2023-07-26 02:05:15 ET
Summary
- Charles River Laboratories' share price has declined over 50% from its 2021 peak, presenting a potential buying opportunity for investors.
- The CRO company is facing headwinds from COVID's overhang and funding constraints amid higher interest rates.
- The long-term outlook of the CRO market remains favorable, and the latest earnings were solid, despite a slowdown in certain segments.
- Current valuation has become extremely discounted compared to other CRO companies and its own historical average.
Investment Thesis
After a strong run during the pandemic, Charles River Laboratories ( CRL ) is now down over 50% from its all-time high in 2021, as the industry is being impacted by the pulled-forward demand in the past few years. I believe the huge pullback presents a compelling buying opportunity for investors as the company's fundamentals remain solid. It should continue to benefit from the long-term expansion of the CRO industry and the latest revenue growth was strong. The current valuation is also very attractive, which should present ample upside potential moving forward.
Huge Market Opportunity
Charles River Laboratories is a life science CRO (contract research organization) that provides different products and services for drug research and development. It currently serves over 5,000 clients with the majority of them being from the biopharma industry. The Massachusetts-based company is divided into three major segments: RMS (research model services), DSA (discovery and Safety Assessment), and manufacturing.
The RMS segment provides research models, screening solutions, and customized components for cell therapy development and production. The DSA segment specializes in drug discovery, development, and safety studies. While the manufacturing segment help ensure the safety around the production and release of manufactured products.
CRO is a huge and rapidly growing market. According to Fortune Business Insights , its global market size is forecasted to grow from $82.6 billion in 2023 to $188.5 billion in 2030, representing a strong CAGR (compounded annual growth rate) of 12.5%. The market expansion is driven by the ongoing increase in R&D (research and development) spending from biopharma companies, which has been rising consistently as their competitive advantage is highly correlated to their spending. The trend may further accelerate as biosimilars are now impacting the sales of previous-developed drugs, as seen with AbbVie's ( ABBV ) Humira.
The market is also benefiting from the increasing popularity of outsourcing. Due to the complexity around R&D, many customers are now outsourcing parts of the process to CROs in order to improve efficiency and save on costs. I believe this should be another major tailwind for Charles River.
Near-Term Headwinds
Charles River has been facing some headwinds in the past year due to unfavorable COVID and macro conditions. Many of its customers are cutting down on R&D spending as they pulled forward a lot of their budget during COVID to capitalize on the trend. This is especially noticeable around smaller clients as they are pressured by rising interest rates, which significantly impacts their funding. According to fellow CRO IQVIA ( IQV ), the number of funding deals declined 20% from 2,500 in 2021 to 2,000 in 2022, while the total funding dropped 23.2% from $54.8 billion to $42.1 billion.
While this may weigh on the company in the near term, the impact should be temporary. As mentioned above, many companies' competitive advantages are built upon their R&D spending, therefore I believe spending will not be compressed for too long. We are also moving toward the end of the tightening cycle as the Federal Funds Rates will likely peak in the coming meeting, which should take some pressure off of funding as well.
Jim Foster, CEO, on near-term headwinds
Clients appear to be more thoughtful about their spending and have prioritized their programs at the beginning of the year. This is not surprising in light of the changing macroeconomic factors that are present today and the unprecedented level of biomedical research activity that occurred over the past several years. However, we still believe that our client base remains adequately funded with one sell-side analyst recently estimating that public biotechs still have about three years of cash on hand.
Solid Financials
Unlike the share price, Charles River's latest earnings were actually pretty solid in opinion The company reported revenue of $1.03 billion, up 12% YoY (year over year) compared to $914 million. The growth was largely attributed to the DSA segment, which grew 21.7% from $544.3 million to $662.4 million amid higher volume and pricing. The RMS segment was also solid, up 13.2% from $176.5 million to $199.8 million, driven by the demand for research models. The manufacturing segment declined 13.4% from $193.1 million to $167.3 million, as testing volumes were lower amid the ease of COVID.
The bottom line was largely in-line with the top line. The operating income increased 12.8% YoY from $148.8 million to $167.9 million. The operating margin was flat at 16.3%. The net income was slightly softer, up 9.2% YoY from $95.2 million to $104 million, as it was being impacted by higher interest expenses and income taxes. The diluted EPS was $2.01 compared to $1.81, up 11% YoY.
The company is reporting its second-quarter earnings in early August and revenue is expected to be $1.05 billion, representing a YoY growth of 8.3%. I believe the company will likely report numbers in-line with the consensus, but it's more important to focus on management's commentary on end-market demand. The R&D spending trend from biopharma customers will be key as it dictates the company's near-term momentum.
Discounted Valuation
After the massive decline in share price, Charles River's valuation has become extremely attractive in my opinion. The company is currently trading at an EV/EBITDA ratio of 12.8x, which is discounted compared to both peers and its own historical average. As shown in the first chart below, the peer group including ICON ( ICLR ) and Medpace ( MEDP ) has an average EV/EBITDA ratio of 19.7x, which represents a significant premium of 53.9% compared to the company. As shown in the second chart below, the current multiple is now also near the low end of its historical range, trading at a discount of 31.9% compared to its 5-year average EV/EBITDA ratio of 18.8x.
Investors Takeaway
While Charles River Laboratories is facing some headwinds in the near term amid COVID and funding constraints, the recent decline in share price seems largely exaggerated. The uncertainty around the macroeconomy is a potential risk, but the long-term market opportunity of CRO remains highly favorable, as biopharma companies are poised to keep increasing their R&D spending in order to strengthen their positions. A rebound in spending could be a major catalyst for the company moving forward.
The company's overall financials were also resilient despite the decline in certain segments such as manufacturing. With the current valuation being deeply discounted, I believe a lot of the headwinds should already be priced in and multiples should start to expand as the overall backdrop improves. Therefore I rate the company as a buy.
For further details see:
Charles River Laboratories: Very Attractive After The Pullback