LH - Fortrea Holdings Q3 Earnings: A Very Mixed Bag

2023-11-14 12:45:02 ET

Summary

• Fortrea Holdings Inc., a global CRO spun off from LabCorp, has seen its stock price fall from $37 to $26 per share.
• The company's third quarter results showed flat revenues and a decline in operating earnings.
• Despite a recent 10% increase in share price after the third quarter earnings report, there are still concerns about realistic earnings and future growth.

In August, I believed that there were many question marks around Fortrea Holdings Inc. ( FTRE ) . This came after the company was just spun off from its former parent LabCorp ( LH ), with the separation taking place in July of this year.

A $37 stock at the time of the spinoff has fallen to the $26 per share mark as the move triggered my interest. What I saw did not really make me enthusiastic. Despite the long-term growth prospects as CRO, Fortrea is unable to post realistic earnings, which in combination with high leverage and no quick avail makes me cautious after shares have seen a recovery in recent weeks.

About Fortrea

Fortrea has been spun off from LabCorp as a pure play global CRO, providing clinical development services and select enabling services which are used by pharmaceutical and biotechnology companies in phase I until phase IV of drug development.

With R&D spending by these clients totaling nearly a quarter of a trillion per annum, the company serves a huge addressable market, even as its target subsegments are a bit smaller. The company employs some 12,000 workers in nearly 100 countries, generating $3.1 billion in sales in 2022, on which solid adjusted EBITDA of $405 million was reported. This however was based on the performance within LabCorp.

By August, the company posted second quarter results with quarterly revenues of $793 million being dead flat compared to the year before, despite its growth prospects. Operating earnings fell from $71 million to $33 million, as it was hard to see which portion of the earnings decline was due to revenue stagnation, and which part was due to the spin-off.

Despite the dramatic operating earnings decline, GAAP earnings of $28 million worked down to $0.32 per share, as the company posted adjusted earnings of $0.52 per share. The majority of the discrepancy related to amortization charges which are adjusted for, although it included an adjustment for stock-based compensation expenses as well.

Pegging realistic earnings at $0.40 per share, that number was too simplistic as well as earnings were not yet burdened by debt, which certainly is an issue post the separation. In fact, net debt of $1.52 billion upon the separation is substantial, at around 5.6 times EBITDA which was pegged at $270 million. In fact, pegging interest expenses as much as $120 million per annum, realistic earnings would largely, or perhaps entirely be evaporated.

With 88 million shares trading at $26, the market value has shrunk to $2.3 billion, granting the business a $3.8 billion enterprise valuation given the substantial debt load. This was equal to just over 1 times sales, but looked like a more than fair multiple given an anticipated $270 million EBITDA number, certainly as realistic earnings were not really seen.

There were many moving parts, including the potential for corporate cost overhang following the separation, although that the distraction as a result of the separation might be a valid reason for softer performance as well. Amidst all these moving factors, and no great positives in the investment thesis, I decided to await the third quarter earnings report before reconsidering a neutral but curious stance.

A Recovery Play

Since August, shares have traded in a $25-$30 trading range until a convincing third quarter earnings report sent shares 10% higher to $31 per share. In the meantime, shares had gotten a small boost in mid-October as activist investor Starboard took a 5% stake in the business.

The third quarter earnings report provide quite a few reasons for investors to be upbeat. Revenues for the quarter rose by nearly 2% to $776 million, as a book-to-bill ratio of 1.24 time suggested a stronger underlying trend. That said, the backlog has a longer period to convert, with a backlog of $7.1 billion being equivalent to more than two years' of current revenues.

That was about the good news as reported operating earnings (based on GAAP accounting) fell from $69 million to $14 million. After incorporating a "new" $35 million interest expense, GAAP losses came in at $13 million. The company posted adjusted earnings of $21 million (equal to $0.24 per share) at the same time, but this among others adjusts for an $11 million stock-based compensation expenses, with adjusted EBITDA posted at $70 million.

The company sees full year revenues at a midpoint of $3.10 billion and adjusted EBITDA at around $270 million. That suggest that fourth quarter sales are seen at a midpoint of $769 million with EBITDA seen at around $70 million, which more or less is in line with the performance in the third quarter, which has been rather lackluster.

And Now?

The truth is that I am positively surprised by the move higher in Fortrea Holdings Inc. shares in reaction to the third quarter results. A 10% move higher seems like quite an overreaction, as quite frankly the positive in the report was a 2% growth rate for the third quarter, and a decent book-to-bill ratio.

The negatives are seen as well. Third quarter realistic earnings were minimal (as predicted) after incorporating interest expenses and stock-based compensation expenses, and the fourth quarter guidance does not provide any avail. All this makes it very hard to get really upbeat, despite relative low sales multiple as great growth and margin works needs to be done from here.

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