Investor Essentials Daily

 A “new” player in the contract research ecosystem

March 21, 2024

Contract research organizations (“CROs”) are crucial for assisting biotech and pharma companies in bringing drugs from testing to market, operating in a growing market with considerable demand.

Global biopharma R&D spending is significant and increasing, with CROs managing an expanding share of clinical trials.

Fortrea (FRTE), the sixth-largest CRO with a 7% market share, supports drug developers through every trial stage, aiming to improve its margins now as an independent entity after separating from Labcorp.

Despite its current lower returns compared to industry leaders, Fortrea is focusing on growth and operational improvements to enhance its profitability.

The CRO industry’s consolidation and Fortrea’s potential acquisition by larger players could rapidly improve its profitability, making it a compelling investment option with strong returns, growth potential, and attractive valuation metrics.

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Contract research organizations (“CROs”) help biotech and pharma firms take drugs from testing to market efficiently. This is a strong, growing market with plenty of tailwinds.

Global biopharma R&D spending is around $250 billion per year. It is forecast to rise by another $40 billion over the next five years.

CROs manage roughly half of the trials fueled by that spending. Plus, they’ve been taking on a larger share. In 2010, CROs managed less than 40% of total trials. In 2022, they were up to 52%.

Like most other CROs, Fortrea (FTRE) helps drug developers through every stage of the trial process.

That includes step-by-step planning of clinical trials, finding and enrolling trial patients, managing each stage of the clinical trial process, from safety trials to dosage level trials to efficacy trials, and if approved, implementation and other services to take the drug to market.

The CRO industry is very concentrated as managing these complex trials requires scale in terms of hospital relationships, sourcing talent and patients, working across big geographic footprints, and investing in technology to run everything smoothly.

Fortreais currently the sixth-largest player in the space, with only a 7% market share, indicating it has plenty of room to grow.

Top-tier CROs earn incredibly high returns, with industry-leading IQVIA garnering a 120%+ Uniform ROA, and ICON plc not far behind at ~90%. Fortrea’s still lofty 34% Uniform ROA looks paltry in comparison.

The issue has been that Fortrea didn’t get enough attention as a subsidiary of Labcorp. Its margins suffered.

That said, now that Fortrea is a standalone company, CEO Thomas Pike has prioritized margin improvement. With its current Uniform earnings margin near 10% levels, Fortrea can make steady progress to catch up with IQVIA’s and ICON’s 15% and 17% Uniform earnings margins, respectively

The CRO business is a scale game and Fortrea management is taking steps to improve operations.

Its 20% Uniform asset growth expansion this year should help it progress toward attaining the scale advantages that would allow it to reach peer-level margins. This would translate to a 50% Uniform ROA in the long run.

Fortreacan stays a public company and improves itself the hard way, but it’s big peers would argue the easiest solution is to buy it and fix it from within.

Fortrea did not benefit from LabCorp’s scale because it was not a part of the firm’s core business. Labcorp specializes in diagnostics and lab testing. It is not a pure-play CRO. Under one of the larger CRO players, Fortrea would benefit from the scale advantages discussed above, which could lead to rapid profitability improvements.

Moreover, its industry-leading competitors have not been shy about acquiring companies in the past.

IQVIA was born from the 2016 merger of two large players, IMS Health and Quintiles. It has made 29 acquisitions since then. ICON has bought 12 companies in the past decade, including PRA Health Sciences for $12 billion in 2021, far larger than Fortrea’s ~$3 billion market cap.

Large peers like these could almost instantly leverage their scale to get Fortrea to 15%+ margins.

Other large investors seem to be clamoring for this option, including serial activist investor Starboard Value. As one of its largest post-spin off shareholders, Starboard has a near-8% stake in Fortrea. Starboard regularly swoops in to help broken companies right the ship.

While the firm’s margin expansion strategy is sound, Starboard thinks Fortrea should be putting out a “For Sale” sign to accelerate returns.

Fortrea’s existence as a standalone company has started well, with the firm leveraging an asset-light model to achieve high Uniform ROA.

As it continues to scale, its operating leverage could allow it to further improve returns in line with industry-leading peers.

Moreover, strong acquisition prospects in a consolidating industry could give investors a nice premium if realized.

With strong returns, growth, and a modest Uniform P/E driven by undue concern regarding the firm’s limited operating history and smaller scale, Fortrea satisfies all three pillars of the FA Alpha 50 screening process. As such, it could be an interesting addition to a well-balanced investment portfolio.

Throughout financial market history, many of the world’s most successful investors have been candid in their belief that Generally Accepted Accounting Principles (“GAAP”) distort economic reality.

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To see the other 49 names on the list, click here.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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