Description

I think the Fortrea investment thesis remains intact.  The company will increase its margins towards industry peers by the end of 2025.  Because it can be sold tax free from July 2025 (2 years after the Labcorp spin), I think there is a for sale sign hanging on the company next summer with a deal likely by 2026.  

Honkeyred wrote up FTRE last August.  The stock performed brilliantly touching over $40 after Q4 results until the most recent quarter, when it round-tripped back to where it was when he wrote it up after a weak bookings number due to some deals that slipped and a delayed 10-Q due to accounting on a subsidiary they are selling.  The stock was probably ahead of itself at $40 given the limited progress made on margins so far, but now I think it represents great potential value again and the story hasn’t really changed.

Description

Fortrea Holdings, Inc. is a Durham, NC based leading Contract Research Organization (CRO).  They run clinical trials for drug companies.  The company was spun out of Labcorp in July 2023.  It was originally part of Corning and spun out on its own as Covance in 1997 until Labcorp acquired it in 2015.

Thesis

Fortrea is a mid-sized CRO company should be able to garner industry standard EBITDA margins from 15-20%.  As a result of the spin and cost duplication, margins are currently in the single digits.  The CEO, Tom Pike, was the CEO of Quintiles (now IQVIA Holdings after merging with IMS Health) from 2012 through its IPO in 2013 until it merged with IMS Health in 2016.  The results he put up there were consistent and good, we expect much of the same at Fortrea, as much of his executive team used to be at Quintiles.

             The CRO industry has a bright outlook as people expect it to grow 6-9% annually for many years. There was a recent slowdown in spend (3-4% growth) when early-stage biotech funding froze up, but conditions are thawing. There has been a ton of consolidation in the space in the last several years typically at mid teens or higher EBITDA multiples.  If AI accelerates the pace at which drug companies can find new compounds as many people are talking about, this should accelerate growth in the CRO market longer-term.

             Since the Tom Pike is 64 and FTRE can be sold with no tax implications for Labcorp after two years, it seems like there is a high likelihood FTRE could be a consolidation candidate starting in July 2025.  In the meantime, it looks like there is plenty of low hanging fruit to bring margins up to industry norms and there is an experienced team in place to do it.

Track record of Tom Pike & Co. at Quintiles

Tom Pike was CEO of Quintiles from 2012 through its IPO in 2013 until it was acquired by IMS Health in 2016. During his tenure the company had growing margins around 15% at a similar size as Fortrea today.  At the time this was 200-300 bps better than peers. In addition to Tom Pike, the current Fortrea COO Mark Morias worked at Quintiles from 2001-2016 as director of commercial development.  The Chief Medical Officer Oren Cohen worked at Quintiles.  Sam Osman the President of Enabling Services worked at Quintiles.  Cassandra Kennedy in charge of Compliance/Regulatory at Fortrea and was with?  You guessed it.  Quintiles for 20 years.  Daryton Virkler Chief Commercial Officer also with Quintiles.   Dave Cooper the HR guy - Quintiles alum.  The General Counsel J. Stillman was Associate GC at Quintiles.  I think you get the idea.  Pretty much the whole gang has done this before together.  There is no real reason to believe they won’t be able to get mid teens margins eventually.  Quintiles IPO’d at $40 per share in May of 2013 and merged into IMS at $80 per share in May of 2016.

CRO Industry and Consolidation

ICLR bought PRA at 23x EBITDA, TMO bought PPD at 20x EBITDA, and Parexel, similarly sized to Fortrea in terms of revenue, changed hands between PE firms for an $8 billion EV all in 2021.  Syneos (a chronic underperformer with 11% margins) got taken out during a biotech drought in 2023 at 10x EBITDA.  There is a long history of consolidation in this industry.  Almost no biotech company runs their own trials (they all use CROs) so as that business grows so does the CRO industry.  Big pharma has outsourced more and more over time.  Furthermore, since it is all the rage these days, think about how AI will likely impact this industry.  It will make it much more efficient to find new compounds that have good potential efficacy.  It won’t happen overnight but this could turn into a decade long tailwind for CROs as the pace of drug discovery and the need for trials quickens.  That should keep the industry growing at 6-9% per year like it has been or possibly even accelerate that growth.

Here are a sampling of articles talking about the potential for AI in drug discovery:

https://www.forbes.com/sites/forbesbusinesscouncil/2024/02/29/ai-is-rapidly-transforming-drug-discovery/?sh=55028a2f84b1

https://hitconsultant.net/2024/05/21/sanofi-formation-bio-openai-partner-on-ai-powered-drug-discovery/

https://www.rockefeller.edu/news/35839-ai-could-accelerate-drug-discovery-but-only-if-we-can-trust-it/

https://www.ft.com/content/a08e4ad9-5277-4860-9df2-d5df2ad1e57d

Margins

This story is all about the margins.  If FTRE can get industry standard margins there is a good chance this is a $50+ stock in a couple of years.  So far the progress has been slow.  Why?  Well FTRE is stuck in transition services agreements (TSA) with Labcorp at a high cost.  They have only exited about 40% of them as of the end of 2023.  They literally have to engineer every business function from IT, to accounting, etc. that Labcorp used to do.  No doubt they are having to hire ahead of this as they prepare to have support shut off by LabCorp. This is definitely driving some duplicative cost. They only just hired Cognizant to help with the IT transition in January of this year. The company has said many of the TSA exits will come in Q3 and Q4 of 2024.  The progress on this should really start to show up in 2025.  However, the potential is strong.

Additionally, I conducted a number of industry calls and almost everyone said Fortrea had too many high cost employees in the U.S. and needed to move work offshore.  Reengineering these processes will also take time.

Most of the industry has 15%+ margins.  Some of the bigger players like IQV, ICLR are pushing 20%.

Valuation/Potential Upside

Revenue guidance is for $2.785-$2.855 billion for 2024 and EBITDA guidance is for $240-$260 million.  Assuming 4% growth (low end of industry) leaves the company with $2.93 billion at the midpoint in 2025 and $3.05 billion in revenue for 2026.  If they can get to 15% margins by then you are looking at $457 million in EBITDA potential.  Sell that at a 14x multiple (where public peers trade) and you will get $6.4 billion.  Less $1.6 billion in net debt and that leaves $4.8 billion for the equity.  On 90 million shares that is $53 per share.  Best in class peers have margins closer to 20% and obviously many peers have sold for much higher multiples over the years, so there could be upside potential to these numbers.

Risks

• Execution thus far has been very sloppy.  The company got stuck with costs it didn’t expect coming out of Labcorp and missed its first quarter out of the gate.  It issued an erroneous slide deck with the wrong EBITDA number and had to correct it.  It couldn’t file its 10Q on time and delayed the Q1 2024 call due to accounting issues discovered when they were selling a subsidiary.  They had to buy forgiveness on their debt covenants due to slower than expected progress on margins.  I’m assuming these challenges will abate the further we get from the spin, but it’s been a messy start to be sure!  Starboard owns 5% of the shares so I expect the activist to hold management accountable.
• Biotech fundraising and spending is important to the story as it tends to drive the biotech side of the business.  So far, those markets seem to be thawing.  Jefferies does a good job tracking it, but IPO funding is up over 100% y/y.  VC funding is also soaring.
• The company came out with substantial debt ($1.6 billion net), which it will need to pay down once it is done putting the infrastructure in place to get off the TSA.

Disclaimer: The information contained herein is solely for research purposes and in no way represents a solicitation. Such information represents the views of the author as of the date submitted based on public information published or disseminated by the companies referenced below, including, but not limited to, through SEC filings, investor relations materials and public conference calls, or other third parties as of such date. Securities of the companies discussed herein have been and are currently portfolio holdings of the author or clients of the author’s firm. Such information does not constitute investment advice or a recommendation, and it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or other asset or to participate in any trading or investment strategy. Forward-looking statements reflect the views of the author as of such date with respect to possible future events. Actual results may differ materially from those in the forward-looking statements as a result of factors beyond the control of the author and you are cautioned not to place undue reliance on such statements. 

Catalyst

EBITDA margin improvement to teens or mid teens.

Possible sale of company after July 2025 when there is no tax for Labcorp.

AI creates a big tailwind for the CRO industry.