LH - Fortrea: A Strong Hold Following The Spin-Off

2023-07-05 12:07:51 ET

Summary

• Fortrea was spun off from Labcorp on July 3.
• I am rating the new company as a strong hold based upon its long history of financial success, its strong position in a growing industry, its extensive capabilities, and valuation.
• I am waiting for formal financial projections before adding more shares.

The Spin-Off

On July 3, Labcorp ( LH ) completed the spin-off of Fortrea ( FTRE ). The market continues to see a fair number of spin-offs as companies seek to increase the value of holdings that may not be fully recognized. In this case, it appears that the slow and steady Labcorp thinks that the value of its contract research portion will be higher when separate. The new company name is Fortrea.

Labcorp acquired most of the assets here in 2014 through the acquisition of Covance for $5.6B. Additional acquisitions since then (Medical device study capabilities, Global Care, etc.) have added scope and customers. This business has been denoted as Labcorp Drug Development. As discussed below, not all of the assets of Labcorp Drug Development are included in the spin-off. The assets being spun off only cover about $3B in revenues. It should also be noted that FTRE made a $1.6B payment to LH as partial consideration of assets contributed by LH to facilitate the spin-off. There is no indication in the filings from LH or FTRE that there will be future payments.

As I have noted in prior articles, famous investor Peter Lynch liked spin-offs, stating in his book One Up on Wall Street that "they often result in astoundingly lucrative investments". While this was written many years ago, much of his underlying rationale remains sound. He points out that parent companies do not want to spin off divisions and then see them get into trouble since that would be embarrassing to the parent company. For that reason, spin-off companies typically have strong balance sheets. He also makes the point that spin-offs are often misunderstood and get less attention from Wall Street analysts. That can translate into hidden value. On this basis, I would highly recommend investigating Fortrea before selling the new shares.

The Business

The business being spun off is one of the oldest and largest contract research organizations in the world. Covance traces its origins as far back as the 1970s and was a spin-off itself from Corning in 1996. As currently constituted, it is an organization with global reach, operating in more than 90 countries. It has a staff of over 21,000 people with expertise in over 20 therapeutic categories. Clients include both large pharma (54%) as well as biotech companies (46%). The company claims to have many very long-term customers. Fortrea has strong capabilities that span the entire clinical development process.

The contract research area has been a growing one as many large and small Pharma and Biotech companies are outsourcing more clinical trial work. Large pharma companies prefer to work long-term with highly trusted partners. This results in consistency of revenues. Smaller biotechs want to concentrate their resources on discovery and often outsource clinical development. Clinical trial development is becoming more complex with more touchpoints and a more diverse patient set. These trends favor outsourcing. A recent (6/22) study from McKinsey projects 40% overall growth from 2020 to 2025. This study does note a recent trend among some larger pharma companies to return some work to in-house resources. That is something to watch as Fortrea reports future results. Fortrea highlights recent successes in the oncology area, which has been a rapidly expanding area for pharma and biotech research. No Fortrea customer represents larger than 10% of the share.

Large competitors include IQVIA ( IQV ), the PPD arm of Thermo Fisher ( TMO ), Parexel, and Syneos Health ( SYNH ).

Financials

The investor presentation lists $3.1B in annual revenue and $405MM in adjusted EBITDA for 2022. Adjustments include typical items such as foreign exchange gain/loss, restructuring, and goodwill impairments. Most of these items have been small, but there was a $406MM Goodwill charge in 2002. The growth rate for revenue given is 8.5% CAGR for the last three years. This is a large portion of the revenues for Labcorp Drug Development (which were $5.72 B in 2022) but not all. LH has stated that the business is expected to generate high-single-digit revenue growth going forward. The observed growth rate in revenues for all of Labcorp Development has been about 10% over the last five years. The growth rate for EBITDA over the last three years is given as 26.3%. The presentation also claims good growth in backlog, an important factor in projecting future business for contract research companies. A 26% CAGR number for margin expansion is also cited for the last three-year period. Fortrea has not yet provided formal projections for future revenues or earnings. Pro Forma net debt of $1.52B is listed as part of what is described as a conservative balance sheet in line with the industry.

Valuation and Balance Sheet

The spin-off provided one share of FTRE for every share owned of LH, with a total number of FTRE shares now 88.1 million. The stock opened on 6/3 around $35 and closed at $36.80. The current market cap of $3.1B gives a price to sales of around 1.0 and a price to adjusted EBITDA of 7.7 by my calculation.

Valuation Comparisons

The company would appear to be selling at a low valuation. For comparison, IQVIA currently has a price-to-earnings ratio around 19 and a price-to-sales ratio around 2.7. Those are for a company growing revenues and earnings at a 16.5% rate. Thermo Fischer acquired PPD 4/2021 for $17.4 billion. PPD had $4.7B in annual revenues at the time, so based upon these comparisons, the valuation being given to Fortrea is modest.

Risk Factors

Labcorp Development reported lower numbers in the most recent quarter, but the first quarter is traditionally the weakest of the year. The company also ascribed the off quarter to a contract loss and slower backlog conversion due to staffing issues and increased patient recruitment time. The investor should watch to see if these are recurring issues in future quarters.

Fortrea has lower margins vs. the peer set. The company feels that margin improvement can be obtained through better productivity and changes in SG&A spending. In the recent investor conference (6/6/23) the company also noted some portfolio rationalization with certain large pharma partners. These are all factors to watch going forward.

Recommendation and Action

I and some of my Freedom Mountain Investment clients received spin-off shares of Fortrea on 7/3. I am retaining all shares as well as all Labcorp shares pending further study. I rate the stock as a strong hold given:

• the long history of financial success
• favorable position in a growing industry
• extensive capabilities in key areas
• low valuation relative to peers

I am waiting for formal financial projections before considering buying more shares.

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