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Morningstar | Acquisitions and Booming Biotech Environment Drive Charles River's Growth; Shares Look Overvalued

Charles River Labs reported first-quarter results mostly in line with our expectations, posting $605 million in revenue, up nearly 11% organically from last year. After modeling in slight increases in full-year capital expenditures and amortization expense due to acquisitions, we are raising our fair value estimate slightly to $103 per share, driven by the time value of money in our valuation model and a slight increase to near-term revenue in the discovery and safety assessment segment. However, our long-term forecast for narrow-moat Charles River of mid- to high-single-digit top-line growth and steady margin expansion remains intact. We continue to believe that Charles River Labs is benefiting from a robust operating environment with strong funding for biotechs. On May 7, shares dropped more than the wider healthcare sector, likely due to a combination of worries of a trade war with China, a driver of the company's future growth, and worries about near-term headwinds. Despite the drop, shares look overvalued, and we believe the market is not pricing in the impact of a more normalized operating environment in the long term.

Total adjusted operating margin was 16.3%, about 50 basis points lower than last year due to pressure from the research models government contract, employee compensation, and capacity expansion. We're not changing our full-year expectation of 18.6% adjusted margin, down 20 basis points from 2018.

The discovery and safety assessment segment continues to benefit from acquisitions, posting $354 million in revenue, representing 36% reported growth and 11% organic. Due to the higher-than-anticipated organic growth in the first quarter and management's ongoing capacity expansion efforts, we have slightly increased our near-term revenue expectations for the segment. With the Citoxlab acquisition completed, we expect over 20% reported growth in 2019 and about 19% growth in 2020 for the segment before normalizing to high-single-digit growth.

The research models business' 5.4% organic growth was driven by demand in China, which we expect will continue to be the main driver for the mature business that forms the foundation for Charles River's narrow moat. Most of the first-quarter growth came from biotech clients rather than large pharmaceutical clients; this is a trend we've seen in the last several quarters and anticipate will continue in the near term.

On April 30, the company notified clients and investors that less than 1% of clients' data was copied by an undisclosed intruder that gained unauthorized access into the company's IT systems. Management indicated it has taken steps to further secure its systems and will continue to do so. The company said that revenue or cost impact stemming from this incident, if any, will be minimal, so the cybersecurity event does not alter our forecast.