In November, I concluded that Fortrea Holdings (NASDAQ:FTRE) announced a very mixed bag of third quarter results. The CRO business, which has been spun off from LabCorp (LH), had seen shares fall from the high-thirties to mid-twenties as investors were concerned about flattish sales and declining earnings. This caused a real overhang on the shares as the company employed quite some leverage as well.

In the meantime, the company has guided for modest growth and announced an important divestment in order to reduce leverage, but the real question of lack of underlying profitability remains a major concern here.

A CRO Business

Fortrea is a pure play CRO (clinical research operator), providing clinical development services as well as select enabling services used by pharmaceutical and biotechnology companies in phase I until phase IV of drug development.

R&D spending by these industries at large total a quarter of a trillion, which makes that the business serves a huge addressable market, even as its targeted subsegments are a bit smaller.

The company employs about 12,000 workers across nearly 100 countries as the company generated $3.1 billion in sales in 2022, on which EBITDA of $405 million was reported. Note that these were the results as reported as part of, and within, LabCorp.

The spin-off from LabCorp was effectuated last summer, as the picture was quite mixed. Soon after the spin-off, the company posted second quarter results in August, with revenues of $793 million being dead flat on an annual basis. Operating earnings fell from $71 million to $33 million, as it was hard to disentangle which part of the profit decline was attributed to generic margin pressure, and how much was related to costs incurred from running a standalone company.

Moreover, reported results were not yet impacted by net debt, which was estimated at $1.52 billion at the time of the spin-off. With EBITDA trending much lower around $270 million, leverage ratio exceeded 5 times. Moreover, the incurred interest expenses would pretty much consume all the operating earnings.

The 88 million shares granted equity a $2.3 billion equity valuation at $26 per share, for a $3.8 billion enterprise valuation. This looked like a reasonable number at just over 1 times sales, but it translated into a demanding EBITDA multiple, with performance on that metric seen down to $270 million.

With many moving parts playing a role, such as corporate cost overhang, distraction from the separation and debt overhang, it was very hard to paint a clear picture here. This picture improved a bit in the third quarter, with revenues up 2% to $776 million, as a book-to-bill ratio of 1.24 times looked impressive. The order intake added to a backlog which now stood at $7.1 billion (equivalent to two years of revenues).

Operating earnings fell from $69 million to $14 million, and after a quarterly interest bill of $35 million, a GAAP loss of $13 million appeared. With adjusted EBITDA posted at $70 million, the company guided for 2023 revenues at $3.10 billion and EBITDA around $270 million. That suggested that fourth quarter sales of $769 million and EBITDA of $70 million would be largely in line with the third quarter results. Despite the relative solid third quarter, the negatives were clearly seen, making it very hard to get upbeat.

Stuck At $33

A $33 stock in November rose to the $40 mark in recent weeks, before now selling off to $33 per share again.

In March, the company announced the divestment of the endpoint clinical and patient access business to Arsenal Capital Partners. These two segments were part of the Enabling Services segment, a segment which in total generated $270 million in sales in 2023.

The price tag was announced upon the release of the annual results, as the company obtained a $345 million price tag, of which $295 million was due upon closing, with the remainder payable upon obtaining certain milestones. The 2023 conference call revealed that the divested assets generated $250 million in sales and $30 million in EBITDA. Including milestone related payments, this meant that Fortrea fetched a 1.4 times sales multiple and 11.5 times EBITDA multiple for these assets.

In March, the company posted mixed results for the year. Fourth quarter revenues of $775 million were up 2% on the year before, yet adjusted EBITDA of $67 million came in a touch light. The fourth quarter book-to-bill ratio came in at an impressive 1.30 times, adding to a $7.4 billion backlog, as the question was when this would translate into more impressive growth (and earnings).

It was somewhat disappointing to see 2024 sales between $3.140 and $3.205 billion, making very modest growth from a $3.109 billion revenue number in 2023, despite the growing backlog. Promising is that EBITDA is seen up to $280-$320 million, up from a $267 million number in 2023, as this guidance excludes the impact of the divestment.

Net debt was reported at $1.52 billion, as the latest sale will reduce this to about $1.22 billion ahead of transaction costs, or potentially a bit more upon milestone relayed payments. With EBITDA seen at $270 million on a pro forma basis, I peg leverage ratios around 4.5 times.

It remains incredibly difficult for the company to remain profitable. Based on a $267 million EBITDA number for 2023, we first have to recognize a structural $42 million stock-based compensation component, a $140 million interest expense (although this will come down a bit) as well as depreciation charges. This remains the real issue here, the lack of real profitability.

The company did report fourth quarter adjusted earnings of $16 million, yet adjusted for a $15 million stock-based compensation expense, no real profits were to be seen.

What Now?

It was hard to see why shares rose to the $40 mark in February, as the outlook for 2024 did not really look inspiring. Shares have fallen now, not on the back of the 2023 results and 2024 outlook, but because Fortrea announced a day before the scheduled first quarter earnings release that it needs more time to work though accounting and operations of the divested assets being part of the Enabling Services segment. Such warnings are never comforting, certainly not a day before their scheduled release.

The latest news is somewhat concerning, but the divestment of assets should alleviate most of the leverage concerns. Less leverage concerns and a backlog being turned into real revenue growth could drive the stock, but real revenue growth is still lagging here.

With the nearly 90 million shares now commanding a $3.0 billion equity valuation, the company is still valued at $4.2 billion, equal to a 1.3 times sales multiple and about 15 times pro forma EBITDA. This looks quite demanding, certainly in the light of the lack of real profitability here, as real growth and margin gains are needed to create appeal, which is far from a given here. All of this makes me quite cautious here.