Starboard may be poised to build value amicably at contract research firm Fortrea

Business: Fortrea Holdings is a global contract research organization, or CRO, that provides clinical development and patient access solutions to the life sciences industry. CROs work with drug companies through all stages of the drug development process, from drug discovery and preclinical development to Phase I through IV post-approval work. The company was originally part of Covance from 1997 to 2015, where it had central lab preclinical and Phase I through IV clinical development capabilities. Covance was acquired by Labcorp in 2015, and Labcorp (LH) spun out Fortrea in July 2023.

Stock Market Value: $2.6B ($29.77 per share)

Activist Commentary: Starboard has made 113 prior 13D filings and has an average return of 26.61% versus 11.88% for the S&P 500 over the same period. Of these 113 filings, 13 have been on companies in the health-care sector, where Starboard has an average return of 38.64% versus 13.23% for the S&P 500 over the same period.

On Oct. 17, Starboard reported an 8.75% position in Fortrea Holdings.

Fortrea was spun out from Labcorp on July 3, as a Phase I through IV clinical development business. The company is one of the top seven contract research organizations that control 80% of the market. Over the years, drug companies have spent an increasing amount of money on research and development. With a material portion of that outsourced, the CRO industry has grown accordingly. So, there are strong secular tailwinds driving growth for the CRO industry, but to be a successful contract research organization, it helps to have global scale. Fortrea has operations in more than 90 countries with a focus on more than 20 therapeutic areas, which has allowed them to conduct over 5,000 trials over the last five years. However, despite having global reach and scale, the company’s adjusted 2023 earnings before interest, taxes, depreciation and amortization margins are only 9% (with projected 2024 margins of 13%), significantly below the peer median of 18%. This is not unusual for a company that has recently been spun out of a larger company as it could be saddled with a bloated cost structure in the spinout and could have been somewhat neglected operationally as a smaller part of a large company.  

So, now it is in a position to be run more efficiently with management solely focused on the CRO business. The crucial factor in achieving this is having the right CEO for the job, and Fortrea has that. In January, Tom Pike joined Labcorp as president and CEO of its Drug Development Clinical Development business unit and retained his CEO seat at Fortrea, upon completion of the spin-off. Pike has a track record for improving CRO profitability. When he was CEO at Fortrea peer IQVIA (formerly known as Quntiles), he increased margins by 425 basis points between 2012 and 2016, and led the stock to substantially outperform the market by 48% over that time. He has already committed to increasing margins at Fortrea to 13% from 9%, but this still falls short of peer performance. Starboard thinks that the company can reach pure margin levels of 18%. The firm has a great deal of experience helping portfolio companies run more efficiently and improve margins either as an active shareholder or member of the board.

With Pike as CEO and margin guidance going in the right direction, we expect Starboard will be an engaged shareholder here and look for a board seat only if things do not progress as planned. In that case, there is no reason why this would not be amicable. Both Starboard and Pike share the same views regarding margin improvement and seem to be rowing in the same direction. With peer margins and peer multiples, Starboard sees this as a $47 to $72 stock.

Finally, there may also be compelling strategic opportunities to create shareholder value. Private equity firms and strategics have been frequent acquirers of CRO assets and recent transactions have been at higher multiples, with a median of 14x EBITDA. Moreover, this is a consolidating industry right now. Elliott Management recently partnered with Patient Square Capital and Veritas Capital to acquire Fortrea peer Syneos Health Inc (SYNH) for $7.1 billion. That acquisition is expected to close in the second half of 2023. Elliott also just got management of Catalent, an outsourced manufacturer in the pharma industry, to pursue a strategic review. Once margins are improved and the company is running efficiently, there may be significant private equity and strategic interest here as well.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. Fortrea Holdings is owned in the fund.