Laboratory Corporation: Trying To Create Value By Spinning Out Fortrea

Summary

• Laboratory Corporation of America Holdings shares have been hurt by the boom-bust cycle induced by the pandemic.
• Tough comparables should run off in the coming quarters, as the company is simplifying the business with the Fortrea spinoff.
• Overall valuations look quite reasonable, amidst modest leverage ratios, which makes me upbeat with earnings growth set to return in the coming quarters.
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Shares of Laboratory Corporation of America Holdings (NYSE:LH) fell overnight from $240 to the $200s, which is not as bad as it looks, as the company has effectuated the spinoff of Fortrea Holdings Inc. (FTRE), its CRO business.

It has been all the way back to 2017 since I last reviewed shares of Labcorp when they acquired CRO business Chiltern in a $1.2 billion deal. That deal added to what at the time was a $10 billion business, set to post earnings near $10 per share, supporting a $160 share price at the time. Ever since, investors in Labcorp have seen relatively modest returns, amidst a non-demanding multiple at current levels.

A Review

Since 2017, it has been tumultuous times for laboratory firms, including Labcorp as they had to digest the boom and subsequent bust cycle in demand for many of its services related to the pandemic, of course. Shares traded rather flattish around the $150 mark until the start of the pandemic and rallied to the $250 mark in the summer of 2021.

Ever since, shares have been trading largely stagnant, having traded in a $180-$220 range over the last year, now trading at $206 (with the prices adjusted for the impact of the spin-off).

To shed some perspective, I go back to February of this year when the company posted its 2022 results. Full year sales fell from $16.1 billion to $14.9 billion, as operating profits fell from $3.3 billion to $1.8 billion (in part due to a $271 million goodwill impairment charge). Net earnings fell to $1.3 billion, reported at $14 per share which is down by about ten dollars from 2021. If we look at the adjusted results, the shortfall is a bit less dramatic with adjusted earnings down from $28.52 per share to $19.94 per share.

Net debt of $4.9 billion is very manageable as the company has seen solid growth since 2017 and has subsequently deleveraged the balance sheet quite a bit.

Of course, if we look at the segments, we see that the pandemic was the driver behind a massive run higher in sales and responsible for the shortfall as well. 2022 sales fell from $10.4 billion to $9.2 billion on the back of lower testing revenues related to Covid-19, accompanied by severe margin pressure, as drug developments revenues actually fell by low single digits to $5.7 billion as well. Note that despite a near 8% fall in sales in 2022, the annual numbers still included about $1.1 billion in Covid-19 related revenues, creating difficult comparables on this front.

2023 - A Mixed Year

Alongside the release of the 2022 results, the company guided for 2023 revenues to rise by 1-4% on a consolidated basis, with the core business set to increase sales by 8-10%, and pandemic-related revenues seen down 75-90% from a $1.1 billion number in 2022. Despite a modest overall revenue growth guidance, the company sees adjusted earnings down from $19.94 per share in 2022 to a range of $16.00-$18.00 per share in 2023.

In April, Labcorp announced first quarter sales which were down 3% to $3.78 billion, with adjusted earnings down significantly from $6.11 per share to $3.82 per share. Despite the softer quarter, the company maintained the earnings guidance (narrowing both sides of the range), all while net debt was pretty stable around $5 billion.

Amidst these trends, the company continued to prepare the spinoff of its subsidiary Fortrea, which entails the Clinical Development and Commercialization business of Labcorp, a spinoff which was effectuated early in July. In connection to the spinoff, Fortrea will pay $1.6 billion to Labcorp, which will cut absolute net debt levels by about a third.

Fortrea is a global CRO which provides clinical developments services and enabling services to pharmaceutical companies which have products in phase I to IV in their development. The business has assisted on more than 5,000 trials over the past five years. The company generated $3.1 billion in sales in 2022, on which it generated about $405 million in EBITDA.

In terms of the spinoff, the exchange ratio was one-for-one which is pretty simplistic. This means that the fall from $240 to $208 in term so Labcorp's shares almost matches the valuation applied to Fortrea, whose shares traded at $36 right after the spin-off.

And Now?

The reality is that the spinoff was designed to unleash value for investors over time, but the simple exchange ratio makes it rather easy to analyze. With earnings power trending around $17 per share, and shares trading at $240, the overall business traded around 14 times earnings. This is based on the assumption that no additional costs are incurred following the spinoff and investors hold onto the shares in both Labcorp and Fortrea. The idea is to create value, using the backlog of Fortrea and a more reliable revenue model to undoubtedly obtain a higher multiple for that business.

Furthermore, Labcorp´s own business should benefit from the lapsing of the pandemic related headwinds, which means that multiples might increase over time again, certainly as leverage come down further.

The reality is that while leverage is low, the long term positioning is sound. That means Labcorp current valuations are not too demanding, in that the company is not living up to its positioning expectations to the full extent. Given this background, I find myself performing a balancing act, as I am quite attracted to Labcorp here, although I have doubts if now is the time to chase the shares (after they ran up 10% in recent weeks as well).

Amidst all this, I am placing shares of Laboratory Corporation of America Holdings on my watch list, with a full intention to initiate a position if shares retreat (again).

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[yardbird99]

I thought CRO is high margin. How does this deal create value?

[Edward J. Roche]

@yardbird99 The idea of spin offs is that the spun out company will command a higher valuation than it did as part of the parent business.
LH is planning to increase its dividend and increase share buybacks as well.

[yardbird99]

@Edward J. Roche Thanks. I understand now. LH + FTRE will (hopefully) have a higher value than LH by itself with the CRO. And holders of LH will now own both, separately. But LH by itself might deserve a lower PE(?).

[Edward J. Roche]

LH valuation is quite modest now. Covid testing is decreasing fast but now patients are going back for other treatments since the worries about getting Covid have decreased. These other treatments will require lab testing.

I wrote an article (published yesterday) about Fortrea. I also have a call into LH Investor Relations to get clarification on a couple key points;

- Labcorp Drug Development had about $5B in annual revenues but Fortrea only has $3.1 B. That implies some parts of Labcorp Drug Development are being retained by LH. What are those?

- the valuation of FTRE appears to be very low with a p/s near one and a p/EBITDA around 7 which are much lower than peer companies. Why is that?

Appreciate any thoughts on those.

I own both LH and FTREA.

Thanks for a article.

[The Value Investor]

@Edward J. Roche Thanks, keen to have a decent look at FTREA as well, although info is a bit limited.