternative research methods, potentially reducing the need for animal models. Finding qualified staff becomes more difficult as demand for outsourced services increases. We believe this may result in rising personnel costs and the potential for greater turnover, producing lower operating margins. With the recent addition of Phase I-IV clinical services, Charles River is subject to increased cancellation risks, albeit much lower than the typical CRO, which typically lack much control over cancellations. DOWNSIDE POTENTIAL. Sponsors may cancel a trial for a variety of reasons, including regulatory issues, a strategic decision to terminate development of a particular compound, or the inability to recruit a sufficient number of appropriate patients. We believe the industry cancellation rate is about 15% to 25%. A significant rate in any one quarter can hurt revenues over the next several periods. The Inveresk purchase significantly expanded Charles River's operations and geographic presence. We believe there are inherent risks in all sizable acquisitions, including the potential clashing of management styles and cultures, the ability to retain and grow the revenue base of both firms, the ability to maintain management control over a significantly larger infrastructure and facilities base, and realizing projected cost savings and operating synergies.
 Analyst Loo follows shares of life-science research and development companies for S&P's Equity Research Services All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc. Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | |
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