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Morningstar | Charles River Expands With Proposed Acquisition of Citoxlab for $510 Million; Increasing FVE to $100

Charles River Laboratories reported fourth-quarter top- and bottom-line results above our expectations and also announced its intent to acquire Europe-based Citoxlab for about $510 million in cash. After accounting for the Citoxlab acquisition and adjusting for a guided increase in near-term capital expenditures and time value of money, we are raising our fair value estimate by about 5% to $100 per share for narrow-moat Charles River.

Fourth-quarter revenue was slightly higher than our expectations and analyst consensus, mainly driven by strong results in the discovery and safety assessment segment. Revenue from research models and manufacturing was in line with our expectations. We believe the safety assessment business currently benefits from a robust operating environment, with strong biotech funding and continued innovation in biopharma research and development. Further, the MPI acquisition (2018) added some capacity to make room for the year's strong demand. Charles River reported that it worked on 85% of all Food and Drug Administration-approved drugs in 2018 and that capacity remained well utilized throughout the year.

Management previously said it would be open to a significant acquisition in 2019, and it remarked that Citoxlab satisfies its acquisition requirements of high-single-digit top-line growth, immediate earnings accretion, and returns on invested capital above 10%. We're usually skeptical of larger acquisitions and the impact on shareholder value, but Citoxlab seems to be a solid strategic fit for Charles River, expanding its geographic footprint in Eastern Europe and augmenting its toxicology capabilities. The price of 11.7 times adjusted forward EBITDA is reasonable for the industry and in line with the purchase price of MPI Research. The company's $800 million-plus acquisition of MPI Research (closed in April), has largely played out well, exceeding top-line expectations with nearly $210 million in 2018 revenue and an operating margin of nearly 16%.

The Citoxlab acquisition will be funded with the company's cash balance and debt from its revolving credit facility, which would bring debt to about 3.5 times adjusted EBITDA when the deal is expected to close in the second quarter. We believe this leverage ratio is within industry norms and expect the company to pay down debt throughout 2019 to get to a more comfortable ratio of about 3 times or lower.

Full-year capital spending ticked up as a percentage of revenue in 2018, to $140 million (6.2% of revenue). Furthermore, management guidance for capital expenditures in 2019 was higher than we had anticipated; the firm indicated that it plans to invest more in expanding capacity, as many Charles River sites are operating at near optimal levels (as are Citoxlab facilities). Guidance of about $160 million of capital spending is within reasonable levels, in our opinion, but at over 6% of expected revenue (including Citoxlab), it's trending higher than the company's historical levels of 3%-5%.

With the $115 million-plus expected contribution from Citoxlab, we expect 2019 revenue to grow over 16% year over year, with approximately 10% organic revenue growth. We expect some improvement on the bottom line in 2019 from benefits of scale, but overall 2019 is likely to be a year focused on internal investment in capacity and staff as well as the integration of Citoxlab. As the company scales, we expect corporate overhead to be a much smaller percentage of total revenue in 2019, helping margins, which would more than offset margin pressure from the lower-margin research models staffing contract with the National Institute of Allergy and Infectious Diseases initiated in late 2018, as well as margin constraint from the transition to a new manufacturing facility in Pennsylvania.