CHARLES RIVER LABORATORIES INTERNATIONAL, INC. quarterly report, Q1 FY2013

Charles River Laboratories International, Inc. — Q1 2013 Form 10-Q

Reporting period: Three months ended March 30, 2013; comparison period ended March 31, 2012. Unaudited results. Charles River provides research models and related services and outsourced preclinical services to pharmaceutical, biotechnology, academic, hospital, and government customers.

Financial results

Metric	Q1 2013	Q1 2012	Change
Net sales	$291.2 million	$286.0 million	+1.8%
Gross margin	35.8%	36.4%	-0.6 percentage points
Operating income / margin	$42.8 million / 14.7%	$43.7 million / 15.3%	Income -2.1%
Net income attributable to common shareholders	$25.6 million	$26.4 million	Lower
Diluted EPS	$0.53	$0.54	Lower
Cash from operating activities	$30.0 million	$25.3 million	Higher

Product sales were $126.3 million versus $126.2 million; service sales were $165.0 million versus $159.8 million. Foreign currency translation reduced total sales growth by 1.0%.

Segments and period-over-period changes

• Research Models and Services (RMS): Sales fell 0.4% to $182.5 million. Operating income declined 7.0% to $55.3 million and operating margin fell to 30.3% from 32.5%, primarily as lower research-model sales weighed on fixed-cost absorption; cost savings partly offset the pressure.
• Preclinical Services (PCS): Sales rose 5.8% to $108.7 million, reflecting market-share gains with large biopharmaceutical and mid-tier clients. Operating income increased to $8.1 million from $4.2 million; margin improved to 7.4% from 4.1%, supported by higher safety-assessment and non-GLP discovery sales and improved biopharmaceutical-services profitability.
• Consolidated gross margin declined mainly because of lower research-model sales. Interest expense was modestly lower at $8.3 million. The effective tax rate rose to 27.3% from 24.7%.

Cash, debt, and liquidity

• Cash and cash equivalents were $100.4 million at March 30, 2013, down from $109.7 million at year-end 2012. The company also held $6.8 million in marketable time deposits. Most cash was held by non-U.S. subsidiaries and was described as indefinitely reinvested.
• Total debt was $648.2 million, including $130.7 million classified as current; long-term debt was $517.5 million. The credit agreement included a $350 million revolving facility maturing in September 2016. The company reported compliance with its financial covenants and $5.0 million in letters of credit outstanding.
• Cash used in investing activities was $28.8 million, including $24.1 million for the Vital River acquisition; capital expenditures were $6.4 million. Cash used in financing was $6.5 million. The net decrease in cash was $9.3 million.
• The company projected approximately $50 million of capital expenditures for 2013 and expected to fund them with operating cash flow, marketable securities, and credit facilities.

Outlook, commentary, and material items

• Management provided no specific revenue or earnings guidance in this filing. It cited continuing uncertainty from measured client R&D spending, delayed decisions, pricing pressure and excess contract-research capacity, biotechnology funding conditions, healthcare-reform uncertainty, and industry consolidation. It said demand had appeared to stabilize, while timing of long-term growth drivers remained difficult to predict.
• Management’s priorities were margin improvement, free-cash-flow generation, disciplined growth investment, and shareholder returns. Strategic outsourcing and demand for early-stage in-vivo services were identified as potential long-term drivers.
• Vital River, a Chinese research-models provider, was acquired in January 2013 for a 75% interest. The purchase-price allocation included $19.7 million of goodwill and $15.6 million of definite-lived intangibles. The remaining 25% is subject to purchase/sale rights beginning in January 2016; its $9.0 million redeemable noncontrolling interest is remeasured at fair value.
• The $350 million 2.25% convertible notes mature in June 2013. The company expected to settle principal in cash, using cash, available credit capacity, and/or other financing alternatives; any conversion premium could be settled in cash or shares. No conversion triggers were met at quarter-end.
• On April 4, 2013, after quarter-end, the buyer of the disposed Phase I clinical business filed for Chapter 11 bankruptcy. At March 30, the company carried a $9.8 million liability for its lease guarantee; remaining lease payments were $12.6 million before considering sublease income. The company may obtain control of the facility if required to honor the guarantee.
• The company reported disclosure controls and procedures were ineffective because of a material weakness in internal control over financial reporting involving IT access and segregation of duties, master-data changes, transaction-level controls, and financial-close controls. Management described remediation work and said additional procedures supported the fairness of the quarter’s financial statements in all material respects.
• Tax items included a $0.7 million discrete cost from French tax-law changes and a $0.5 million cost related to nondeductible Vital River transaction costs, partly offset by a $0.3 million U.S. tax-law benefit. Unrecognized tax benefits totaled $32.2 million. A Canadian transfer-pricing dispute remained under audit; the company had reserved $2.4 million and recorded a $3.0 million related U.S. tax asset, both subject to the eventual resolution.
• Management said pending ordinary-course lawsuits and claims were not expected to materially affect the financial statements, and reported no material changes to the risk factors in its 2012 Form 10-K.

Important facts for investors to verify

• How the June 2013 convertible-note maturity was ultimately funded and whether any conversion-related dilution or additional financing resulted.
• Whether RMS sales and operating margins stabilized, and whether PCS growth and improved margins continued.
• Progress in remediating the disclosed material weakness and whether disclosure controls were later deemed effective.
• The final cost and outcome of the Phase I lease guarantee following the buyer’s bankruptcy, including any sublease recoveries.
• Final Vital River purchase accounting, performance, and the future cash obligation associated with the remaining 25% interest.
• Developments in the Canadian transfer-pricing audit and other uncertain tax positions.