Ladies and gentlemen, thank you for standing by. Welcome to the Charles River Laboratories' First Quarter 2019 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to Mr. Todd Spencer, Corporate Vice President of Investor Relations. Please go ahead.

Thank you. Good morning, and welcome to Charles River Laboratories' First Quarter 2019 Earnings Conference Call and Webcast. This morning, Jim Foster, Chairman, President and Chief Executive Officer; and David Smith, Executive Vice President and Chief Financial Officer, will comment on our results for the first quarter of 2019. Following the presentation, they will respond to questions. There's a slide presentation associated with today's remarks, which we posted on the Investor Relations section of our website at ir.criver.com. A replay of this call will be available beginning at noon today and can be accessed by calling 800-475-6701. The international access number is 320-365-3844. The access code in either case is 466217. The replay will be available through May 21. You may also access an archived version of the webcast on our Investor Relations website. I'd like to remind you of our safe harbor. Any remarks that we make about future expectations, plans and prospects for the company constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by any forward-looking statements. During the call, we will primarily discuss results from continuing operations in non-GAAP financial measures, which we believe help investors gain a meaningful understanding of our core operating results and future prospects. The non-GAAP financial measures are not meant to be considered superior to or a substitute for results of operations prepared in accordance with GAAP. In accordance with Regulation G, you can find the comparable GAAP measures and reconciliations on the Investor Relations section of our website through the Financial Information link. I will now turn the call over to Jim Foster.

Good morning. In the first quarter, we saw a continuation of the robust business trends that we experienced throughout the second half of last year. Organic revenue growth for each of the three segments was at/or above our long-term targets. We attribute this performance to the success of our ongoing efforts to enhance our position as the leading early-stage CRO as well as the strong industry fundamentals, including biotech funding. Overall, we believe our first quarter performance supports our solid outlook for the year. By continuing to invest in our portfolio, our people and our infrastructure, we believe we are maintaining and enhancing our leading position among early-stage CROs and our ability to support our clients' diverse research needs. The acquisition of Citoxlab, which was completed on April 29, is another step forward in our strategy and will enable us to deliver incremental value to clients. The success of our strategy was validated by the fact that we worked on 85% of the FDA-approved drugs in 2018 and have discovered 80 novel molecules for our clients. Before providing further details on our first quarter performance and the Citoxlab acquisition, I will briefly comment on the cybersecurity incident that we disclosed last week. On April 30, we notified clients of unauthorized access into portions of our information systems after recently determining that some client data was copied. This incident did not disrupt our day-to-day operations and was not a malware or ransomware attack. Further details on this incident can be found in our 8-K filing and on our website. We have reached out to affected clients, which represents approximately 1% of our total number of clients. The client response has been appropriately measured to date, yet most were understanding. I was struck by the collaborative nature of many of our client…

Thank you, Jim, and good morning. Before I begin, may I remind you that I'll be speaking primarily to non-GAAP results from continuing operations, which exclude amortization and other acquisition-related charges, costs related primarily to our global efficiency initiatives and certain other items. Many of my comments will also refer to organic revenue growth, which excludes the impact of acquisitions and foreign currency translation. Highlights of our first quarter performance include a continued robust revenue growth, which was above the 10% level on an organic basis, and earnings per share that were in line with our outlook from February. In addition, we are pleased to have completed the $500 million acquisition of Citoxlab. We have already begun working with their talented team to share best practices and drive operational synergies between our businesses as we move forward with the integration process. First quarter non-GAAP earnings per share were $1.40, an increase of 8.5% from $1.29 last year. The primary driver to earnings per share growth was better-than-expected organic revenue growth of 10.8%, partially offset by a softer first quarter operating margin. On a year-over-year basis, the first quarter operating margin declined by 50 basis points to 16.3%. Similar to last year, the first quarter operating margin was expected to be the lowest level of the year due primarily to seasonality in the Biologics business and higher fringe costs. The impacts of the large RMS government contract with NIAID, the headwind from the compensation structure adjustments implemented on July 1 last year and the capacity expansion in the Biologics business all reduced the operating margin in the first quarter as anticipated. In total, these items reduced the operating margin by 60 basis points. We expect each of these factors to either be anniversaried or become a much smaller headwind in the…

That concludes our comments. Operator, we will now take questions.

[Operator Instructions]. Our first question comes from the line of Tycho Peterson with JP Morgan.

Maybe, Jim, starting with research models. I think you noted softness some outside of China, in particular for large biopharma. Can you maybe just elaborate on that a little bit?

Yes. Sure. It's always related to infrastructure and capacity management, and usually, reductions by these clients. So we saw some more of that. The business is on linear so it's pretty difficult to call the quarters, but pharma has been reducing their overall R&D footprint for several years. As we said previously, we are disproportionately impacted by that since we're the principal supplier to big pharma. So China continues to be really strong for us. We'll continue to be -- services had a strong quarter. Organic surprise is probably seen on the academic marketplace and the nongovernmental clients as some of them have an offset to the pharma reductions, but nothing unusual, Tycho.

And if I could ask one related follow-up. We did see an interesting strategic move with the asset transfer between Envigo and LabCorp-Covance this quarter. Did that change anything from your perspective competitively?

Not really. That was to be anticipated for sure. We're the largest player in the research model space. So they will continue to be a competitor of ours. They compete with us in some of the species that we produce; and others, we don't participate in at all. So the sort of standalone business that's left at Envigo will be a competitor of ours as it has historically, primarily in price, I would say, as opposed to really deep science. And the combination of Covance and the former Hannington will -- obviously makes a larger player on the international field in safety assessment. We're about 50% larger than they are at this [indiscernible]. And we will continue to distinguish ourselves with deeper science and greater geographic dispersion than they. The market is a really good one. Between the 2 of us, we have about half the markets. So there are much, much smaller players so there's a balance. There's de novo work appearing all the time from new clients -- biotech clients that's available to any of us. And so we feel we are very good about the strength of our franchise, really good about the three deals we've done in the last 3 years, WIL, MPI and now Citoxlab, and just the enormous geographic and scientific footprint that we have. So to be expected, I would say there's some change. We acknowledge and accept that. We're feeling increasingly safe -- increasingly a stronger franchise.

Our next question comes from the line of John Kreger with William Blair.

This is Courtney Owens on for John Kreger. Just a quick question on the cyber issue that you guys have said a little bit earlier in the call. I didn't see it in the 8-K. Did you -- or have you guys -- or do you plan to, I guess, disclose at all about how long it was going on before you guys caught it?

We did. We can disclose it again to you now. So we saw some unusual activity in our system in the middle of March. We don't know what that was or where that was or what was going on, and we worked arduously with federal law enforcement and some cybersecurity experts to figure out what was going on. It took us a while to do that. We found that some data had been copied. And it took us until just recently, April 30, to discern what clients were impacted and how they were impacted. We've contacted all of those clients, by the way. So they tell us that caught it extremely quickly. It takes most people much longer to do that. So I think our systems identified something unusual, and we were able to identify specifically who was impacted and contact them immediately. So we're feeling not good about the incident but really good about our response time and how clients have taken the information we provided them.

Our next question comes from the line of Ross Muken with Evercore.

It's Luke on for Ross today. Just kind of want to dig in a little bit more on the margin dynamics, if you could break out kind of the magnitude of the various impacts, there's a lot of moving parts there. And ultimately, looking forward to the outlook for the year, the NIAID contract, kind of that rolling off and then how -- the rest of the margin pressure for the year.

Okay. So I'll take that. Obviously, margin is an important question for us, and I know it's an important question for you. So why don't I go through all the pieces? So you should be familiar with -- Q1 is normally down. Seasonality and Biologics is the fringe. Q1 was 50 basis points down further than last year. So that needs explaining. 60 basis points of that is 3 components: The largest component to that is the compensation structure adjustment that we announced in July last year. The second largest component to that is the Biologics capacity expansion. Another smaller piece was the drag on the NIAID contract. So those 3 pieces make up 60 basis points. And just talking about the Biologics capacity, just to comment on that. Manufacturing had a 90 basis points degradation, 80 basis points is added entirely attributed to the capacity expansion. So that's breaking out the quarterly pieces. We did expect DSA to be slightly better. It was flat. I will call out that the compensation structure adjustment gives us 60 basis points -- slightly, slightly over 60 basis points headwind in the quarter for DSA. In Q3, we had a similar headwind. Q4 last year, we had a similar headwind. Both of those quarters, we had margin improvement year-over-year. So we were expecting to see that in Q1, but we were flat. Notwithstanding that, there's -- it's not a linear business. We've had some investments in staffing in Q1, which we'll see the benefits in the second quarter. As Jim called out, we will see margin improvement, and going forward, second half of the year will be better than the first half of year. It's not unusual for DSA, and particularly Safety Assessment, to have a stronger second half than the first half. And so that will enable us to have some confidence for the remaining year's margin. And then we did call out that we got a bit of a drag going forward on Citoxlab, mid-teen margin, similar to what we had with WIL. We did successfully walk WIL margins up in the two years that we promised. And we will and still expect to be able to do that we Citoxlab going forward as well.

That's very helpful. Then I guess just more on thinking about China outside the RMS business. I kind of get that RMS is your foothold into the research market and then gaining share there and then you kind of roll in the other businesses. When can we expect the bigger investment in the DSA and Manufacturing, if at all, that is, in the strategy in China?

We think that eventually we'll have our entire portfolio and footprint in China, principally for the Chinese market. And as we've said a couple of times previously, M&A in that space, which is our preferred methodology of entering China, is tough given the evaluations and the public markets over there. So we'll minimally wait until that market cools off, assuming that it ever does. And if not, we'll have to look seriously at -- on going at it organically. There's a big market for us in the RMS business so we're going to stay focused on that for a while. It's going to require us to continue to build sites and reeducate the marketplace, which we've been doing very well. We have some RMS services associated with the research models business. So in time, I would say nothing imminent. I wouldn't expect anything for -- in the immediate future though.

Our next question comes from the line of Robert Jones with Goldman Sachs.

I guess, David, just to go back to the margin question. I want to make sure I was following this. And I was more focused specifically on the DSA margin because that, I guess, you highlighted, came in a little bit lighter than you and what we were expecting. But it looks like based on the slides, you're expecting that to rebound back to 20-plus percent, I think, beginning next quarter. Sounds like you're still facing the wage increases, and you mentioned the mix shift being negative with Citoxlab. So just trying to understand the visibility and the moving pieces as we think about the model forward on the DSA margins. What gets us from the 1Q levels to that 20-plus percent as we move into the next quarter and beyond?

Well, just to give you a little bit more color then. If you look at Safety Assessment and you look historically, historically, just going back to the few years, so recent history, we've had a second half in Safety Assessment being greater than the first half by somewhat over 50 basis points, so just under 500 basis points. So there are different reasons for that. Some is price. Last year, we talked about the long-term steady mix. This year, it is a little bit of that anniversarying the compensation structure adjustment. We did beat that in the second half of the year of last year. So really, it's -- there isn't much more the cook -- pull out. It's just that we're not a linear business. We've had some of the investments in staffing to support the really strong and robust revenue growth that you've seen this morning. And we're expecting that to have [indiscernible] as we go through the year, we needed to staff up for the demand that we were seeing in our order books, et cetera. So again, yes, to reaffirm, we would expect the Q2 to be above the 20% margin. And as we move through the year -- the second half of the year, we'll be better than the first half.

And I guess just one point of clarification on the modest IT remediation costs. Do those fall in DSA? Or is that in other segments? Or is it kind of spread across the business?

So why don't I unpack that a little bit for you? So as Jim called out, we're not expecting that to be a material impact for the year. It is still early days. We've got some preliminary assessments which give us that confidence, particularly in the remediation aspect. We will -- we've got insurance to -- which will partly cover some of those costs. It won't cover it all. So the third-party, adviser-related to cybersecurity costs to do with the remediation aspect, some of that will be non-GAAP. But for anything that's internal or anything to do with the enhancement that will continue to be part of our business, I'm not sure that will be in corporate. Some of it will be spread but not -- I wouldn't like to characterize that as a major drag either for total Charles River, and therefore, not for DSA.

Your next question comes from the line of Jack Meehan with Barclays.

Now that the Citoxlab deal is closed, I was wondering if you could just give us a little bit more color on some of the customer overlap between the businesses and the $115 million to $130 million contribution this year. Just what does that imply for their growth over the balance of 2019?

So the customer overlap is slightly less than the overlap for MPI, so similar. We would remind you that with both WIL and MPI, clients have gone there for a specific reason and not come to us, probably because they wanted to work with a smaller company. So they were now clients of a larger company. And in both instances, we worked really thoughtfully and arduously to retain those clients, and we didn't lose any. So similarly, with this deal, we have a bunch of new clients who went to Citox for a host of reasons: history, reputation, whatever, geographic proximity. We will very carefully service those clients in the geographies that they're in. We will -- and we hope that we will derive the same results that we had with the other 2 deals, which is that we have immediately had former MPI and WIL clients use multiple CRL sites and vice versa. So legacy Charles River clients now happily -- have happily audited in utilizing WIL and MPI sites. We think the same thing will happen with Citoxlab. And as I've said in my prepared remarks, and we've been saying this for a while now, I just want to reiterate it because it's critically important, client mobility is something we're focusing a lot on. And so that's clients being pleased to do their work at multiple Charles River sites. So we can take advantage of our infrastructure and keep it full. They can start studies faster. And if that's what's important to them, they can start studies more closely related -- more close to them. Without getting too specific, I would say that the growth rates for the company we just bought is similar to what we've been seeing in our marketplace. We feel that the market dynamics are as good as we've ever seen them. Bookings and backlog are strong, and we're going to work really hard at the integration so that it's seamless and effective. And we will be surprised and disappointed if we're not able to retain these clients as well.

Great. And as you get into the merger, could you just outline for me the capture of the synergies, what you're expecting in terms of the timing there? And as we sit here today, I know there's been a big focus on the margin point. Do you think DSA margins can return to expansion? Is that what we're looking at in 2020?

So on Citoxlab, $8 million to $10 million of synergies over 2 years. We -- similar to when we did WIL, MPI, we didn't break out that synergy in-year. So we haven't broken out how much of that will fall into 2019. However, once we have achieved the $8 million to $10 million, that does enable us to get Citoxlab's margins up to the 20% mark, which is, of course, our first and initial target. In terms of your second question, which is around the expansion of, I think, did you say DSA? Or should I talk...

Just on the DSA segment overall.

Yes. Well, we have -- as I've just mentioned just a moment ago, we do expect that to improve as we go through the second half of the year. I'm not quite sure what more color I can provide.

Our next question comes from the line of David Windley with Jefferies.

Congrats on the quarter. Jim, I joined late but I did hear you just reiterate the strength of the environment, and that shows through on your revenue performance. In DSA, I had thought, I guess, that the contribution of high-margin MPI starting in 2Q of last year might average up the DSA margin performance relative to the first quarter of last year. And it looks like it was more kind of in line year-over-year, so I may have missed some of the factors that impacted that. But if you could help me with the kind of pull-through to EBITDA or EBIT on the better revenue growth, I'd appreciate it.

Well, I guess the conversation goes back to the linearity of DSA. I mean as I mentioned before, we've had history where we've had Safety Assessment second half over 50 and under 500. That just shows you the difference that can happen in the second half of year compared to the first half of year. So we constantly reminded people we're not a linear business. We are holding true to the guidance for the full year. We're holding to the guidance in terms of the DSA's ability to grow. Yes, as I acknowledged, we didn't see as much pull-through in the first quarter in the margin as we had hoped, but we at least were level despite the 60 basis points headwind from the compensation structure adjustment. The macroeconomics look good. And we've seen -- feel confident that when we annualize some of these headwinds, like the stock -- the compensation adjustment, et cetera, that, that will help improve the margins for the second half of the year.

Got it. You may have mentioned this, and again, I apologize, I joined late. But were there -- was it simple mix factors? Or was it more an SG&A type of issue? I guess and rolled into that, some of the channel checking that we've done lately suggests that in the last 6, 7 months or so, that the pricing environment, if anything, is probably firmed up. That had -- at least directionally, it's better not worse. So just again trying to understand some of the specific factors that influenced the first quarter.

So again, we -- there wasn't -- the only thing I've mentioned in terms of the first quarter that's a little unusual was there was some timing of investments around staffing to support the growth rate that we're expecting for Q2, et cetera. There is inevitably a component of mix in there and inevitably a component of price. So those clearly take place within a quarter-to-quarter basis. But really, what we're trying to guide you towards is that we still feel confident for the full year.

Your next question comes from the line of Stephen Baxter with Wolfe Research.

Hopefully, a pretty simple one on the quarter. So I want to make sure that I'm following the adjustment to interest expense. It looks like this adjustment decreased non-GAAP interest expense despite it being described as an FX loss. So I don't see an adjustment for this in your reconciliation at the back of the release. It seems like what you're saying is that this is offset by a similar item in other income. So just to put this one to bed, did this item help the adjusted results, hurt the adjusted results or have no impact?

No impact.

So there's no impact from that. But while I've got the floor, I'll just comment a little bit about why we said a little bit more about the interest. So many of you will be aware that EURIBOR is negative. Our credit agreement didn't actually allow us to access that. We have a floor of 0. So to get around that, we used a forward derivative FX contract. Essentially what this does is you get -- you borrow in US dollars, and therefore, the interest rate goes up. But the actual FX contract has a gain component and a loss component. The gain component actually goes into interest line and actually pulls the interest down. The loss component actually goes into other income. So what we were articulating is when you bring all of those components together, we then got to the -- just over the $16 million, $16.2 million of interest, which is down from Q4 of last year.

So then as you report the year, we should kind of expect the trajectory of net interest expense, as you reported on the face of the P&L, to be similar to what you did in the first quarter with the similar adjustment in other throughout year. Is that the right way to think about how to look at it now?

So there is -- yes. This forward derivative, we do it quarter-by-quarter. We lock in each quarter so we've got no exposure. And it depends what the FX does and the EURIBOR rate does. So it's not a big gain. I mean if everything held true for the remainder of the year, we're talking about $1 million. So it's not a great improvement, but it is an improvement, and well, we'd rather have $1 million than not.

And our last question comes from the line of Tim Evans with UBS.

I'd like to go back one more time to the DSA margin, if you don't mind. If we look at your expectations that you laid out last quarter for that, you did indicate that you expected the DSA margin to be up year-over-year. And it came in flat. So while we understand that there were these compensation structure issues there, it does look like there was something that was a little bit different than your expectation. Is it possible to highlight what that was?

Yes. That was the investments in staffing, which I mentioned. And to Dave's earlier question, there is an element of mix and price. But it's not so significant that it's a particular individual item that we wanted to call out. When we look at the full year, we see the corrections taking place.

Right. Okay. And just to elaborate on the price. I mean I know you're not going to get specific on what the pricing is in Safety Assessment right now. But with this filling of capacity across the industry and with the consolidation in the industry, I guess, we would kind of naturally expect pricing to improve, maybe even materially so. Is that your expectation? Or is there something else that you want to...

We're going to do the best we can to achieve maximum price given the complexity of the studies we're performing and the costs of running this business. And it's all based upon the demand. So we would hope that demand continues so we continue to be able to get price. How much we can increase it is -- we'll see what the market throws at us. So we really don't want to get more specific than that, particularly immediately on the heels of all this consolidation. I just don't think it's appropriate. But we are pleased with the price that we've been getting. And that we, without knowing exactly what's going on behind closed doors, we would expect that the competition is exacting price as well. So I think the market is healthy and that buyers are pleased that they have high-quality scientific enterprises to work for them and don't have to make that internal investment. And I think we're all poised to continue to improve both the top and bottom line of our business going forward.

Great. Thank you for joining us on the conference call this morning. We look forward to seeing you in upcoming investor conferences. This concludes the conference call.

Thank you. Ladies and gentlemen, that does conclude your conference for today. We thank you for your participation and for using AT&T Executive TeleConference Service. You may now disconnect.