Positive Long-Term Outlook Despite Near-Term Headwinds for Narrow-Moat Fortrea

Equity Analyst

Rachel Elfman

Fortrea is a global, late-stage contract research organization, or CRO, that provides comprehensive Phase I through IV clinical trial management, clinical pharmacology, and patient access solutions. Fortrea has a lengthy, 30-year history dating to the 1990s, originally part of Corning Incorporated's pharmaceutical services business. In 1997, Corning spun off this segment, which was named Covance. In 2015, Laboratory Corporation of America Holdings, or LabCorp, acquired Covance for $6.1 billion.

LabCorp invested in its new clinical development business through several acquisitions to expand its capabilities and global footprint, including through the 2017 acquisition of U.K.-based CRO, Chiltern, for $1.2 billion and other smaller-scale acquisitions expanding the company's pharmacovigilance, medical device, and decentralized technology capabilities.

Ultimately, LabCorp's clinical development and diagnostics segments operated largely autonomously and in July 2022, LabCorp announced that its board of directors had authorized it to pursue a spinoff of its clinical development business. On June 30, 2023, LabCorp completed the spinoff of Fortrea Holdings, and it began to trade as a separate public company.

There are potential operational risks, especially in the near term, with Fortrea functioning as a newly independent company after its spinoff from LabCorp. The company is carrying some additional costs associated with the spinoff, and it has higher costs and selling, general, and administrative expenses compared with its peers, resulting in margins below industry norms. Management is prioritizing its margin improvement efforts, and we have a positive long-term outlook for Fortrea. We anticipate outsourced clinical development from biotechnology and pharmaceutical companies will continue to drive growth for the company.

Business Strategy & Outlook

We award Fortrea a narrow moat due to its significant late-stage clinical trial exposure, regulatory expertise, and strong client relationships, which are supported by intangible assets and high switching costs. We believe exposure to late-stage clinical trials is crucial for moats in the CRO space as late-stage trials are larger in scope, more complex, often multinational, and have greater risks of failure, which enforce high switching costs.

As more complex clinical trials involving novel therapeutics provide room for differentiation, CROs like Fortrea leverage their expertise to shorten the clinical trial time frame while ensuring accuracy and precision for their clients. The drug development process is quite lengthy, as the entire process from discovery to registration with the U.S. Food and Drug Administration takes 10-15 years for a typical drug and the average length of time from the start of clinical testing to marketing is 7.5 years. Drugs typically have a 20-year patent life span, which begins at discovery. This means that clinical trials consume a significant portion of what could otherwise be patent-protected profits before generic drugs come to market.

Biotechnology and pharmaceutical companies seek to shorten the drug development timeline while maintaining the precision and accuracy necessary for regulatory approval. This is the driving force in the CRO business model, in which CROs leverage their assets and expertise to design a trial tailored to regulatory technicalities, quickly identify target patients at sites around the world for rapid enrollment, and then advise on data collection and analysis for regulatory approvals.

According to Research and Markets, clinical trials conducted by CROs are completed up to 30% more quickly than those conducted in-house by pharma companies. This increased speed results in considerable savings for clients because drugs could reach commercialization faster, which results in longer patent-protected time on the market.

The speed and quality of clinical trials are essential since late-stage trials are expensive and the stakes for a successful outcome are high. There is also a high risk of failure at each step of a drug’s development process, and clinical trials are very expensive. According to a 2020 study released in the Journal of the American Medical Association, the median cost of developing a new drug was $985 million, with the average cost totaling $1.3 billion. The study was based on data for 63 drugs developed by 47 companies between 2009-18. Additionally, biopharma companies need a CRO not only with strong technical expertise in specific disease areas, but also with knowledge of government relations, regulations, and even local country cultures as most clinical trials are multinational. 

The scope of clinical trials is multinational, which emphasizes the need for a global infrastructure and extensive knowledge of global regulations. Rather than carrying out a clinical trial in one geography and securing one regulatory approval before moving on to trials and approvals in other countries, biopharma customers tend to initiate large, multinational late-phase trials for promising therapies to expedite the process of bringing a drug to market on a global scale. Fortrea possesses this expertise, with its team of 19,000 staff members and operations in 90 countries. Fortrea helps its customers by running trials across more than 20 therapeutic areas across every phase of the development process, from clinical pharmacology to phase 4 studies conducted post-approval.

Biopharma clients choose top-tier CROs to run their clinical trials for their intangible assets, reputation, and long-standing partnerships. Clinical trial outsourcing has steadily increased from 37% in 2007 to over 51% in 2022, and we expect outsourcing penetration will continue to steadily grow as trials become more complex with novel therapeutics.

Fortrea is focused on serving a diverse set of customers across the biopharma landscape, with 54% of its 2022 customer mix represented by large pharma firms while biotechnology and medical device firms comprised 46%. Fortrea works with these customers to run their clinical trials as a functional-service provider, full-service provider, and offers hybrid trials.

Small biotechnology companies are heavily reliant on outsourced clinical trial services as they do not have the capacity to conduct in-house clinical trials compared with large pharmaceutical firms. Large pharmaceutical companies typically select a handful of trusted CROs to run their clinical trials. Some of these large pharmaceutical firms contract work to CROs on a functional-service model, meaning they outsource specific clinical trial tasks. In comparison, small to mid-size biotech companies tend to select one trusted CRO to run their clinical trials and they often need full outsourcing solutions, so they outsource studies on a full-service model.

Biopharma customers are very reluctant to switch to a different CRO once late-stage clinical trials begin since it is difficult and costly in terms of time and expense to switch as this would create a several monthslong delay in the clinical development timeline and reduce precious patent-protected time if the drug proves successful and receives regulatory approval. Additionally, companies typically stay with their selected CRO throughout the drug’s lifetime for the continued study and development of additional indications, such as expanding a drug to patients of different age groups or evaluating booster/combination therapies. These switching costs are also supported by familiarity, in which clients prefer the continuity of working with the same trusted CRO since it has expertise concerning the clients' needs, systems, and methods.

We also appreciate Fortrea’s clinical pharmacology business and the value it provides to customers. Fortrea’s capabilities in this business support early-phase studies by conducting phase 1b hybrid studies that move from normal healthy volunteers into patient populations, providing early insights into pharmacodynamics and signals of therapeutic effectiveness. Fortrea has developed a multinational infrastructure of phase I facilities in both the U.S. and the U.K. This infrastructure is part of an integrated platform designed to enable consistent execution of complex early-phase clinical trials through project management, comprehensive monitoring, pharmacokinetic analysis, and biometrics. 

Additionally, Fortrea offers a suite of decentralized clinical trial capabilities, which allows it to be well-positioned to carry out next-generation trials. Decentralized, or remote trials, have seen increased adoption due to the COVID-19 pandemic. Biotechnology and pharmaceutical companies are encouraging regulatory agencies to continue building out a framework for evaluating decentralized clinical trials and real-world evidence for the use in regulatory decisions, so we appreciate that Fortrea has invested in decentralized technologies to keep up with customer demand for hybrid trials. Fortrea also has integrated technology and artificial intelligence within its clinic scheduling process to optimize the utilization of bedspace and has implemented bedside data capture technology.

Narrow

Economic Moat

Fortrea Holdings Inc

Earnings data Q2 2023

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Earnings data Q4 2023

Earnings data Q1 2024

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Fortrea Holdings, Inc. engages in the provision of clinical development and commercialization services. It operates under the Clinical Services and Enabling Services Segments. The Clinical Services segment provides services across the clinical pharmacology, clinical development, and other clinical service spectrum utilizing enabling services and technology through multiple delivery models. The Enabling Services segment provides technology solutions directly to customers that streamline complex randomization and optimize the trial drug supply process, while minimizing operational costs and supporting timely and accurate patient dosing. The company was founded on January 31, 2023 and is headquartered in Durham, NC.

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Fortrea Holdings Inc. (FTRE) Q4 2023 Earnings Call Transcript

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For the three months ended September 30, 2023: Revenues of $776.4 million GAAP net loss of $13.1 million Adjusted EBITDA of $70.5 million GAAP and adjusted diluted earnings (loss) per share of ($0.15) and $0.24, respectively Quarterly book-to-bill ratio of 1.24x DURHAM, N.C., Nov. 13, 2023 (GLOBE NEWSWIRE) -- Fortrea (Nasdaq: FTRE) (the “Company”), a leading global contract research organization (CRO), today reported financial results for the third quarter ended September 30, 2023.

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