Investor unrest: what's going on at Charles River Labs?
On December 9, 2010 The Wall Street Journal reported that two investor groups (Relational Investors, LLC and the California State Teachers' Retirement System) submitted a U.S. Securities and Exchange Commission filing requesting that Charles River consider strategic initiatives to maximize shareholder value including the actual sale of all or part of the company. These investors cited Charles River's purchase of the Inveresk Group in 2004 that led to a $700 million goodwill impairment charge in 2008 and the 2010 attempt to acquire WuXi AppTec as examples of decisions that "destroyed our confidence in the Company's current management and board of directors, and their capital allocation discipline and stewardship over the Company's assets."
Are the Investor Concerns Justified?
In the interest of full disclosure, I worked at Charles River from the summer of 2002 through 2003. I debated about writing an article about a former employer, but seven years have passed and it seemed newsworthy that investors had proposed the sale of one of the largest preclinical CROs in the industry.
Also, as I have noted in the past, I am not a financial analyst or investing expert. CRL is a publicly-traded company and you should not base your investment decisions on my observations. I will not discuss or offer opinions regarding the finances of CRL or any other company. What I will address are operational observations that may (or may not) shed light on the investor concerns. Consider the following:
Acquisition of the Inveresk Group: The Montreal facility that was part of the Inveresk Group was regarded in the client community as one of the leading preclinical operations at the time of CRL's acquisition in 2004. This acquisition immediately positioned CRL as a top-tier provider of preclinical services. Some industry veterans believe that the company immediately lost a competitive advantage shortly thereafter when it did not retain the services of the Inveresk management individual who was widely regarded as the driving force behind the success at the Montreal operation. Another senior management individual who was retained during the acquisition elected to leave CRL in May 2010.
While we have seen that the investor groups have taken issue with the Inveresk purchase price, CRL also apparently miscalculated its assertion that the Inveresk operations would be integrated with their existing preclinical operations within a year. Other industry CRO multi-site harmonization efforts have taken years and it is likely that CRL's own multi-site harmonization efforts are still ongoing.
Preclinical Facility in Shrewsbury, MA: What was once regarded as the east coast flagship facility for CRL, operations at the Shrewsbury facility were "suspended" in 2010 just a few years after opening. The Shrewsbury facility was considered an upgrade to CRL's older preclinical facilities in nearby Worcester, MA. The work that was transitioned from Worcester to Shrewsbury was primarily drug discovery services. In 2008, CRL management expressed the desire to improve the sales mix at the Shrewsbury facility since discovery studies were shorter in duration. Ironically, during an investor update on December 14, 2010, CRL identified Discovery Services as a key area for revenue growth. Operations at Shrewsbury remain "suspended" but could be restarted if a rebound in customer demand necessitates additional capacity. What wasn't stated and is widely understood is that you just don't turn a preclinical operation on or off like a light switch. The majority of the staff at Shrewsbury was laid off when operations were suspended and it is unlikely that these individuals are just sitting by the phone, waiting for CRL to make the site operational again. Hiring and training a new staff will require a considerable amount of time and money. Remember, the whole concept of preclinical outsourcing is that CROs can offer a cost-effective alternative to internal capabilities at pharmaceutical and biotechnology companies. It is rumored that the overhead costs at Shrewsbury exceeded the revenue that could be generated on an annual basis. If true, then closing the site could be considered as an effective cost control tactic. The plans to develop the Shrewsbury site likely originated as the demand for capacity was increasing earlier in the decade and no one could foresee the current slowdown in customer demand that is now into a second year. So why close a brand-new preclinical facility? Was Shrewsbury a victim of a poor economy, poor planning or a combination of both?
Proposed Acquisition of WuXi AppTec: We have already seen that the investors took issue with the cost of the proposed acquisition of WuXi AppTec. Frankly, watching CRL trying to justify the acquisition while various investors challenged the acquisition was one of the more fascinating industry stories during 2010. Cost aside, establishing a preclinical operation in China presents considerable operational challenges. Companies like WuXi have made progress to that end but these capabilities are still under development. Despite best intentions, language and cultural differences present significant obstacles to establishing credible toxicology capabilities. For whatever reason, we saw Covance terminate a joint venture with Wuxi in 2008. Had this acquisition gone forward, CRL would have faced harmonization challenges that would dwarf the ongoing efforts among its existing multi-site operations. In an interview with the Boston Globe in May of 2010 where he spoke of the proposed acquisition, CRL's chief executive officer Jim Foster was quoted saying, "For some period of time, there'll be a wage benefit to using Chinese labor [...] The labor is plentiful, cheaper, and better educated than in the States. It pains me to say so, but it's true." This statement may be accurate but it would have been best to make sure that the acquisition was going to happen before championing the attributes of another workforce at the expense of your own employees.
Has Covance strategically outmaneuvered CRL?: Customer demand for preclinical toxicology services began to subside at the end of 2008 and, although business improved somewhat at small and mid-sized CROs, customer demand remained slow through much of 2010. In 2009, a price war developed in the preclinical CRO industry where discounts of 30% or more could be realized by customers that conducted competitive bidding. Unlike past years, it has been said that Covance was an aggressive participant in discounting prices during this time. Some have pondered if this competitive pricing was not only designed to attract business during a time of low customer demand but also to put financial pressure on the competition as they would need to lower their prices to compete with Covance. No one would ever admit that it was an intentional strategy on behalf of Covance, but more than one CRO expressed frustration at losing business to Covance during this timeframe. Although the pricing of preclinical services stabilized in 2010, Covance continued to differentiate itself from its larger competitors by signing another asset transfer deal with Sanofi-Aventis. The Sanofi deal follows the asset transfer deal that Covance struck with Lilly several years ago. To date, not only have CRL and its competitors been unable to establish similar asset management deals but you have to wonder if they will realize--or have already realized--a loss of business as Lilly and Sanofi strive to fulfill their obligations to Covance. While it is not necessary to have asset management deals in place to have a successful preclinical CRO business, it is worth considering whether Covance's success in establishing guaranteed revenue streams from these deals has adversely impacted those competitors like CRL that recently completed expensive facility expansions.
Ironically, the recent investor action could actually end up hurting CRL's preclinical business even more. While it is perfectly natural for investors to want to maximize the value of Charles River's holdings, their call to consider the sale of the company could have an unsettling effect within the client community. If the company was sold to a third party, who would manage this new entity? What would become of ongoing studies during a sale? There is a certain amount of risk associated with outsourcing preclinical toxicology studies. To mitigate this risk, many clients conduct due diligence reviews at preclinical CROs.
Clients like stability in their CRO partners. Knowing that a preclinical CRO could be sold and a new management team could take over during the conduct of preclinical studies could cause clients to take their work to other CROs that are perceived to be more stable. If this is a real concern in the client community, other CROs could benefit from the exodus of clients from Charles River. Although there is no evidence of a rebound in customer demand for preclinical outsourcing in the immediate future, as long as this investor action is unresolved, the rest of the industry could rebound at the expense of CRL.
CRL has an animal model business in addition to its preclinical research business. Selling rodents is a whole lot different that selling preclinical services. While the animal model business is (somewhat) akin to selling widgets, the preclinical business is primarily based on effective operational management and developing longstanding relationships with the client community. Beyond the investor challenges about effectively managing finances, the aforementioned operational observations could lead one to wonder if Charles River truly understands the preclinical side of the business. When Charles River got into the preclinical business they likely saw the opportunity to leverage research model clients to become preclinical services clients. It is a great business strategy but in large pharmaceutical companies, the person who purchases research models is often not the same person that makes preclinical outsourcing decisions. Furthermore, unless there is a directive from the senior management level in a pharmaceutical company to coordinate vendor selections, it would be challenging for CRL to enact its business strategy especially since other preclinical service providers can compete on quality, price, and/or perceived organizational stability.
In fairness, I have always stated that it is easy to make observations about the operations at any CRO especially when you don't have to deal with the day to day challenges. Every preclinical CRO has its own operational challenges and I am quite certain that similar observations could be made about CRL's competitors. Unfortunately for CRL, many of its operational challenges ranging from animal welfare issues to layoffs to facility closures have been well-publicized.
That is the challenge with publicly-traded preclinical CROs: management teams are accountable to their investors but, in my opinion, cost-cutting initiatives that may appease Wall St. (e.g., multiple rounds of layoffs) may not always be in the best interest of maintaining a sustainable preclinical CRO business. CRL has conducted multiple layoffs since 2009. Its large competitors have conducted their share of layoffs as well. These may placate those who worry about costs, but at some point, a significant loss of experienced personnel will ultimately limit any CRO's ability to remain competitive when customer demand improves. And that's the problem: the fix that satisfies the investor community could increase risk for the client community.
CRL Outlines Business Plans
IN MID-DECEMBER, CHARLES RIVER LABORATORIES released its business outlook, highlighting its portfolio and its plan to focus on four key initiatives in an effort to drive shareholder value. The initiatives include:
1. Improving the consolidated operating margin by managing its cost structure and driving operating efficiencies, with the goal of 20% within three to five years, depending on the demand for preclinical services,
2. Pursuing strategic alternatives for non-strategic or under-performing Preclinical Services assets, including the U.S. Phase I clinic and the China preclinical facility, resulting in the elimination of approximately $10 million in combined operating losses from the two facilities in 2011,
3. Improving free cash flow generation; investing in growing businesses, such as Discovery Services, In Vitro products and Biopharmaceutical Services, and
4. Initiating a $750 million stock repurchase program to drive immediate shareholder value and earnings per share, completing an initial $500 million by the end of 2011.
James C. Foster, CRL's chairman, president and chief executive officer, said, "Over the last two years, Charles River has taken decisive action to address the accelerating changes in the biopharmaceutical industry. We have aligned our infrastructure to current demand, rigorously managed operating costs and increased our stock repurchases, all of which were implemented to drive shareholder value. The four initiatives that we outlined today will allow us to further intensify our disciplined focus on driving profitable growth and maximizing value for our shareholders."
BASi, Pharmasset Enter Preclinical Services Pact
BASI HAS ENTERED INTO A preferred provider agreement with NJ-based Pharmasset, Inc., a clinical-stage pharmaceutical company specializing in novel drugs to treat viral infections, to provide preclinical services for pre-IND and post-IND activities. The agreement includes exclusive toxicology services as well as pharmaceutical analysis and bioanalytical services as needed.
BASi president and chief executive officer Anthony S. Chilton, Ph.D., said, "The agreement between Pharmasset and BASi is an important strategy and commitment for both companies. It represents a significant step in BASi's strategy to work closely with our partners in the pharmaceutical industry. We look forward to developing our relationship and continuing to contribute to the successful development of Pharmasset's future medicines."
Steve Snyder is a consultant with more than 25 years of experience in preclinical toxicology as an outsourcing customer and provider. He can be contacted at firstname.lastname@example.org.
By Steve Snyder
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|Title Annotation:||PRECLINICAL OUTSOURCING|
|Article Type:||Company overview|
|Date:||Jan 1, 2011|
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