Charles River Laboratories: Q2, Cost Structure Streamlining (Rating Upgrade) (NYSE:CRL)

I highlighted Charles River Laboratories’s (NYSE:CRL) near-term challenges due to the weak biopharma market, initiating with a ‘Hold’ rating in my previous coverage published in February 2024. The company released its Q2 result on August 7^th, lowering its full-year guidance due to weak demands from small and mid-sized biotechnology customers. I think the current stock price has already factored in the softness of biopharma market, making it an opportune time to invest in this high-quality company. Therefore, I am upgrading to a ‘Buy’ rating with a fair value of $220 per share.

Weak Biopharma Market Continues

The biggest takeaway from the quarter is the recovery of biopharma market is slower than the company had expected, particularly for the mid-sized and small biopharma customers. During the earnings call, their management indicated that they no longer expect an end-market recovery in the second half of FY24. As such, the company cut the full-year guidance for both organic revenue and bottom-line growth, as detailed in the table below.

CRL’s Discovery and Safety Assessment (DSA) organic revenue declined 5% year-over-year for the quarter, driven by sluggish end-market demands. There are two major factors contributing to this weakness:

• Small and mid-sized biopharma companies are struggling with limited capital for new drug development, leading to industry-wide layoffs and cost-cutting measures. As a result, CRL’s Discovery and Safety Assessment and research model businesses are facing growth challenges.
• On the other hand, large pharma companies are tightening their operating expenses to navigate the weak macro environment. As discussed over the earnings call, the management expected the weakness to persist through the second half of FY24 and potentially into FY25.

As discussed in my initiation report, I do not anticipate a recovery in the biopharma market before the Federal Reserve cuts interest rates.

Cost Streamlining Initiatives

As illustrated in the chart below, CRL’s adjusted operating margin expanded by 90bps in Q2 despite a -3.2% decline in organic revenue growth.

CRL has already consolidated several manufacturing sites and reduced headcounts in the past few months. As communicated over the call, the management anticipates the cost cut measures will continue into Q3, generating over $150 million in annualized cost savings, which are expected to be fully realized by FY25. I view the company’s cost streamlining initiatives positively, especially given the current weak market environment.

The $150 million in cost savings represent around 5% of CRL’s total operating costs, which should significantly enhance the company’s operating margin for FY25. Based on my calculations, if CRL’s revenue growth recovers to its historical average of 8% in FY25, the company could potentially expand its margin by 230bps.

Growth Projection and Valuation

In Q2, the company experienced a 3.2% decline in organic revenue but achieved a 1.1% growth in operating profits, driven by their cost-cutting initiatives. It is evident that the company is currently undergoing a down cycle.

In FY24, the biopharma market is more likely to remain soft due to the high interest rate and a tight capital funding environment. It is unlikely to see any market recovery before the Fed cuts interest rate, in my view. I calculate CRL’s revenue will decline by 3% in FY24, assuming:

• Research Models: While CRL has seen growth in small research models, challenges persist in research model services. Although the small research models could help biopharma customers save cost, they generate lower revenue for CRL. I forecast a 5% decline in CRL’s Research Models segment for FY24.
• Discovery and Safety Assessment: The business represents more than 60% of total revenue. The business segment will be most impacted by the weak biopharma market. Assuming no recovery in the second half of FY24, I anticipate a 6% decline in this business segment.
• Manufacturing Solutions: I forecast the business will grow by 5%, consistent with recent trends.

For the growth rate from FY25 onwards, I model an 8% normalized revenue growth, assuming:

• I anticipate the Fed will begin to cut interest rate later this year, leading to a gradual recovery in the capital funding environment in FY25. As such, I assume the company’s Discovery and Safety Assessment will recover to 10% annual growth.
• For the research model and Manufacturing Solutions, I model a 5% annual growth for both segments, consistent with their historical average.

In addition, I assume the company will allocate 4.7% of total revenue towards acquisitions, contributing 140bps to the topline growth.

On the margin side, I forecast the cost savings plan will be fully realized in FY25. As discussed previously, I calculate the margin will expand by 230bps in FY25. From FY26 onwards, I assume the company will deliver a 20bps annual margin expansion driven by a 10bps improvement from gross margin and 10bps operating leverage from SG&A.

The DCF summary:

The WACC is calculated to be 9.8% assuming: risk free rate 3.8% ((US 10Y Treasury)); beta 1.33 (SA); equity risk premium 7%; cost of debts 7%; debt $2.4 billion; equity $3.6 billion; tax rate 25%.

Discounting all the FCF, the fair value is calculated to be $220 per share, as per my estimates.

Key Risks

The company has $2.4 billion in total debts, with 80% of it at a fixed rate. Although the company is committed to repaying its debts, the net debt leverage of 2.2x remains relatively high, in my opinion. The Board recently approved a new stock repurchase plan of $1 billion. I calculate the company will generate $435 million in free cash flow for FY24 , so this stock repurchase plan could impact their ability to continue with ongoing debt repayments.

Verdict

Despite the overall weakness in the biopharma market, I consider CRL a high-quality growth company. The current stock price has already factored in the weak growth expected in FY24, as per my calculations. Therefore, I am upgrading to a ‘Buy’ rating with a fair value of $220 per share.