Fortrea Holdings Inc. (FTRE) Earnings Call Transcript & Summary

I want to get started and to make sure we don't shortchange anybody. I'm Tom Pike, I'm CEO of Fortrea. We are the spin-out of Labcorp's Clinical Services Division. We've spun-out for about 8 months now. And so we've been an independent company but our heritage is in a company called Covance, which is one of the real innovators in the CRO industry and one of the leaders since 1990s. So we have an interesting company, interesting story. I'm told that everybody here understands the CRO industry pretty well. And what I love about this industry and the reason that I came back after running Quintiles to run 1 of these companies, is because the backdrop for this type of company is so great, and these companies can be very successful in that backdrop. The general backdrop is that we are clinical services firms that grow because the R&D associated with pharmaceutical firms has been growing for basically forever. And the growth of pharmaceutical R&D continues to be probably on the order of 3% to 5% this year. And historically, it has grown in the high single digits for years in terms of what we do. That growth in our industry really has two components to it. It's innate growth associated with R&D but it's also been an increase in outsourcing. So you've seen the combination of those two result in 3% to 5% or high single-digit growth for many of the last 30 years, and we expect this trend to continue. We don't see large pharmaceutical firms taking on a huge amount of staff to do more clinical research. They're relying on companies like us to do that with them around the world. And then the biotechs very much rely on us in terms of clinical services. Now turning to Fortrea, of course, there are may be forward-looking statements here. We are a company that spun out of Labcorp. Covance used to have two arms. They had a clinical services arm where that services piece, they have what we call a central lab in this business. That's stayed with LabCorp. We have about 18,000 people in this company. We're global. We operate in 100 countries. We have 700 medical docs. We have 1,500 PhDs. This company is a real player in this industry. In terms of the spin, it was completed in record time. Actually, my colleague, Jill McConnell led it from the LabCorp side. She had been CFO of this group before that. They pulled her out to lead it. I'm proud to say that she did that on time, and it's great that she is with us because 1 of the big activities now is getting the rest of the way out of Labcorp. And since he knows the internals of all this from looking at it for last year, she's the best person to help us get fully out of Labcorp. We immediately created an investment and differentiation strategy. So coming to this business felt like it wasn't differentiated enough. And it was an interesting mix. It was actually a mix of some skills that were on the bench and hadn't really been in the game. We had the 700 medical docs, many of who have been in this industry for 25 or 30 years, did hundreds of trials, but they weren't out at customers enough. So what we did is we brought some of those talents from the organization and then at the same time, created an investment thesis that many of you have seen in terms of our investments that range from things like more magnet talent. So this is talent that's so good that the pharmaceutical industry notices that we have this talent and wants to bring us in. Also areas like site differentiation, how can we differentiate when we work with investigator sites. Now you've seen some progress on that with our site advisory boards and some of the augmented services. We have strategies associated with technology. We knew with people like Veeva here spending $250 or more million on technology that a CRO can't be a technology leader in this business, it's really going to fall to those high-quality vendors. So we complement, we don't compete with those vendors, and then we develop intellectual property where we want -- where it adds value on top of it. Same thing in data. Years ago when we created IQVIA, as they were the only game in town, they and Optum were the only two games in town associated with data. Now there are probably 100, certainly tens of data providers. You have people like ConcertAI who focus on oncology data. So our goal there is also to complement, not compete with data. We don't need to own data, we need to be really good at using it, and making sure that we mine it effectively and use tools against it to help our customers. So we complement, don't compete with technology and data providers. So we've got this full differentiation strategy. You may have seen it in our Investor Day, but it is paying dividends in terms of the relationships we have with customers, the focus of the business, and you'll hear more about that. We had to commercially transform too. As you can imagine, being a division of a division with a huge lab, the focus was not on clinical services. So one of the first things that Jill and I did when we took over in July is we changed the incentive strategy. So we changed to focus more on the most attractive parts of our business from a growth and margin standpoint, which is largely full-service outsourcing. But we did other things, too. Some of you in the audience know this industry very well, and we weren't engaging early enough with customers who weren't using all that medical expertise with biotechs. And so all of this part of our commercial transformation that I'd say we're in probably the third or fourth inning of, but it's already producing results, a 1.3 book-to-bill in the last quarter and 1.27 since we've been independent company. We developed a road map. I think any of you who are interested in us understand the same thing we do and not that we're really a margin appreciation story. This company traditionally has been subindustry peers, the spin has made it even more difficult in terms of margins. So we have a very clear road map both in operating and SG&A transformation. We picked some partners to help us through that. So we picked Cognizant and Accenture. Cognizant is helping us with the more technology-oriented aspects of getting out of Labcorp. And then Accenture is helping us with some other technology, mainly our ERP, and they're also helping us with security. And then finally, we put together an experienced management team. We took some folks from the parent company like Jill and then added other really experienced great players. I think we have a world-class management team, and we also have a great board. With respect to 2024, so what are we doing this year? So last year, we were really setting up, getting things started, starting the commercial transformation. Now we're really focused -- refocusing the business on Phase I to IV clinical development, including real-world evidence in some of the consulting. Now those of you who saw our earnings announcement yesterday showed that we just announced that we are divesting the two key businesses in the Enabling Services segment. We can talk about this a bit more in our Q&A, but we're divesting those 2. They are good businesses, very good businesses, but they do need a lot of attention and a fair amount of capital. And we think the real value creation here is concentrating on our clinical businesses. So we're starting on that journey this year. It also gives us a little bit of extra capital, deal with our debt situation. But I think we're excited about that, and we think those two businesses have a great home with Arsenal. In terms of the commercial transformation, it's still going on before coming down here last night after our earnings call, Jill and I met for 1.5 hours with a customer. And that is a big part of what we're doing. You should -- we should see more progress in terms of building our pipeline, how we engage, and I hope, continue to drive these book-to-bills that you've seen. We're continuing these investments. So they're not done yet. We've started on the investments, as I described but we're adding to it more specificity around AI. So that same customer that we were talking about, one of the things they're going to do today is they're going to see our AI experts talking about how AI can potentially help transform the clinical services industry. And so I may not talk about all of that here just because of competitive issues, but we have a terrific AI leader groups, people in that. We have tremendous -- I think for our industry, we have some of the best thinkers associated with technology, artificial intelligence, et cetera. So that's going to be a key part of our drive going forward. Capital structure and SG&A improvement, clearly something that we're focused on. And again, I think we'll talk about that a little bit more in the question and answer, but Jill can take you through how we're looking to drive improvements in those areas. And then finally, the most -- one of the most important things this year is that we will be exiting the transition service agreements from our former parent company. And this is really what unlocks the opportunity to improve the margins in the SG&A here. And again, we'll talk about that a little more. Finally, 2025, what do we want to be? We want to be the CRO of choice for our customers, that's biotech and selected you large pharma. Now I say selected only in that in our size, we can't do everyone but we do serve about 50% large pharma, about 50% biotech. We want to keep that ratio. So as we grow, we want to continue to work with large pharma and also biotech, and we just think we've got the perfect combination. What large pharma does for you, is it gives you that consistent backlog? You know that you have a lot of projects coming because you're preferred with them. And what biotech does for you probably gives you a little bit better margins, you do a little more innovation there, and then you can bring that back to the larger pharmaceutical firms. So we want to keep that mix. If we have any TSAs left, we should be exiting them. And then importantly, we removed kind of an overhang on the business. When you do a spin, essentially, you indemnify your parent associated with tax issues and other issues. It's just part of what they do, they put the liabilities on you, it's part of that. So we would essentially extinguish all of those indemnities and that kind of overhang that we would have on the business when we exit all the TSAs. We're going to keep investing in differentiation, keep focusing on the commercial organization. This is 2025, continue to -- we'll really start driving the post-TSA operating and SG&A efficiencies. And as it says on the bottom, we're expect to start getting to -- toward market leverage ratios closer to 3 towards the end of 2025. Something that Jill and I have been explicit on though is that we are trying to exit 2024 at about a 13% EBITDA margin. This is where this company was in 2022 before the spin. And we believe if we exit those TSAs, we keep working on these levers, and we bring revenue back to this business, we can do that. So that we're at that level as we go into 2025 and then Jill can describe a little bit how we've given some modeling information to people on our earnings call, we could talk a little bit more about 2025 as well. So given that Barclays helped us with the transaction, we actually don't have Luke as our interviewer today as we normally would. So we're in that unusual situation. So our Head of Investor Relations, Hima is going to ask us questions and start us off, and then she'll take some questions from the audience. So Hima, I'll leave it to you.

Thank you, Tom. So Tom, maybe we'll start off with the Enabling Services divestiture the you announced yesterday. Maybe if you could talk about, give us some color on the strategic rationale behind the deal and what led you to this point?

Yes, yes. Essentially, last fall, we did a strategic review, and we really looked -- as we looked across the investments and what the different business needed. We decided that our investments and our management focus, to be honest with you, is really best placed in these clinical businesses Phase I to Phase IV. If you look at these businesses, the trading multiples in the private markets are high. It's very attractive. The most attractive part of our business when you look at when we speak to book bills, that is really on the clinical segment of our business. And then the other two businesses are great businesses but something like patient access, it's really targeted towards that 10% of commercial pharmaceuticals that goes to patients who need access to those products. It's a very different business, not really aligned in with us. And then the endpoint business is what we call it's a randomization tool, and they can be very good businesses but they're going through a transition to introducing new technology generation. And just given the investment and attention that they need and the nature of randomization business, we thought if we had the right partner, those two could flourish better with that partner. I think in Arsenal, we found that partner. Probably everyone here knows Arsenal. They've certainly got a good history of really being able to develop businesses in this sector. And so we're excited about them taking those two businesses forward. But ultimately, what it lets us do is we focus on the business. We put our investments where we want. We think it's attractive both to our customers and to investors. And then finally, it does let us deal with our leverage with a little bit of flexibility.

Next question I'll ask you Jill, the one that is on everyone's mind. So if you can maybe talk about your margin trajectory for 2024 and 2025, you've exited 40% of TSAs at the end of 2023. So how do you see the incremental margin mention opportunity in 2024 from exiting the remaining TSAs?

Sure. So in the call yesterday, I talked about 2 halves for 2024, and that is really important. The first half, we still have kind of the headwinds from the spin year with the soft sales that we had the soft net new business award that was in that period of July of '22 through June of '23. That's going to really manifest most strongly, particularly in Q1. And then we're going to see that in the second half, we get back more to market growth, which we're saying roughly in that 3% to 5% based on the book-to-bills that we've delivered over the last two quarters and the solid pipeline that we see in front of us for 2024. And I guided around the fact that a midpoint about $300 million, you could see about 1/3 of that in the first half, more so in the second quarter and then the majority of that in the second half. So that improvement in the second half is largely driven by that revenue. We have been transparent about the fact that we've held on to some cost of sales resource essentially are people that generate revenue in anticipation of the growth because if we would let them go and then have to hire them back a couple once later, you're going to pay 20% more. And so we've held on to those people. So that growth in the second half largely doesn't need additional resources to support it. So it will drop through pretty strongly. The TSAs are really more so coming very much at the end of the year, and they really unlock the SG&A margin expansion into 2025. So we've shared that in the first quarter, we're going to start to report our cost of sales and our SG&A more in line with our peers. It was done a bit differently as part of Labcorp, you're going to see that there's a lot of opportunity in SG&A and exiting those TSAs at the tail end of this year will give us that opportunity for 2025. And as Tom mentioned, we said we expect to exit this year on that 13% trajectory and we would expect to continue that through 2025.

Great. And when you think about the longer term -- you're a great CFO, so when you think about longer term, right, how do you see margins evolving? Is there anything structurally different versus peers?

No, we don't think so at all. In fact, I think the focus on the Clinical Services businesses allows us to more closely match some of our peers. Probably when you get to the really, really high teens and low 20s, there is a little bit of scale mostly around your corporate cost, just being spread over a larger volume of revenue. But other than that, which I would say is relatively small, we still believe high teens is absolutely appropriate margin for us over time.

Great. So switching over to Tom, maybe if you could talk about a little bit about your recent conversations with customers? And any feedback you've received for spin, any feedback you have received at the end of the year?

Yes. Thank you. I think those of you who have followed us know that as we spun we were getting a lot of comments about the spin and there was concern. And one of the reasons that sales were soft in that 20 -- July 2022 to June of '23 period is because of concerns about the spin. Within about 6 weeks of the spin, we stopped hearing that. And I have to say now, it feels very much that we're at the table, and we're at the table with the largest CROs in terms of opportunities with big pharma. In terms of biotech, we have a solid pipeline. We were -- we have disclosed or disclosed in the earnings call that our pipeline is solid for Q1. We're obviously late in the quarter. We still have to execute because the way the CRO business works and some of you know it well, you have a lot coming at the very end of the quarter. And so -- but if we execute well, we can be at our target book-to-bill and -- but the exciting thing, honestly, I think our whole team is energized by the access for getting the leading pharmaceutical firms and great biotech firms. So I'm really pleased with our progress on that since becoming an independent company. If you think about it, nobody knew Fortrea a year ago, right? It was an idea. And now our name is around and well understood.

Great. Thank you. In the last few minutes, we'd like take any audience questions.

Any question.

All right. I am going to...

Hima has a few more prepared in any case.

Yes. Tom, maybe -- if you could talk about differentiation between FSP and full service, given all the distinction that's going on in the industry and what are peer are saying?

It's interesting. Those of you who follow this industry know that we have these two primary service models on the clinical side. One is full service outsourcing, where really the CRO takes over pretty much control of a project and drives the project independently with the support of the sponsor. And then the other model is FSP with much more resource focused where it's a bit more of a staffing business where project managers or CRAs or other elements, data management people will essentially be staffed to that sponsor. What we've seen over the last decade is quite a bit of growth from the latter model to that FSP model. Interestingly, as we look at it today, for a company of our size, and I want to emphasize that, for a company of our size, we are seeing sponsors still move in both directions. The meeting we had yesterday was the sponsor who traditionally has done virtually all FSP, who is now looking at adding full-service outsourcing. And so we're seeing that move. We're seeing some of the largest, most successful companies that have in-sourced start looking at outsourcing because some of them have had such successful products in the last couple of years and moving into new therapeutic areas, and they realize it's more efficient to do full service. That being said, you're still seeing some of the largest companies being very focused on FSP and a few people moving more towards it. So it's a really interesting thing in our business. It's probably -- it is push and pull, some are moving towards full service outsourcing, some are FSP. I think what we want to do as a company, though, if you think about what we're trying to do with our size, trying to improve our margins, it's to continue to focus on that full service outsourcing piece, and then where we think it makes sense, we will definitely do FSP too. Like we just won a really interesting FSP with a very large and successful leading pharmaceutical firm that gives us a foot in the door there. But then on the other hand, we heard this opportunity last night, where we're working on full service. So our goal is to kind of keep our mix and use FSP where it's appropriate to do it effectively but then also continue to focus on the full service outsourcing.

Thank you. We have 1 minute, if you have any closing remarks?

Well, I guess that's a long time for closing remarks, but it is good to end early. At Fortrea, we get a lot of stuff done. So we often end things early. I do think we remain super excited. We've put together a great leadership team considering where we are. And if you listened to our earnings call yesterday, I tried to tick off some of the things we've accomplished in the past year, Jill, with the spin team up to the spin and then since we've done it. I mean we're moving at an incredible pace. We're really establishing this brand. We're at the table with leading pharmaceutical firms and their executive teams who are really interesting to buy our tech. We've got the plans and already have started to work on the cost structure elements. We've put in place the partners to do it. We're working closely with our former partner or a former parent to get out of these TSAs. So given where we are today and where our margins are, I feel like the growth we're putting through us and then the plans and actual activities we have improve margins are going to make this one of the most interesting investment stories over the next couple of years. So I -- we do appreciate your interest, and you can always contact Hima to get more information and get access to us. So with that, thank you.

Thanks, Tom. Thank you very much.

Thank you, everyone.