Fortrea Holdings: Many Questions Post The Spin-Off

Summary

• Fortrea Holdings, a spin-off from LabCorp, has seen a substantial decline in its share price since its July spin-off.
• The company has outlined a not-so-impressive outlook for the year, with flat earnings expected and a high leverage multiple.
• Given this situation, it is hard to see appeal emerging here, as some execution is needed before I am considering a potential.
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sanjeri

Fortrea Holdings (NASDAQ:FTRE) was spun off from its former parent company LabCorp (LH) in July, as its shares have fallen quite a bit since that period of time. A $37 stock around the time of the spin-off has fallen to $26 here, as the prolonged and substantial decline in the share price triggers my interest.

While the decline is substantial, the issue is that the business has outlined a not so impressive outlook for the year, with associated interest costs meaning that realistic earnings likely come in around the flat line according to my calculations. This observation, no topline growth and a huge leverage multiple make me cautious, as I require some execution before I would be interested to get involved.

The Business

Fortrea has been spun-off from LabCorp and has become a pure play global CRO which provides clinical development services and select enabling services in phase I until IV to big pharma companies and biotechnology organizations.

Fortrea claims that pharma R&D spending totals nearly a quarter of a trillion per annum nowadays, with clinical development spend pegged around a hundred billion, with the company's addressable market being roughly a third of this market.

The contract research organization is quite large, employing some 12,000 workers in over 90 countries. These workers generated $3.1 billion in revenues in 2022 on which the company reported adjusted EBITDA of $405 million, but this of course was still within LabCorp. Operating in 20 therapeutic areas, the company has performed over 5,000 trials in the past five years.

The company has involvement with many drugs development programs and was quite well diversified between its clients, many of whom it has long term relationships.

The Numbers

By the middle of August, the company has posted second quarter results, with revenues of $793 million coming in dead flat compared to the same quarter last year. Operating earnings fell from $71 million to $33 million and change, as it is hard to see how much of the earnings decline is due to the spin-off, of course.

The company posted a GAAP profit of $28 million, equal to $0.32 per share, thanks to a foreign exchange gain and the fact that no significant interest expenses were reported yet. The company posted adjusted earnings of $46 million, or $0.52 per share. The major differences between both earnings metrics are due to a $16 million amortization charge and a $9 million stock-based compensation expense, the latter which I am not happy to adjust for.

This results in earnings of around $0.40 per share, but this is a bit too simplistic as well. Net debt is reported at $1.52 billion and adjusted EBITDA is seen between $255-$285 million this year, meaning that leverage ratios are seen as high as 5.6 times. As the company recently priced $570 million in 2030 notes at a 7.5% coupon, I peg pro forma interest expenses at around $120 million per annum.

With no significant interest expenses hurting the second quarter earnings number of $0.40 per share, the incremental pre-tax interest expenses come in at $0.34 per share based on a $120 million run rate, revealing very modest earnings power. The worse thing is that a second quarter adjusted EBITDA number of $72.5 million translates into a run rate of $290 million, as the full year guidance to $270 million is a bit softer, suggesting worse profitability in the remaining quarters, and thus no real profitability at all.

This reduces the potential to deleverage, certainly as no topline growth is seen, leverage is sky-high and lack of realistic earnings is not there, making it hard to see how the company can make progress. With 88.8 million shares now trading at $26, the equity valuation has fallen to $2.3 billion, for a $3.8 billion enterprise valuation.

This values the operations at just over 1 times sales, but the issue is that adjusted EBITDA of $270 million is very low at high single digit margins. This results in a huge multiple, with operating leverage badly needed as interest expenses are likely enormous and make it hard to produce real earnings, or potential to deleverage.

And Now?

Given the discussion above, that of no revenue growth, sky-high leverage ratios, and lack of realistic earnings after accounting for the steep debt costs, it is too early to get overly bearish. That said, one has to recognize that the business is facing some turmoil being spun-out of its former parent, as management is clearly not happy with the results, looking to boost margins and growth from here.

That however requires some real execution as the situation looks highly uncertain based on the current situation. Any potential to boost margins works to reduce leverage and could translate into a nice long term entry opportunity. That however requires some real execution, as I am patiently awaiting the third quarter results and hopefully some sequential improvements before getting upbeat and involved here.

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

[Spekulatius]

I think you are better off just investing in CRL. better business, better balance sheet and similar valuation (based on EV/EBIT).
If FTRE can improve their margins, then this could become interesting.

[Fred. L.]

@Spekulatius

Agree

[Fred. L.]

It will be interesting to see if LH faces litigation over this spin. At the time of the spin they were referencing prior year EBITDA at 400mm…and then boom now it’s magically in the 200’s. I’ve already sold all my FTRE and LH.

[Chebah]

Can't wait to sell my shares.

[biochemist]

FTRE is a dog. LH kept the revenue-generating central labs business and loaded up FTRE with debt.