Charles River Laboratories: Not The Right Time To Own At This Point In The Cycle

seekingalpha11-19

Charles River Laboratories presents with optimistic growth expectations that seem a stretch given the business's current performance.Weak momentum in both stock price and business fundamentals, ...

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(NYSE:CRL) the stock has drifted 7% to the downside, and now we've got to take stock of where we're at with this name. Three factors stand that help guide decision-making for sound investment management from here:  The business is reasonably priced at 15x forward EBIT, but that's calling for $12.35/share in pre-tax earnings next year (vs. 20x/$9.97/share trailing, or ~32% YoY growth). This seems a stretch for this business for reasons I'll discuss here, and my view investors are overly optimistic in calling for that level of bottom-line growth. On that basis, my view is 20x is too expensive for anything remotely close to $10 EBIT/share for CRL, and that leaves too much floorspace to the downside. As such, valuations aren't cheap, bringing expectations high. Momentum leading into this report has been weak on a price basis, with CRL in a continued downtrend since May. The healthcare sector is down 15% in the past 6mo and >17% in the last 9mo. Expectations are tempered by this, providing support for the risk/reward symmetry. But fundamental momentum is also low. My view is the economic quality of this business in investment terms is 'neutral'. It earns a sector-wide ROIC of ~8–9% on a rolling TTM basis, but these have contracted sharply, driven by tighter operating margins. It isn't low-quality given the work it does and the economics of the industry it resides in, notwithstanding its competitive position. But this isn't what I'd dub as a high-quality business for investment purposes right now.  So we have (i) optimistic valuations, (ii) soft momentum on price and business returns, and (iii) low factors of quality. Let's call [i] and [ii] risk, and [iii] reward. In this instance, there isn't an asymmetrical risk/reward opportunity. Investors are paying full price, but at least the momentum is weak leading into the position (leaving room for upside risk). Fundamentals are also deteriorating, and there's no added economic incentive to own this business in terms of its reinvestment capacity or current earnings power. Management is focused on restructuring and restoring operating margin and returning capital to shareholders (buybacks)—both prudent moves in the scheme of things, but on the investment matrix, not enough to move the needle just yet. Alas, the risk/reward is skewed away from our favour in my best estimation. But I'm watching very closely. There is upside risk here due to the weak momentum and softer fundamentals. If valuations come down...there might be something worth looking at. Net-net, reiterate hold. Figure 1. TradingView What's happened? (1). Q3 FY'24 earnings insights Plenty is gleaned from the situation from the company's Q3 numbers. It put up $1Bn of quarterly sales (-190bps YoY) and results modestly exceeded the revised guidance from August. Management slightly raised full-year guidance, now projecting a 3–4% decline at the top line (vs. consensus -250bps or $4.03Bn) and earnings of $10.10–10.30 (vs. consensus of -450bps o $10.18/share). Whilst this is a revision to the upside, the fact downsides are expected can't be overlooked when the business still trades at ~20x trailing EBIT. To me, this hasn't been fully priced in. Turning back to the quarter, the segment breakdown was as follows:   Discovery and Safety Assessment (\"DSA\"): Revenues were down 7.4% YoY to $615mm. Pricing remained flat but is expected to decline slightly in Q4, and I'm not surprised given the current cautious demand environment in biotech + life sciences + the net book-to-bill ratio was <1 (higher cost of capital, less benign pricing environment).  Research Models and Services (\"RMS\"): Sales were +600bps YoY and put up $197.8mm on the back of 1) higher pricing and 2) increased small model sales in China. Declines in unit volumes for small models in North America and Europe were attributable to large pharma spending cuts and a slowdown in new biotech company formation.  Manufacturing Solutions: Sales were +11.8% YoY organic, underscored by demand/volumes across all businesses, particularly in the contract development/manufacturing organization (\"CDMO\") and biologics testing.  My views of the quarter are they largely fall in line with the broader trend in earnings and fundamental momentum for the business. Whilst these can be good opportunities on the perspective of upside risks, my view is the quality aspect isn't there to justify a more constructive opinion just now. (2). Leaning up operations CRL is undertaking significant restructuring initiatives to enhance efficiency + align its cost structure with the current demand environment. Actions include 1) reducing total headcount by >6%, and 2) consolidating ~15 smaller sites by FY'26 to generate ~200mm in annualized cost savings. If successful, this should eliminate >5% of its cost structure. This is something to consider—higher operating margins for this business would be a major positive. We've seen the sensitivity of market values to the wind back in operating profit, thanks to the ratio of operating earnings to sales declining. I'd naturally expect some upside in market, with a reversion to the mean in operating profit. Figure 2 Company filings, author But turning to the specifics, the company faces several challenges:   The demand environment remains subdued, particularly among small- and mid-sized biotech clients. Biopharma licensing + partnerships are down vs. FY'20 and worse still the share of upfront funding in all deal values is only ~6% as of Q3 '24. So even though forward-looking indicators show slight sequential improvement, the recovery is more gradual than anticipated. This includes the push to expedite phase 2 assets for many in the sector. Added to this, major pharmaceutical clients are undergoing significant restructuring, leading to tighter budgets and accelerated pipeline reprioritizations, which has decreased revenue from this segment.  Pricing pressures persist in the DSA business. Management expects the inability to pass-thru cost increases amid competitive pressures and a softer demand environment to compress margins further. It also says that increased unallocated corporate expenses (in health and fringe-related costs) have eroded operating margins.  But operating earnings have been pressured by reduced high-margin revenue streams, particularly in the DSA + RMS segments. Flat to negative pricing trends limit margin expansion, and increased operational costs further compress the ratio of operating profit to sales.  CRL's challenges are intrinsically linked to its clients' R&D expenditure trends. Reduced spending on drug discovery and early development directly affects demand for the company's services. This has been the case since 2021. Thankfully, we might be exiting the lull period, with the top 20 R&D investments in 2024 tallying $148Bn or the year so far. But this is down from $180Bn the year prior.  Consequently, management's moves to unlock value are twofold:   Cost leadership/optimization. Implementing restructuring initiatives to generate significant cost savings. Headcount is <6% vs. '23 with further reductions and site consolidations expected. These actions are expected to eliminate more than 5% of the cost structure and enhance operational efficiency, or ~$200mm annualized.  Stock buybacks. Reinitiating modest stock repurchases totaling ~$100mm in the third quarter reflects confidence in the company's intrinsic value. Strong free cash flow generation and moderating capital intensity support this decision, although it also signals limited high-return investment opportunities in the current environment.  Valuation insights CRL has traded down from 3x Ev/IC to less than 2x over the span of two years, as seen below. The price investors are willing to pay for a dollar of post tax earnings in this business has compressed from more than $80 down to $13.80 at the time of writing. Investors have marked CRL's business assets in the market at a drastically lower level since 2022. All new capital that management has rolled in over this period has been valued at -$6.40 for every dollar of reinvestment (Figure 3). This tells me earnings retained and subsequently reinvested by this business are valued at less than one dollar in the market. From an opportunity cost perspective, this simply will not do, and my question is: What would suggest this trend might reverse? Figure 3. Company filings, Author Figure 4. Author For answers, I've analyzed the distributions of key operating factors for the life sciences tools and instruments industry (Figure 5).  Pre-tax margins are mostly centred ~13% to 20% for the industry, and CRL falls within this peak of the distribution (Figure 5). Similarly, it is positioned around the bulk of the pack in terms of asset turnover but enjoys slightly above median returns on capital, as mentioned earlier. It is important to mention, however, that the majority of the industry is \"unprofitable\" from a GAAP accounting perspective. Several adjustments have to be made to capitalise R&D investments that are expensed on the income statement to reflect actual capital injections, with corresponding charges against earnings also adjusted. As such, these figures might be slightly misleading, but they are applicable to the entire data set. CRL also produces about average net profit per employee relative to the group. However, trades towards the right side of the distribution in terms of relative valuation multiples. Consequently, we have a fairly explainable situation. CRL offers no statistical advantages over similarly priced/risked peers in the industry. As a result, any abnormal or outsides returns (both in business returns and stock market returns based on this) have reverted to the main at a rapid pace. It is now producing industry level business returns.  Figure 5. Bloomberg Finance LP, Author My views are that compounding ability from here is therefore limited, given the fact all new capital is currently being <$2 in the market. My numbers shown in Appendix 1 call for a market valuation of $196 by FY'26 at 1.9x invested capital of $6.5 billion. This supports a hold rating. Figure 6. Author's estimates Risks to thesis Downside risks to the thesis include 1) continued compression of returns on invested capital, 2) continued tightening of operating margins which will compress earnings further, and 3) a spike in inflationary inputs for manufacturers and suppliers which could erode both of these factors further. On the upside, management could reverse the situation, and cost-saving efforts could flow positively to the operating line. This could result in a slight loosening of multiples, and inflect positively on the stock price, not to mention earnings. Investors should familiarise themselves with these risks in full before proceeding any further. In short CRL remains a hold at this point in the cycle, in my view, given the combination of fundamental and market-based factors. Principally, the business is in a cycle of earnings contraction and is focusing on operating efficiencies and consolidating operations to clean up its cost structure and drive profitability. Without evidence of this being executed successfully right now, I don't believe it is the right time to own CRL at this point in the cycle. I am watching closely given management's efforts and what the outcome of these might be. Net-net, reiterate hold at a valuation of $196 per share. Appendix 1.  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