Fortrea Holdings Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (in millions) The following discussion and analysis is intended to provide a summary of significant factors relevant to the financial performance and condition of Fortrea Holdings Inc., which we refer to in this discussion and analysis as “Fortrea,” the “Company,” “our” and “we”. Prior to the spin-off (the “Spin” or “the Separation”), Fortrea existed and functioned as part of Laboratory Corporation of America Holdings, which we refer to in this discussion and analysis as “Labcorp” or “Former Parent.” The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited combined financial statements and corresponding notes and our unaudited condensed consolidated and combined financial statements and corresponding notes in Item 1. “Financial Statements.” Cautionary Statement Concerning Forward-Looking Statements This Form 10-Q and other materials we have filed or will file with the Securities and Exchange Commission (the “SEC”) include or will include forward-looking statements. Some of the forward-looking statements can be identified by the use of terms such as “believes,” “expects,” “may,” “will,” “should,” “could,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” “anticipates,” or other comparable terms. These forward-looking statements include all matters that are not related to present facts or current conditions or that are not historical facts. They appear in a number of places throughout this Form 10-Q and include statements regarding our intentions, beliefs, or current expectations concerning, among other things, our results of operations, financial condition, liquidity, prospects and growth strategies, and the industries in which we operate and include, without limitation, statements relating to our future performance. Forward-looking statements are subject to known and unknown risks and uncertainties, many of which are beyond our control. We caution you that forward-looking statements are not guarantees of future performance and that our actual results of operations, financial condition and liquidity, and industry development may differ materially from those made in or suggested by the forward-looking statements contained in this Form 10-Q. In addition, even if our results of operations, financial condition and liquidity, and industry development are consistent with the forward-looking statements contained in this Form 10-Q, those results or developments may not be indicative of results or developments in subsequent periods. A number of important factors could cause actual results to differ materially from those contained in or implied by the forward-looking statements, including the risks and uncertainties discussed in “Risk Factors” Section of our Information Statement filed with our Registration Statement on Form 10, as amended (the “Form 10”), as filed with the SEC. Factors that could cause actual results to differ from those reflected in forward-looking statements relating to our operations and business include, among other things: the risk that we may not realize some or all of the benefits expected to result from the Spin, or that such benefits are delayed; risks and consequences that are a result of the Spin; the impacts of becoming an independent public company; our reliance on Labcorp to provide financial reporting and other financial and accounting information for periods prior to the Spin through the end of the relevant transition agreements, as well as IT, accounting, finance, legal, human resources, and other services critical to our businesses; our dependence on third parties generally to provide services critical to our businesses throughout the transition period and beyond; the risk that establishment of our accounting, enterprise resource planning, and other management systems post the transition period could cost more or take longer than anticipated; the impact of the rebranding of the Company; our ability to successfully implement our business strategies and execute our long-term value creation strategy; risks and expenses associated with our international operations and currency fluctuations; our customer or therapeutic area concentrations; any further deterioration in the macroeconomic environment, which could lead to defaults or cancellations by our customers; the risk that our backlog and net new business may not rebound after the Spin to the extent or over the time period we anticipate, that such measures may not be indicative of our future revenues and that we might not realize all of the anticipated future revenue reflected in our backlog; our ability to generate sufficient net new business awards, or the risk that net new business awards are delayed, terminated, reduced in scope, or fail to go to contract; the risk that we may underprice our contracts, overrun our cost estimates, or fail to receive approval for, or experience delays in documentation of change orders; and other factors described in the Form 10 and from time to time in documents that we file with the SEC. 25 Table of Contents All forward-looking statements are made only as of the date of this Form 10-Q and we do not undertake any obligation, other than as may be required by law, to update or revise any forward-looking statements to reflect future events or developments. Comparisons of results for current and any prior periods are not intended to express any future trends, or indications of future performance, unless expressed as such, and should only be viewed as historical data. For a further discussion of the risks relating to our business, see the “Risk Factors” section of our Information Statement filed with our Form 10. Company Overview Fortrea Holdings Inc. ("Fortrea" or the “Company”), a Delaware corporation incorporated on January 31, 2023, is a leading global contract research organization (“CRO”) providing biopharmaceutical product and medical device development services, patient access solutions and other enabling services to pharmaceutical, biotechnology and medical device customers. The Company offers customers highly flexible delivery models that include Full Service, Functional Service Provider (“FSP”), and Hybrid Service structures. We have a rich history of providing clinical development services for over 30 years across more than 20 therapeutic areas, first as Covance and later as Labcorp Drug Development. On June 30, 2023, we completed a spin-off (the “Spin” or the “Separation”) from Laboratory Corporation of America Holdings (“Labcorp” or “Former Parent”). We leverage our global scale, clinical data insights, technology innovation, industry network and decades of experience as a standalone company and as a business unit prior to the Spin to deliver tailored solutions to our customers. With what we believe is a distinctive market offering, Fortrea meets growing global demand for clinical development services. Our team of approximately 19,000 employees conducts operations in more than 90 countries and delivers comprehensive phase I – IV clinical trial management, clinical pharmacology, differentiated technology enabled trial solutions and post-approval services for our customers. Our offering is scaled to deliver focused and agile solutions to customers globally, streamlining the biopharmaceutical product and medical device development process. Additionally, we successfully utilize enabling technologies to optimize processes and evolve with a dynamic marketplace. We manage our business in two reportable segments - Clinical Services and Enabling Services. The Clinical Services segment comprises services across the clinical pharmacology and clinical development spectrum. The Enabling Services segment provides patient access and clinical trial technology solutions. Separation from Labcorp On June 30, 2023, we completed the Spin from Labcorp through a pro-rata distribution of one share of Fortrea common stock for every share of Labcorp common stock held at the close of business on the record date of June 20, 2023. Fortrea began to trade as a separate public company (NASDAQ: FTRE) on July 3, 2023. Incremental Independent Public Company Expenses The condensed consolidated and combined statements of operations include costs for certain centralized functions and programs provided and administered by Labcorp that were allocated to us in the periods presented prior to the Spin. These centralized functions and programs include, but are not limited to, legal, tax, treasury, risk management, sales expenses, IT, human resources, finance, supply chain, executive leadership and stock-based compensation. These expenses were allocated to us based on direct usage when identifiable or, when not directly identifiable, on the basis of proportional net revenues or headcount or other reasonable driver, as applicable. We consider the basis on which the expenses have been allocated to reasonably reflect the utilization of services provided to, or the benefit received by, us during the periods presented. However, the allocations may not reflect the expenses we would have incurred as an independent company for the periods presented. Actual costs that may have been incurred if we had been a standalone company would depend on a number of factors, including the organizational structure, whether functions were outsourced or performed by employees, and strategic decisions made in areas such as IT and infrastructure. For a period following the Separation, however, some of these functions will be provided by Labcorp under transition services agreements. 26 Table of Contents The actual costs of services represented by these allocations may vary significantly from the amounts allocated to us in the accompanying financial statements. RESULTS OF OPERATIONS Three Months Ended September 30, 2023 compared with Three Months Ended September 30, 2022 and Nine Months Ended September 30, 2023 compared with Nine Months Ended September 30, 2022 The following tables present the financial measures that management considers to be the most significant indicators of the Company's performance. Revenues Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Clinical Services $ 711.7 $ 697.2 2.1 % $ 2,129.8 $ 2,127.6 0.1 % Enabling Services 64.7 65.1 (0.6) % 203.8 206.8 (1.5) % Total $ 776.4 $ 762.3 1.8 % $ 2,333.6 $ 2,334.4 — % The Company’s revenues for the three months ended September 30, 2023 were $776.4, an increase of 1.8% over revenues of $762.3 in the corresponding period in 2022. The change in revenues was due to an increase in organic revenues of 1.0% and favorable foreign currency translation of 0.8%. The Company defines organic growth as the change in revenues excluding the year over year impact of acquisitions, divestitures and currency. The 1.0% increase in organic revenues was primarily driven by an increase in pass through revenues offset by lower service revenues resulting from the mix and quantity of recent new business wins and the impact of a prior year FSP cancellation. The Clinical Services segment’s revenues for the three months ended September 30, 2023 were $711.7, an increase of 2.1% compared to revenues of $697.2 in the corresponding period in 2022. The increase in revenues was driven by an increase in pass through revenues offset by lower service revenues resulting from the mix and quantity of recent new business wins and the impact of a prior year FSP cancellation. The Enabling Services segment’s revenues for the three months ended September 30, 2023 were $64.7, a decrease of 0.6% compared to revenues of $65.1 in the corresponding period in 2022. The decrease in revenues was due to lower call center volume. The Company’s revenues for the nine months ended September 30, 2023, were $2,333.6, essentially flat over revenues of $2,334.4 in th e corresponding period in 2022. The change in revenues was due to an increase in organic revenues of 0.2% offset by unfavorable foreign currency translation of 0.2%. The 0.2% in crease in organic revenues was primarily driven by an increase in pass through revenues offset by lower service revenues driven by the impact of a prior year FSP cancellation, a customer concession and the mix and quantity of recent new business wins. The Clinical Services segment’s revenues for the nine months ended September 30, 2023 were $2,129.8, an increase of 0.1% compared to revenues of $2,127.6 in the corresponding period in 2022. The increase in revenues was driven by an increase in pass through revenues offset by lower service revenues resulting from the impact of a prior year FSP cancellation, a customer concession and the mix and quantity of recent new business wins. The Enabling Services segment’s revenues for the nine months ended September 30, 2023 were $203.8, a decrease of 1.5% compared to revenues of $206.8 in the corresponding period in 2022. The decrease in revenues was due to customer cancellations and lower call center volume. 27 Table of Contents Direct Costs, Exclusive of Depreciation and Amortization Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Direct costs $ 647.3 $ 594.8 8.8 % $ 1,932.9 $ 1,847.6 4.6 % Direct costs as a % of revenues 83.4 % 78.0 % 82.8 % 79.1 % Direct costs increased 8.8% during the three months ended September 30, 2023 as compared with the corresponding period in 2022. Direct costs increased as a percentage of revenues to 83.4% during the three months ended September 30, 2023 as compared to 78.0% in the corresponding period in 2022. Direct costs increased 4.6% during the nine months ended September 30, 2023 as compared with the corresponding period in 2022. Direct costs increased as a percentage of revenues to 82.8% during the nine months ended September 30, 2023 as compared to 79.1% in the corresponding period in 2022.The increase in direct costs in both periods was primarily due to higher pass through costs, transition services agreement costs and personnel costs partially offset by the removal of Former Parent corporate allocations and carve-out adjustments Fortrea received prior to the Spin. Pass through costs are paid by the customer resulting in revenue fully offset by these direct costs. Selling, General and Administrative Expenses, Exclusive of Depreciation and Amortization Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Selling, general and administrative expenses $ 78.9 $ 70.7 11.6 % $ 237.7 $ 216.5 9.8 % Selling, general and administrative expenses consist primarily of administrative payroll and related benefits, advertising and promotional expenses, credit loss provision, professional fees, administrative travel, facility charges and certain IT costs, and other administrative expenses. Selling, general and administrative expenses increased by 11.6% during the three months ended September 30, 2023 as compared with the corresponding period in 2022. The increase was primarily due to an increase in personnel costs, transition service agreement costs, credit loss provisions, and professional fees partially offset by elimination of prior year Former Parent corporate allocations and carve-out adjustments Fortrea received prior to the Spin. Selling, general and administrative expenses increased 9.8% during the nine months ended September 30, 2023 as compared with the corresponding period in 2022. The change in selling, general and administrative expenses was primarily due to an increase in personnel costs, credit loss provisions, transition service agreement costs and professional fees partially offset by elimination of prior year Former Parent corporate allocations and carve-out adjustments Fortrea received prior to the Spin. 28 Table of Contents Depreciation Expense Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Depreciation expense $ 8.6 $ 6.5 32.3 % $ 24.6 $ 20.0 23.0 % The increase in depreciation expense for the three months and nine months ended September 30, 2023 as compared to the corresponding periods in 2022 was due to the increase of property, plant and equipment, primarily IT assets, when they were separated between Fortrea and the Former Parent at Spin. Amortization Expense Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Amortization of intangibles and other assets $ 16.0 $ 16.2 (1.2) % $ 47.9 $ 49.7 (3.6) % T he decrease in amortization of intangibles and other assets during the three months ended September 30, 2023, as compared to the corresponding period in 2022, was not significant. The decrease in amortization of intangibles and other assets during the nine months ended September 30, 2023, as compared to the corresponding period in 2022, is primarily the result of the impairment of technology assets that occurred in the fourth quarter of 2022. Restructuring and Other Charges Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Restructuring and other charges $ 11.6 $ 5.2 123.1 % $ 16.7 $ 27.8 (39.9) % During the three and nine months ended September 30, 2023, the Company recorded net restructuring charges of $11.6 and $16.7, respectively, which is reflected within restructuring and other charges in the condensed consolidated and combined statements of operations. These charges are associated with Company actions to reduce overcapacity, align resources, and restructure certain operations and included eliminating redundant positions and aligning resources for cost improvement and to meet customer requirements. During the three and nine months ended September 30, 2022, the Company recorded net restructuring charges of $5.2 and $27.8, respectively. These costs were associated with general cost improvement and headcount reduction initiatives at various locations around the world. Interest Expense Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Interest expense $ (34.6) $ — 100 % $ (35.3) $ — 100 % The increase in interest expense for the three and nine months ended September 30, 2023, as compared with the corresponding period in 2022, is primarily due to the incurrence of indebtedness, consisting of borrowings under senior secured term loan facilities and senior secured notes. 29 Table of Contents Foreign Exchange Gain (Loss) Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Foreign exchange gain (loss) $ (0.9) $ 4.8 (118.8) % $ (1.0) $ 21.1 (104.7) % The change in foreign exchange gain (loss) for the three months ended September 30, 2023, as compared to the three months ended September 30, 2022, was primarily due to the relative weakening of the U.S. Dollar against the British Pound and the Euro resulting in $3.1 in foreign exchange losses offset by $2.2 of hedging gains from the Company’s hedging program for 2023. For the three months ended September 30, 2022, foreign exchange gains were $10.1 offset by $5.3 of hedging losses from the Former Parent hedging program. The change in foreign exchange gain (loss) for the nine months ended September 30, 2023, as compared to the nine months ended September 30, 2022, was primarily due to the relative weakening of the U.S. Dollar against most major foreign currencies resulting in $1.1 in foreign exchange losses and $2.1 of allocated hedging losses from the Former Parent hedging program offset by $2.2 of hedged gains from the Company’s hedging program for 2023. For the nine months ended September 30, 2022, foreign exchange gains of $34.2 were offset by $13.1 of allocated hedging losses from the Former Parent hedging program. Income Tax Expense Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 2023 2022 Income tax expense $ (4.8) $ 13.6 $ 9.5 $ 35.8 Income tax expense as a % of income before tax 26.8 % 18.3 % 22.6 % 18.3 % For the three months ended September 30, 2023, the Company's effective tax rate was 26.8% compared to the 2022 tax rate of 18.3%. For the nine months ended September 30, 2023, the Company's effective tax rate was 22.6% compared to the 2022 tax rate of 18.3%. The fluctuations in the quarter-to-date and year-to-date periods were primarily due to earnings mix and application of available tax credits in various jurisdictions. Operating Results by Segment Three Months Ended September 30, Nine Months Ended September 30, 2023 2022 Change 2023 2022 Change Clinical Services operating income $ 59.9 $ 108.5 (44.8) % $ 192.4 $ 299.8 (35.8) % Enabling Services operating income 2.3 5.7 (59.6) % 6.0 21.3 (71.8) % Segment operating income $ 62.2 $ 114.2 (45.5) % $ 198.4 $ 321.1 (38.2) % Clinical Services operating income was $59.9 for the three months ended September 30, 2023, a decrease of 44.8% from operating income of $108.5 in the corresponding period of 2022. The decrease in operating income was primarily due to lower service revenues driven by the mix and quantity of recent new business wins and the impact of a prior year FSP cancellation. Enabling Services operating income was $2.3 for the three months ended September 30, 2023, a decrease of 59.6% from operating income of $5.7 in the corresponding period of 2022. The decrease was driven by lower revenues combined with investments in resources related to servicing a recent new award. Clinical Services operating income was $192.4 for the nine months ended September 30, 2023, a decrease of 35.8% from operating income of $299.8 in the corresponding period of 2022. The decrease in operating income was primarily due to lower service revenues driven by the impact of a prior year FSP cancellation, a customer 30 Table of Contents concession, the mix and quantity of recent new business wins and an increased provision for credit losses. This was partially offset by decreased personnel costs. Enabling Services operating income was $6.0 for the nine months ended September 30, 2023 a decrease of 71.8% from operating income of $21.3 in the corresponding period of 2022. The decrease was driven by lower revenues combined with investments in resources related to servicing a recent new award. Liquidity, Capital Resources and Financial Position The Company manages cash flow to fund and invest in operational growth, capital expenditures, and credit facility repayments. In connection with the Spin, we have incurred indebtedness in an aggregate principal amount of $1,640.0, which consists of borrowings under senior secured term loan facilities and senior secured notes. We have also entered into a senior secured revolving credit facility, which consists of a five-year facility in the principal amount of up to $450.0 as further discussed in Note 6, Debt to the condensed consolidated and combined financial statements above. We have also entered into an accounts receivable purchase program (“ARPP”), which establishes a receivables factoring facility that permits the Company to sell up to $80.0 in customer receivables to a financial institution based on the availability of certain eligible receivables and the satisfaction of certain conditions. As of September 30, 2023, the Company had no outstanding factored customer receivables. We believe our existing cash and cash flows generated from operations, plus existing credit facilities, will be sufficient to cover the needs of our current and planned operations for at least the next 12 months. From time to time, we routinely evaluate strategic opportunities, including potential acquisitions, joint ventures or investments in complementary businesses. We may also access capital markets through the issuance of debt or equity, which we may use in connection with the acquisition of complimentary businesses or other significant assets, or for other strategic opportunities, or general corporate purposes. Cash Flows for the nine months ended September 30, 2023 and 2022 In summary the Company's cash flows were as follows: Nine Months Ended September 30, 2023 2022 Net cash provided by (used for) operating activities $ 155.0 $ 59.2 Net cash used for investing activities (22.8) (35.6) Net cash (used for) provided by financing activities (134.4) (0.4) Effect of exchange rate on changes in cash and cash equivalents (2.3) (10.3) Net change in cash and cash equivalents $ (4.5) $ 12.9 Cash and Cash Equivalents Cash and cash equivalents at September 30, 2023 and 2022 totaled $107.5 and $107.5, respectively. Cash and cash equivalents consist of highly liquid instruments, such as commercial paper, time deposits and other money market instruments, which have maturities when purchased of three months or less. Cash Flows from Operating Activities During the nine months ended September 30, 2023, the Company's operations provided $155.0 of cash as compared to $59.2 of cash during the nine months ended September 30, 2022. Net cash provided by operating activities increased by $95.8 for the nine months ended September 30, 2023 as compared to the nine months ended September 30, 2022. Cash flows from operating activities benefited from an improvement in unbilled services and deferred revenue and lower cash used for accrued expenses partially offset by a decrease in net income. 31 Table of Contents Cash Flows from Investing Activities Net cash used for investing activities for the nine months ended September 30, 2023 was $22.8 as compared to net cash used for investing activities of $35.6 for the nine months ended September 30, 2022. The $12.8 decrease in net cash used for investing activities for the nine months ended September 30, 2023, was primarily due to a year over year decrease in capital expenditures. Capital expenditures were $30.9 and $36.0 for the nine months ended September 30, 2023 and 2022, respectively. Capital expenditures in 2023 were 1.3% of revenues, primarily in connection with projects to support growth in the Company's core businesses. The Company intends to continue to pursue selective investments in key therapeutic areas and geographies to drive growth and to improve efficiency of the Company's operations. Such expenditures are expected to be funded by cash flow from operations. Cash Flows from Financing Activities Net cash used for financing activities for the nine months ended September 30, 2023 was $134.4 compared to cash used by financing activities of $0.4 for the nine months ended September 30, 2022. Cash provided by financing activities related to proceeds from term loans and senior note offerings was offset primarily by the net transfers to Former Parent. Off-Balance Sheet Arrangements The Company does not have transactions or relationships with “special purpose” entities, and the Company does not have any off-balance sheet financing other than normal operating leases and letters of credit. Critical Accounting Policies and Estimates We have chosen accounting policies that management believes are appropriate to accurately and fairly report our operating results and financial position in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). We apply these accounting policies in a consistent manner. Significant accounting policies are summarized in Note 2 to the combined financial statements included in the Form 10. The application of these accounting policies require that we make estimates and assumptions about future events and apply judgments that affect the reported amounts of assets, liabilities, revenues, expenses, contingent assets and liabilities, and related disclosures. These estimates, assumptions and judgments are based on historical experience, current trends and other factors believed to be reasonable under circumstances. Management evaluates these estimates and assumptions on an ongoing basis. If actual results ultimately differ from previous estimates, the revisions are included in results of operations when the actual amounts become known. The accounting policies that involve the most significant estimates, assumptions and management judgments used in preparation of the condensed consolidated and combined financial statements, or are the most sensitive to change due to outside factors, are discussed in Management's Discussion and Analysis in the Form 10. Except as disclosed in Note 1 to our condensed consolidated and combined financial statements in this Form 10-Q, pertaining to the adoption of new accounting pronouncements, there have been no material changes in these policies. 32 Table of Contents