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Get Four
|  | JUNE 28, 2005
 FOCUS STOCK By Jeffrey Loo, CFA Charles River Keeps on RollingBig Pharma's outsourcing of drug-discovery and development should continue to lift the stock of this efficient market leaderPharmaceutical and biotech concerns are under intense pressure to discover and develop new therapeutic drugs more rapidly and efficiently. We at Standard & Poor's Equity Research Services believe they face increased competition, rising costs due to the growing complexity of drug discovery and development, patent expirations enabling generic competition to cut into sales and profits, and heightened regulatory scrutiny, among other factors. As a result, we believe, these outfits are increasingly turning to companies like Charles River Laboratories (CRL; recent price, $48), one of the largest providers of outsourced drug-discovery and development services. DOMINANT PLAYER. In our opinion, pharmas and biotechs are realizing that outsourcing is both more efficient and cost effective, and that it also speeds up the drug-development timeline. We believe the outsourced drug-discovery and development industry is poised for significant growth over the next several years, and we see demand primarily benefiting the larger contract research organizations (CROs) with global operations. Charles River is well positioned to benefit from this growth, in our view, and should expand faster than the industry, based on its leadership position, global operations, and efficiency. We expect significant share-price appreciation over the next 12 months, earning the stock a 5 STARS (strong buy) recommendation. The Wilmington (Mass.) company operates over 100 facilities in more than 20 countries and has three reporting business segments: Research models and services (RMS) (about 47% of sales), preclinical services (about 41%), and clinical services (about 12%). Charles River has the highest operating margins in the industry due to its dominant market position in RMS and strong preclinical franchise. GOLDEN RATS. The RMS unit principally engages in the commercial production and sale of animal-research models, primarily purpose-bred rats, mice, and other rodents for laboratory use. Animal research models are required in the research and development of new drugs, devices, and therapies. The FDA and other foreign regulatory bodies typically require the safety and efficacy of new drug candidates and many medical devices to be tested on research models, prior to human testing. The company's market share in RMS is estimated to be over 50%, and we expect it to maintain its leadership position. RMS is a highly profitable business, and Charles River has been able to increase prices every year. Gross margins are about 43%, and operating margins around 32%. We believe Charles River can boost these margins even further, as research models become more complex and demand remains strong. One of the world's two largest providers of preclinical services, Charles River has market-leading positions in general and specialty toxicology with facilities in the U.S., Canada, and Europe. DIVERSIFIED OFFERINGS. We believe demand is outpacing supply within the preclinical services segment. While CROs are adding capacity, we believe the imbalance will continue into 2007, resulting in an attractive pricing environment. This situation is also leading to dedicated-space agreements with pharmaceutical companies more interested in having capacity rather than in getting the best price, in our view. Gross margin in preclinical services is about 34%, with operating margins about 17%. In our view, Charles River will be able to slightly increase those margins in 2006. Clinical services represents a new market for Charles River. As part of its purchase of Inveresk Research Group in October, 2004, the company also acquired a clinic to conduct European Phase I drug trials and an established international operation to manage Phase II-IV studies. FINE FIT. We believe Inveresk is a good strategic fit for Charles River. The deal enabled it to diversify service offerings and geographic presence, thus lowering the risk profile. In our opinion, there has been a trend among pharmaceutical outfits to move toward fewer suppliers with extensive global operations and diversified service offerings. Although the addition of lower-margin Phase I-IV services should result in reduced overall margins, we believe Charles River will be able to maintain the highest margins in the industry. Overall, we forecast 2005 operating margins declining 70 basis points, to 22.5%. We expect outsourcing demand from pharmaceutical and biotech companies to continue rising for at least the next several years. Indeed, the CRO industry has been growing at a compounded annual rate of about 10%. This pace has moved in parallel with the rise of pharmaceutical R&D spending. DOMESTIC EXPANSION. However, we see growth accelerating and expect the industry to expand about 11% to 12% annually over the next several years. We think the main beneficiaries will be those companies with global operations and diversified service offerings. Additionally, we believe the potential repatriation of over $100 billion in foreign earnings by pharmas could be a source of additional R&D funding that should result in more compounds under development. We expect Charles River to grow faster than the competition as a result of its leading market position in research-model services and preclinical services. In addition, we think it will seek to expand its Phase I testing capabilities through U.S. acquisitions. PROJECTED GROWTH. We project a 50% rise in 2005 sales, to $1.15 billion, primarily due to the full-year inclusion of Inveresk and low double-digit organic growth in RMS and existing preclinical segments. The inclusion of Inveresk's preclinical division essentially doubled this segment's revenue. We expect organic sales growth in the low double digits in 2006. Based on our view of strong sales and utilizing a 29% tax rate due to increased foreign earnings, we forecast 2005 operating earnings of $2.37 per share. We also see 2006 pro forma EPS up 20%, to $2.84 on double-digit sales growth and better operating margins. After including an estimated 16 cents for stock-option expense, we project 2006 operating EPS of $2.68. The quality of Charles River's earnings is high, in S&P's view. After a series of adjustments to its net income from continuing operations and before extraordinary items (on a generally accepted accounting principles, or GAAP, basis) to conform to S&P Core Earnings methodology, our estimated operating EPS of $2.37 for 2005 would be lowered by 7.2%, to $2.20. The reduction for estimated option expense accounts for the majority of the difference between our operating and Core estimates.
BW MALL
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