Description

FTRE is an underearning asset that was recently spun from LH now being led by one of the top managers in the CRO industry. FTRE is a classic spin – as the smaller segment within LH, it was neglected, lacked focus/investment and should prosper as a stand-alone entity. The stock has performed poorly since the late June spin – combination of selling pressure from LH shareholders post-spin and a poor Q2 / initial ’23 “kitchen sink” guide. Believe the stock can more than double over the next 2-3 years from a combination of margin improvement, better bookings trajectory and interim deleveraging

Industry Overview: CRO industry has consolidated in the past decade – it is effectively a six-player market with IQV and ICLR as the leaders, FTRE and PDD both around #3 or #4 and two sub-10% share players (SYNH and MEDP). The industry has seen some pressure in the past year from funding pressure on start-up / smaller biotechs, but there are some green shoots and over half comes from large cap pharma where pipeline / funding capacity is at record levels. Long-term industry growth should be M-HSD%

FTRE Overview: Formerly known as Covance – was acquired by LH in 2014 – strategic vision was to create end-to-end solution from LH’s medical testing and Covance’s contract research. Never panned out, were never well integrated, customers did not see the benefit of bundled approach, etc. FTRE was neglected for a # of years and recently spun. New CEO (Tom Pike) is excellent – he was CEO of Quintiles (top tier CRO) – led a successful IPO and eventual merger with IMS (now IQV). Pike is focused on leveraging his contacts in the space, improving the mgmt/sales team and allowing FTRE to sell specific services that the customer wants/needs (versus the mandate of a bundled solution previously at LH)

Q2 Results / Initial 2023 Guide: Q2 was soft and initial ’23 guide was weaker. Q2 EBITDA was down 37% y/y despite flat ~revs with EBITDA margins of 9.1% versus 14.5%. Q2 and 2023 are burdened by a higher cost structure – transitional service agreements (TSAs with LH), dis-synergies and it seems like LH stuffed FTRE with some unallocated costs they were not anticipating (in negotiations to remediate). As such, ’23 EBITDA margin of ~9% was a 1-200 bps weaker than expectations and well below ’22 margins of 13%.

Path Forward: FTRE has acknowledged that starting point for margin improvement objectives are slightly weaker than expected. Positively, I think they will likely announce a restructuring program in the fall and share more details in November (Q3 earnings call), which should yield some short-term margin improvement, plus during 2024 they should exit TSAs, move some US-based labor to lower-cost countries, etc. Have spoken to getting back to ’22 margins (13%) exiting 2024. Positively, bookings were negatively impacted by the overhang of the spin – is in a better position post spin, e.g. July was their best “first month” of bookings since 2021 and I would expect a step-change in bookings in Q3/2H. Importantly, CEO Pikes (and some of management) have a stock-heavy compensation package that was issued post Q2 / 2023 guide, hence the “kitchen sink”. Pike believes that in the medium/longer term, FTRE’s margins can be comparable to ICLR (close to 20% EBITDA margins) – seems ambitious, but closing half the gap drives meaningful upside

Balance Sheet: Given the implosion in EBITDA, B/S leverage should be around 5x – leverage will naturally come down with growing EBITDA, plus some improvement in FCF in ’24 / ’25. The businesses can handle leverage given low capital intensity (capex LSD% of sales). I also wouldn’t rule out some smaller segments being sold to accelerate deleveraging, e.g. Patient Access and/or Enabling Services

Valuation: Assuming 4-6% rev growth in the coming years, EBITDA margins can improve to 15% by 2026 (versus their expectation of 18-19%) and a 12x EBITDA multiple (2 turn discount to ICLR) yields a $62 target price. Have assumed that 80% of FCF is dedicated to delevering in the interim.

Catalyst

November earnings call - clarity on margin imprvoement and better bookings momentum