Earnings Call Transcript - FTRE Q3 2024

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to Fortrea Third Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would like now to turn the conference over to Hima Inguva, Head of Investor Relations and Corporate Development. Please go ahead.

Hima Inguva, Head of Investor Relations and Corporate Development

Good morning. Thank you for joining Fortrea's third quarter 2024 earnings conference call. I am Hima Inguva, Head of Investor Relations and Corporate Development at Fortrea. On the call with me today are our CEO, Tom Pike; and CFO, Jill McConnell. The call is being webcasted, and the slides accompanying today's presentation have been posted to the Investor Relations page of our website, fortrea.com. During this call, we'll make certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to significant risks and uncertainties that could cause actual results to differ materially from our current expectations. We strongly encourage you to review the reports we filed with the SEC regarding these risks and uncertainties. In particular, those that are described in the cautionary statement concerning forward-looking statements and Risk Factors in our press release and presentation that we posted to the website. Please note that any forward-looking statements represent our views as of today, November 8, 2024, and that we assume no obligation to update the forward-looking statements even if estimates change. During this call, we'll also be referring to certain non-GAAP financial measures. These non-GAAP measures are not superior to or a replacement for the comparable GAAP measures, but we believe these measures help investors gain a complete understanding of results. A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available in the earnings press release and earnings call presentation slides provided in connection with today's call. With that, I'd like to turn it over to our CEO, Tom Pike. Tom?

Tom Pike, CEO

Good morning, everyone. Welcome to the call. Let me start by saying that Fortrea had a solid quarter of execution and progress on our strategic objectives. Our bookings landed well, and we delivered on other key metrics as anticipated. Fortrea, as you probably know, is a pure-play CRO serving Phases 1 through 4. We're a leading global provider of clinical pharmacology or Phase 1 development, functional service provision, which we call FSP, and full-service outsourcing. Fortrea is broad and deep in how we address the market. We have preferred relationships with some large pharmaceutical firms and broad exposure to biotech. Our business overall is about 50:50 between large pharma and biotechs. Our large pharma partners appreciate that we have sufficient scale to conduct clinical services almost anywhere in the world. The biotech customers value that we're small enough to give our customers the personal attention they need to drive agile solutions. Both types of customers value our 30 years of experience and expertise. Since Fortrea spun out of our parent, our customer and net promoter scores have improved, especially recently. We're getting external recognition too. This quarter PharmaTimes recognized a number of Fortreans for their great work, including an in-house CRA, global project manager, and other roles. In addition, Fortrea has just been named a finalist in Fierce Healthcare's Excellence in Data-Driven DEI Award for our DEI Dashboard. We're also a finalist in the CRO of the Year category in the annual Scrip Awards. Both awards will be announced in early December. All that is pretty incredible given we've only been independent for 16 months. Now, here are some highlights for execution and progress during the quarter. We achieved a book-to-bill of 1.23 for the quarter. We closed a number of important projects with larger pharmaceutical customers, and we had success with biotechs. Our pipeline of opportunities for the next two quarters is solid. Our exit from our former parent is nearly in sight with over 90% of the servers and application systems migrated to our independent Fortrea environment. Our EBITDA and revenue were in line with our expectations. And finally, we continue to uncover why this business has underperformed financially and the people, process, and technology required to fix that. As usual, I'll provide some detail on some of these highlights, and Jill will fill in with others. Last quarter I discussed a new large pharma relationship and some footholds, as we call them, of work in other larger companies. This quarter, we made progress getting started with these customers, including responding to some early request for proposals. For instance, one of the footholds resulted in an attractive full-service engagement. This project is a significant Phase 3 trial that Fortrea won based on our therapeutic expertise in the specific area and our deep investigator relationships. Some other larger projects also came through as planned from long-time larger customers. Biotech companies also featured strongly in our full-service wins in the third quarter across a number of therapeutic areas. We had key biotech wins in oncology, diabetes, dermatology, and autoimmune disease. While we're known for our oncology expertise across our customer mix, we continue building a strong position in other areas such as ophthalmology, where our expertise in wet AMD and gene therapy skills are seen as a strong differentiator. Fortrea's real-world evidence consultants and scientists won several virtually designed observational studies in the AsiaPac region for different pharma customers. Our consulting and science help us differentiate. Our clinical pharmacology business continues to have strong bookings with attractive book-to-bills, customers, and indications. As we've discussed in the past and with analysts, our lead executive for CPS saw some softness in biotech around the time of the spin and has successfully transformed the mix to ensure a strong pipeline of attractive opportunities. That team has been particularly successful with larger pharmaceutical firms who are spending. Our CPS business also continues to have a solid pipeline of qualified new business with biotech customers. For instance, this quarter, we secured an important contract with a new biotech customer for a Phase 1 study supporting its Alzheimer's program. What was significant about this award is that we were initially not selected for the program but were able to unseat the incumbent CRO because of our solutions, focus, and expertise in the area. Our experience with complex programs and CPS helps us transition our strong relationships in Phase 1 into Phase 1b and 2. As we discussed last time, we're making progress there with an increasing win rate. We also continue to press ahead with some productivity and innovative technology projects. We have a nice tool that's used by Fortrea and a couple of pharmaceutical firms for study oversight and optimization. We showed our roadmap to customers and several prospects this quarter and generated a lot of excitement. AI and ML are being added to try to improve predictability and utility to that tool. We're also looking at some other interesting applications of technology and AI tools in practical complex areas such as protocols and amendments, SOPs, a CRA co-pilot tool, and continuous data cleaning. Now, let me address the questions I anticipate you will ask about our second half bookings. As we told you, going into the third quarter, our pipeline was higher than the average of the prior three quarters with a nice mix of large pharma and biotech. Coming into the fourth quarter, the same metric held, and the pipeline was greater than the average of the prior three quarters. Consistent with our Q2 commentary, we continue to target a 1.2 book-to-bill for the second half. We know we need to execute through the quarter. Regarding revenue and adjusted EBITDA in light of the backdrop of spin-related complexity, I'm pleased with our execution. In addition to a strong quarter for new business, we delivered on expectations of revenues. We also continued to expand our margin delivering EBITDA as we expected. We know that we have continued work to do, but we're making progress.

Jill McConnell, CFO

Thank you, Tom, and thank you to everyone for joining us today. As a reminder, all my remarks relate to continuing operations of Fortrea following the divestiture of our Enabling Services businesses unless I note otherwise. I'll start by saying that this quarter has delivered as we expected. Revenues of $674.9 million declined 5.4% year-on-year. The reduction versus the prior year was driven by lower service fee and pass-through revenues. Our service fee revenue continues to be impacted by a combination of factors, primarily lower new business awards in the pre-spin period along with the mix of later-stage and longer-duration studies in our portfolio. The pass-through decline is driven by lower pass-throughs on the biomarker study we have previously called out, which is continuing to normalize given its stage in the project life cycle. On a GAAP basis, direct costs in the quarter decreased 6.6% year-over-year, primarily due to lower personnel costs as well as lower pass-through costs, partially offset by an increase in stock compensation and professional fees. SG&A in the quarter was higher year-over-year by 27.6%, primarily due to an increase in professional fees and incremental one-time costs incurred for exiting the TSA, along with the yield costs related to the receivable securitization program we initiated in the second quarter. The company reclassified $39 million from direct cost to SG&A expense in the prior year comparison period, primarily related to information technology costs and certain non-clinic facility charges. For the third quarter, you will see SG&A as a percent of revenue on a GAAP basis at 20.2%. However, if you exclude the impact of approximately $27 million of one-time costs related to the continued separation from our former parent and the incremental impact of a full quarter's worth of expense related to the yield cost underlying SG&A as a percent of revenue, it was consistent with the last two quarters. Net interest expense for the quarter was $22.4 million, a decrease of $12.2 million versus the prior year benefiting from the repayments we made on Term Loan A and Term Loan B during the second quarter. When looking at annualized interest expense using outstanding debt, securitization usage, and rates in effect during the third quarter 2024, annual total cash interest and securitization costs are estimated to be approximately 18% lower compared to the annualized costs we were incurring at the start of 2024. Turning to our tax rate. The effective tax rate for continuing operations for the quarter was a benefit of 48.3%, reflecting an updated split of domestic versus foreign earnings relative to our latest forecast. During the third quarter, we recognized the tax benefit of $17.3 million in continuing operations primarily due to this update in forecasted pre-tax loss, partially offset by a valuation allowance on our deferred tax asset related to the carry-forward of disallowed interest expense. We continue to consider initiatives that we expect could improve our overall tax position over time. Our book-to-bill for the quarter was 1.23x and for this trailing 12 months is 1.15x. Our backlog at around $7.6 billion has grown 6.2% over the past 12 months. Adjusted EBITDA for the quarter of $64.2 million decreased 5.9% year-over-year compared to adjusted EBITDA of $68.2 million in the prior year period. Note that adjusted EBITDA increased 16.3% on a sequential basis in line with our expectations. Adjusted EBITDA margin for the third quarter was 9.5%, compared to 9.6% in the prior year period. Adjusted EBITDA margin in the quarter was negatively impacted by lower service fee revenues in the quarter along with higher SG&A costs post-spin to support operations as a public company. These were partially offset by the benefit from the restructuring program we initiated in the third quarter of 2023, which has continued into 2024. In the third quarter of 2024, adjusted net income of $20.7 million increased 3% compared to adjusted net income of $20.1 million in the prior year period. Adjusted and net income for both basic and diluted share for the current quarter and the prior year period was $0.23. Turning to customer concentration. Our top 10 customers represented 51% of third-quarter 2024 revenues. One customer accounted for 15.1% of revenues. As I comment on cash flows, note these relate to Fortrea in total as we have not segregated cash flows from discontinued operations. For the nine months ended September 30, 2024, we reported $245.7 million in cash flow from operating activities compared to $150 million generated in the prior year. Cash flow benefited from the sale of receivables under the securitization facility and an increase in unearned revenue, partially offset by the decrease in net income. Free cash flow was $217 million, compared to $119.1 million in the first nine months of 2023. Net accounts receivable and unbilled services for continuing operations were $689.1 million as of September 30, 2024, compared to $988.5 million as of December 31, 2023. Days sales outstanding from continuing operations was 50 days as of September 30, 2024, four days lower than June 30, 2024. The reduction versus the second quarter is primarily due to reductions in our unbilled services balance, as we continue to enhance our contracting terms and processes. We continue to make changes to our contracting and order to cash processes to enable further improvement to our DSO profile over time. We are fully compliant with the financial maintenance covenants of our credit agreement as of the end of the quarter. We ended the quarter with more than $0.5 billion of liquidity. Our capital allocation priorities are unchanged, focusing in the near-term on infrastructure investments for the timely exit of the transition services agreement with our former parent, targeted investments to drive organic growth and improve productivity, and then debt repayment. Now, I will provide an update on our transformation program. We continue to make progress on our journey towards improving the longer-term growth and profitability of Fortrea. Our competitive approach to winning new business awards is a primary objective of our entire leadership team, and we regularly leverage their relationships and experiences to enhance our partnerships with our customers. On operational execution, our first priority is delivering high-quality work for our customers. We continue to execute on productivity improvements and actions that speed our time to study startups and milestone delivery. At the same time, there are specific areas that we believe require measured investments to ensure revenue growth and enhanced operational effectiveness. For example, we are making select investments in our commercial organization, certain operational areas, and parts of SG&A. We know that given our current margins, we need to deliver savings elsewhere to fund these investments. We expect to exit the vast majority of the TSA services by year-end with a limited number being exited early in 2025 to ensure business continuity through 2024 year-end. We are continuing with targeted programs to reduce costs, including programs intended to better align our resources with the needs of specific projects while reducing pockets of lower productivity. The improvement in overall adjusted EBITDA this quarter is attributable largely to these programs. We are continuing with our plans to reduce SG&A costs across our supporting functions. We expect the benefit from these to ramp up during 2025, as we believe that full independence from our former parent will enable us to deliver these functions in more efficient ways versus how they were historically delivered. Regarding 2024 guidance, we have updated our revenue guidance range to $2.7 billion to $2.725 billion. The reduction in the top end of the range is primarily driven by lower trends and pass-throughs consistent with what I discussed earlier. Our adjusted EBITDA guidance range of $220 million to $240 million remains unchanged. There are a number of moving parts that we are navigating and managing closely, such as the transition of key internal IT systems and devices in and around the fourth quarter. These technology transitions do not impact customer-facing systems. We expect to provide 2025 guidance in the first quarter of 2025. Building our backlog along with efforts to drive margin expansion continue to be the primary focus of our leadership team. I am not commenting specifically on 2025 targets as they will be informed by the exact timing of exiting the TSA services from our former parent along with having more certainty on fourth quarter net new business awards and a better sense of the pipeline of opportunities heading into 2025. Before I conclude, I want to take a moment to acknowledge the significant progress our teams are making towards fully exiting the Transition Services Agreement, as well as to build the new infrastructure that will enable us to operate more efficiently and effectively. As Tom mentioned, more than 90% of our IT applications and servers have been transitioned, and the teams leading our HCM and ERP implementations are on track for their respective December and January go-live dates. It's easy to think, okay, what's next? But this demonstrates that our teams have the determination and agility to execute difficult tasks under challenging circumstances. This effort, combined with the work we've done to strengthen our capital position, is laying the foundation for the long-term growth and profitability of Fortrea. There is still work to be done, but we are putting building blocks in place to create long-term value for all of our stakeholders. With the solid foundation we have laid in the past year, attractive backlog of nearly $7.6 billion, and a talented global team of more than 15,500 professionals, we are committed to longer-term growth and margin expansion. Our commitment to execution along with our focus on innovation and customer satisfaction, as shown by our improving NPS scores, are unlocking new opportunities, enhancing our position in the market. We are confident in our ability to improve margins and deliver significant value for our customers, employees, and shareholders over time. Now, I'll turn it back to Tom for the remainder of his remarks.

Tom Pike, CEO

Thank you, Jill. In closing, let me provide a few thoughts about the remainder of the year. Regarding the fourth quarter of 2024, as I mentioned, our pipeline of opportunities has grown and has sufficient large pharma which should be more predictable. We're targeting 1.2 book-to-bill in the second half. We have looked at qualified opportunities for Q1 and feel it is solid at this point. Our customer systems such as Veeva and Medidata are already transitioning in production in Fortrea's environment. I'll be excited to see our new ERP system implemented this quarter. Next year, our hardworking teams will turn their attention to making improvements for Fortrea. Moving to customers, I had a number of senior-level meetings with our larger pharma customers this quarter and got consistent reports of the strong job our teams are doing. While the environment is uncertain for some larger pharma organizations causing companies to increase or decrease their spend in R&D, we're doing our best to help them through whatever they need to do. I have also met with many biotech prospects and customers, and the Fortrea teams are doing well. They're bullish on their therapeutic assets and know Fortrea can provide top-quality data packages for regulators. We provide multiple executive touch points to help them achieve their goals, often complex goals with clinical research. In Q3, we published our inaugural Corporate Social Responsibility Report, underscoring our commitment to safety, environmental stewardship, fairness, and ethical governance in everything that we do. In summary, Fortrea had a solid quarter of execution and progress, and we're well-positioned for growth and value creation in the future. I would like to recognize our Fortrea team around the world. It can be challenging to balance the competing demands of working at a 30-year old company with the needs and energy of a startup. Our team is committed to customers and the important work of developing solutions that bring treatments to patients sooner. I'm proud of what we've achieved so far and remain excited about what we can deliver in the years ahead. Operator, can you please open the lineup for questions? Thank you.

Operator, Operator

Thank you. Our first question will come from Eric Coldwell with Baird. Your line is open.

Eric Coldwell, Analyst

Thanks very much. Good morning. Good job to pull in 3Q as you did. I wanted to ask about clinpharm in particular. You have quite a few studies going in your various units. They're not all diabetes and weight loss, but there are quite a few of them. I'm curious if you could talk about what the nature of studies have. How that's transitioned this year? Is clinpharm really getting a lift because of the GLT-1 type category or are you seeing strength in other therapeutic categories as well? What's your overall read on how strong the overall Phase 1 market is?

Tom Pike, CEO

Yes. I think I'd start, by the way, good morning, Eric. I think I'd start by saying that one of the things we think about here at Fortrea is given our size and given our breadth, we do have a different kind of exposure than the largest CRO to the marketplace. And the exposure we have is to some attractive large pharmaceutical firms in Phase 1 in particular, as well as to biotechs around the world. And so the combination of those two, we've kind of re-spliced that business in terms of how we target ourselves in the market, and we're really trying to target those organizations that are spending well. Interestingly, Eric, we do some work on GLP-1s, but we also have broad exposure across the business. As I mentioned, and I actually, I had another point that I didn't add in, an interesting autoimmune compound that we have in the UK that we're working on. We have a wide variety of things that we work through. So it's actually less GLP-1 oriented and it's more oriented across a wide array of sophisticated scientific therapies.

Eric Coldwell, Analyst

That's good to hear. And Tom, you mentioned the win rate was up and Net Promoter Score is up. Are there any stats or metrics you could give us around those putting comparison…

Tom Pike, CEO

...specifics, because then you'll ask me next time and.

Eric Coldwell, Analyst

Of course.

Tom Pike, CEO

We have seen an increase in our win rates since the spin year. Our CPS win rates are performing well, and the Net Promoter Scores have also improved since the spin. We are quite proud of these achievements as we progress.

Eric Coldwell, Analyst

Great. If I could squeeze one last one in with Jill, just a technical one. A lot of moving pieces with the TSAs, the facility and the rates changing just a lot moving on here with your interest expense, you gave some metrics on the improvements year-over-year. I'm curious if you could give us a sense on where you see sort of normalized interest expense quarterly. What's the exit rate on that as we go into 2025?