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Charles River Getting Back on Course

Michael Latwis

Charles River Labs (CRL Quote) surprised the Street last night by raising its 2007 revenue forecast to between 9% and 12%, compared with the 8% consensus forecast. This represents an uptick from recent trends and should help improve investor confidence in the company's near-term fortunes. After what can only be described as an up-and-down year, the company's shares appear due for a rebound following the better-than-expected guidance.

The company also affirmed its earnings outlook for this year and provided initial guidance for 2007. Next year's pro forma earnings are expected to rise 13% to 15% to a range of $2.43 to $2.53 per share; this is likely to provide some upside to the current $2.47 consensus number.

Charles River management was expected to provide a relatively cautious forecast for 2007 after disappointing investors on several occasions over the past year. Importantly, these guidance upgrades do not signal a dramatic change in underlying business trends, as they are largely due to accounting- and acquisition-related factors. Specifically, the earnings lift is due to a 3-cent-per-share accounting change related to the reclassification of ongoing amortization expenses.

Similarly, a large part of next year's upgrade to top-line forecasts is due to the lift from the recently acquired Northwest Kinetics business and a minor currency benefit. I'm encouraged because these new forecasts will directly address market sentiment, which has been sliding in its expectations for 2007. Management's confidence and clarification of the '07 outlook is likely to help repair sentiment toward the stock in the near term.

Many investors had been avoiding the stock in anticipation of another earnings or guidance disappointment. The company is undergoing a big capacity expansion of its clinical research facilities in the first half of next year, which is expected to dampen overall margins.

The cost of this expansion and uncertain pace of new business ramp-ups does provide some uncertainty in the first half of next year. This added preclinical capacity will help meet current market demand and improves the company's growth profile going forward. Although execution risk and early margin trends will remain key focal points for investors, I believe the worst is over in terms of market sentiment toward the stock.

Management Clarifies Outlook on the Call

Recent guidance was accompanied by a conference call this morning, in which management clarified its top-line forecast for key businesses and slightly lower operating margin assumptions for the full year.

Specifically, the company expects its research models business to show improved mid-single-digit revenue growth with a stabilization in the transgenics segment and the early '07 market return of large-animal models following the recent quarantine. The company is also adding West Coast capacity in research models during '07, which should contribute to '08 results.

On the preclinical side, revenue growth is forecast at a mid-teens pace, with efficiency improvements at mature facilities offsetting a large part of the cost from added capacity. Expansion projects are on schedule in Massachusetts and Nevada for the first quarter of '07 and the summer of '07, respectively.

Building a Better Mousetrap

Charles River Labs competes in three main segments of the drug discovery and development process for major pharmaceutical, biotech, academic and government research institutions. The company possesses a leading market position in research models and services, which provides outsourced rodent and larger-animal models for drug research. The company's current expansion in preclinical research services largely involves growing demand for toxicology studies. The company also occupies a smaller presence in the clinical research operations segment for all phases of clinical development.

Charles River is generally well positioned with stable to improving market demand for its outsourced research models, testing and clinical services businesses. The company has faced larger-than-expected business fluctuations this year but occupies a relatively defensive space as a key service provider to Big Pharma and biotech investments in R&D.

Shares Set to Rebound

CRL shares have been struggling to hold long-term support at the 200-day moving average just below $42. I expect that today's news will enable the stock to hold this level and show renewed momentum in the short term.

The stock also has room for improvement from a valuation perspective, trading at only 16.9 times the midpoint of the revised '07 forecast of $2.48 a share. This forward P/E corresponds to about a 15% discount to the CRO group. Although further volatility may be in store during the first half of next year, I believe the share valuation and earnings performance both contain room for improvement in '07. I therefore expect the stock to reach the $50 level at about 20 times next year's earnings in the not-too-distant future.