Summary
- Charles River Laboratories' fourth quarter of 2022 was its strongest quarter in the company’s history.
- However, the company’s stock dropped ~12% because of challenges the company is facing with non-human primate supply resulting in 2023 guidance coming in below estimates.
- The company has voluntarily stopped importing non-human primates from Cambodia and this source of supply may not return until year-end.
- We see the recent drop as an opportunity to acquire shares in this compounder as the non-human primate supply headwinds are mostly likely a short-term issue.
- Based on recent prices, we forecast Charles River's stock has the potential to produce double-digit annualized returns over the next 3 to 5 years.
Background
Charles River Laboratories (CRL) provides contracted research services and solutions to the pharmaceutical and biotechnology sector. Originally founded in the 1940s to provide rodent research models, the company has grown into one of the largest providers of research services and manufacturing solutions to the biopharma sectors.
CRL June 2022 Investor Presentation
CRL operates in several areas across the pharmaceutical and biotechnology research and development value chain. The trend from large pharmaceutical companies to outsource parts of their drug development and the increase in venture capital funding in biotech companies has resulted in an acceleration of growth within the contract research organization ("CRO") market.
Biotechnology companies do not have the resources to build their own R&D operations, hence they outsource significant portions of their efforts to CROs like CRL.
The trend in outsourcing and the growth of investment in biotech companies provides the potential for CRL to organically grow in the low-double digit to mid-teen percent range for several years.
CRL has also supplemented their organic growth with acquisitions that help the firm gain exposure to emerging therapies and trends. Accretive acquisitions in combination with double-digit organic growth and a highly profitable business model should lead to mid-teens EPS growth for at least the next 5 years, well above what is expected for the S&P 500 and the health care sector.
We originally recommended the stock to our marketplace subscribers in the summer of 2022 after the stock had fallen to ~$200 from its pandemic high of $450. Investors and analysts were starting to question whether the company could keep growing if biotech funding started to dry up. However, these concerns have so far been largely unfounded as financial performance in 2022 was excellent.
Recent Financial Results
Charles River showed strong momentum in its business as its fourth quarter of 2022 was the strongest quarter in the company's history. Adjusted EPS was $2.98 vs. an estimate of $2.74. Revenues were up 22% y/y to $1.1 billion, which beat the average analyst estimate of $1.03 billion. Organic revenue growth was up 19% y/y. The company's Research Models and Services ((RMS)) and Discovery and Safety Assessment ((DSA)) segments both generated revenues above expectations. The only disappointment was that Manufacturing Solutions' revenues were 1% below estimates.
NHP Supply Issues
While the 4th quarter was one of the strongest quarters in company history, unfortunately guidance for 2023 was disappointing. The company disclosed that last week (Feb 17th) it received a subpoena from the DOJ requesting information about non-human primates (NHPs) it received from Cambodia.
Management has voluntarily decided to suspend all shipments of NHPs from Cambodia until it can develop a program with the U.S. Fish and Wildlife Service. Importantly, CRL must verify the heritage of NHPs imported from their Cambodian suppliers. Cambodia supplies ~60% of all NHPs imported into the U.S. and 60% of Charles Rivers supply. Management expects CRL's reported revenue growth rate to be negatively impacted by 200bps to 400bps in 2023
Below are a couple slides from the earnings presentation.
Charles River Laboratories Fourth Quarter 2022 Earnings Presentation Charles River Laboratories Fourth Quarter 2022 Earnings Presentation
2023 Guidance
CRL guided to reported revenue growth of 1.5% to 4.5% and organic revenue growth of 4.5% to 7.5%. Organic revenue growth would have been in line with the company's medium-term targets of low-double digit organic growth without the 2% to 4% impact of the NHP supply constraint issues. The upper end of guidance assume that the company begins to import NHPs from Cambodia starting in Q4 of this year. The lower end of guidance assumes that there's no NHPs imported from Cambodia this year.
Naturally, slower revenue growth will result in lower EPS growth, which management guided to $9.70 to $10.90 ($10.40 at the midpoint) . That's ~$1.10 below what the street was expecting for FY2023.
Based on management's commentary, if the company were able to achieve ~3% higher revenue growth and margin expansion that management was originally expecting, EPS guidance would probably have been ~$11.63 at the midpoint . That is $0.11 per share above the average 2023 street EPS estimate of $11.52.
The guidance, subpoena, and voluntary suspension of NHP imports is obviously disappointing. The stock's $30 decline over the past few days is not surprising given how swiftly health care investors seem to be willing to sell a stock. A $1.10 miss on EPS guidance at a 20.5x multiple results in an estimated decline of $22.55 in the stock, implying an overaction in the stock.
Long-Term Outlook Still Intact
Our initial thoughts are that this issue is temporary, only likely to impact 2023. Long term growth expectations have not changed, and this just delays revenues for a year or two.
CRL's position and importance to the future of new drug and therapy developments is unlikely to change. Biotech and pharmaceutical firms continue to outsource more and more pre-clinical work to companies like Charles River.
Unfortunately, it is unknowable how long these NHP supply issues are going to last. But based on management's comments and guidance it seems that this is a 10 to 12 month issue. We would expect that any positive developments as it relates to NHP supply will result in a significant increase in the company's stock price (perhaps immediately).
It is important to remember that access to NHPs is vital to the future of biopharmaceuticals. Large cell pharmaceuticals require non-human safety assessments before they can be brought to clinical trials. This includes ALL vaccines, cell, and gene therapies, etc.
Also importantly, the other major global supplier of NHPs is China, which shut down their exports during the outbreak of Covid. These exports are unlikely to restart, ever. China aims to be a global leader in drug development, and they know how important NHPs are to the process.
If the supply constraints drag on for too long, it only enables China to catch up to the U.S. (an industry the U.S. has come to dominate). If this drags on for too long, the Biden administration may intervene to speed up this process.
Charles River Laboratories Fourth Quarter 2022 Earnings Presentation
Valuation and Return Forecast
Assuming NHP supply headwinds abate in late 2023 or early 2024, we are modeling EPS of $12.68 in 2024 . At an average multiple of ~20x, CRL is a $253 stock in 12 to 18 months , or up ~16% from recent stock prices. Downside could be $175 in a bad tape.
Overall, we think a position below $220 is warranted, while seeking to acquire more shares if the stock dropped below $210, and a fully loaded position if the stock fell into the $190s.
Conclusion
Charles River Labs is an impressive compounder, whose long-term growth story has been temporarily disrupted by these NHP supply headwinds. The stock's 12% decline this week has presented a great opportunity to begin to accumulate shares as the stock has the potential to produce double digit annualized returns over the next 3 to 5 years. Additionally, while recession concerns have come down significantly in recent weeks, if a recession were to occur, it is likely that the nature of the CRL's business would allow the company to remain resilient in an economic downturn.
The outlook for outsourcing from pharma companies and the increasing investment interest in biopharma companies is a trend that should give CRL the opportunity to generate significant value for shareholders in the medium to long term.
A starter position is warranted in the $210s, and the stock is a pound the table buy in the $190s. Strong EPS growth combined with a reasonable exit P/E ratio could drive 12%+ annualized returns for the next 5 years.
For further details see:
Charles River Laboratories: Buy This Compounder After The Recent Decline