Sotera Health Company (SHC) Earnings Call Transcript & Summary

Thanks, operator. Morning, everyone, and I appreciate you being with us on Sotera Health's call covering results from the first quarter of 2021. We've begun 2021 strongly, posting growth in the double digits for both revenue and adjusted EBITDA during Q1 while navigating continuing difficulties brought on by the pandemic. These solid figures — our initial complete quarter operating as a public company — remind us that Sotera Health occupies an essential spot within the health care value chain, acting as a top worldwide supplier of mission-critical, end-to-end sterilization solutions along with lab testing and advisory services for the health care industry. Against Q1 of the prior year, total revenue rose roughly 13%, adjusted EBITDA climbed about 15%, and adjusted EPS came in at $0.18. We're also still carrying out our strategic priorities, including buying BioScience Laboratories, directing capital toward growth efforts, and reducing leverage further. Scott will cover our segment results and capital structure in greater depth shortly. During this quarter, just as in others, our segments kept concentrating on serving customers, healthcare workers, and patients; we carried out essential testing on personal protective equipment such as masks and gowns, plus we sterilized numerous medical devices and pharmaceutical products. A large number of those items are employed in the worldwide battle against COVID-19. We make sure this vital sterilization and testing is available while maintaining a safe workplace for our employees throughout the pandemic. Although our attention is on expanding the business, we're equally committed to using our cash and deploying capital strategically. Our priorities for capital deployment haven't changed, since we keep investing for growth, cutting debt, and seeking strategic M&A to expand the business over the long haul. On our debt situation, net leverage improved to 4.1x as of March 31 from 4.3x at year-end. We remain on track to hit the 2 to 4x long-term net leverage goal we shared with you before. Thanks to paying down debt combined with repricing our term loan, interest expense for Q1 2021 fell $35 million compared with Q1 2020. Operationally, we kept investing throughout the first quarter so that we can satisfy customers' present and future requirements. Nordion is putting money into 3 long-term cobalt supply development projects, while Sterigenics keeps moving forward with its 9 active capacity expansions across the globe. At Nelson Labs, we're continuing to grow capacity and capabilities so customer demand for microbiological plus extractable and leachables testing is met. We're likewise making excellent headway on constructing our European microbiological center of excellence, which should wrap up by year-end; regarding M&A, we closed 2 small transactions during the first quarter as well. As noted on our previous earnings call, we're happy to welcome BioScience Laboratories into Nelson Labs in March. BioScience, which has locations in Bozeman, Montana, offers outsourced antimicrobial and virology testing services to the pharmaceutical, medical device, and consumer products sectors. This acquisition is a strategic one and will build on capabilities Nelson already possesses in virology and antimicrobials. Additionally, during March we acquired the outstanding 15% stake in Nelson Labs Fairfield. That transaction was arranged as part of the 2018 deal to acquire Gibraltar Labs. Through Nelson Labs Fairfield, we gain broader microbiological and analytical chemistry testing capacity aimed at pharmaceutical and medical device market segments. Across our segments, we keep giving priority to operational excellence initiatives so as to generate efficiencies and better performance; over time, we anticipate that operational excellence will keep fueling margin expansion. Stepping away from our particular results for a moment, I'll offer a short remark about conditions in the wider markets we serve. When we shared 2021 guidance, we likewise stated an assumption that volumes would normalize gradually across the year. I'd characterize the first quarter trend as consistent with that expectation, since volumes began the quarter somewhat weakly and then strengthened progressively as the quarter went on. As you'd anticipate, there was some regional variation. Volumes have recovered more rapidly in the U.S. market, whereas Latin America and Europe — dealing with elevated virus case counts and other pandemic-related difficulties — have been slower to bounce back. On the whole, we feel good about both the broader market direction and our own results. Consequently, since first quarter performance gives us a strong base for the remainder of the year, we are at ease reaffirming the 2021 outlook we issued on March 9 of this year. Before handing things to Scott to walk through the first quarter and our 2021 outlook in greater depth, I want to pause once more and stress how much pride I take in the whole Sotera Health team as we keep pursuing excellence through this difficult period. I'll now pass the call to Scott.

Appreciate it, Michael. I'll walk through Sotera Health's Q1 highlights on a consolidated basis, then go deeper at the segment level. I'll wrap up with some thoughts on the balance sheet and cash flows, plus additional color on our 2021 outlook. During the first quarter of 2021, revenue increased roughly 13%, reaching $212 million. Constant currency revenue was up about 11%. Adjusted EBITDA rose nearly 15%, hitting $105 million, while adjusted EBITDA margins widened by more than 80 basis points versus Q1 a year ago. Solid operating results translated into adjusted EPS of $0.18 per share, an increase of $0.08 over Q1 of 2020. Before diving into segment specifics, I'd like to remind everyone how we handle reporting of corporate costs. Rather than reporting a standalone corporate segment, we allocate every administrative cost across our segments. In Q1, the segments are absorbing roughly $4 million in added administrative costs versus Q1 a year ago. About $1 million of that increase comes from the secondary offering we completed in March of this year, with the rest mostly tied to costs of operating as a public company. Those costs produced a margin headwind across all 3 segments; that headwind was especially notable at Nordion, which saw margins compress as a result. Now let's examine segment results more closely. At Sterigenics, Q1 brought 12% growth in both revenue and segment income compared with the prior-year first quarter. Growth drivers for the quarter included the Iotron acquisition, which added 5%, pricing, which added approximately 3%, and organic volume growth, which added a little over 2%. Versus last year's first quarter, segment income margins at Sterigenics edged higher in Q1 of 2021, as favorable pricing and operating leverage were largely offset by added administrative costs tied to being a public company. As Michael noted, we keep making meaningful investments in Sterigenics. We recently announced an expansion at one of our European facilities, which is 1 of 6 Sterigenics expansions slated to come online this year. We're also continuing to advance facility enhancements at our North America EO sites. Nordion posted Q1 revenue growth of 10% over the prior year, reaching approximately $26 million, along with segment income growth of 6%, to almost $14 million. Nordion's top line benefited from a 4% lift due to the Canadian dollar strengthening against the U.S. dollar, a 3.6% increase from pricing, and roughly a 2% impact from volume, primarily tied to shipments of medical-use Cobalt-60. Margins declined by approximately 200 basis points, driven largely by the added administrative costs I mentioned earlier. Nelson Labs grew Q1 revenue versus the prior year by more than 16%, to $55 million, and grew segment income by approximately 30%, to $23 million. The Q1 2021 revenue performance continued to be driven by strong demand for testing related to personal protective equipment, which accounted for 10.3% of the growth. Although the mix of volumes across our other testing segments varied, we're pleased by the robust demand in certain areas, such as testing tied to product development and antimicrobials. During the first quarter of 2021, margins grew 430 basis points versus the same quarter a year earlier, since Nelson Labs keeps gaining from multiple operational excellence programs along with pricing and mix that worked in our favor. On CapEx, our spending is on track with the full-year guidance we've set, with $21 million spent in Q1. Our outlays stayed concentrated mainly on EO facility upgrades, capacity expansions at Sterigenics and Nelson Labs, and Nordion's cobalt supply development. We closed out the quarter holding $108 million in cash, up modestly from December 31 levels, even after putting roughly $25 million toward the BioScience Labs acquisition and the Nelson Labs Fairfield buyout. Thanks to $390 million in combined cash and revolver availability, the company maintains a strong liquidity position to support operational requirements and investments. During March, we took another step to optimize our capital structure, amending the revolving credit facility so borrowing rates came down and the maturity date moved out to June of 2026. Throughout the entire year, we haven't drawn on that facility. A sizable drop in interest expense benefited us in Q1, mostly from paying down debt with IPO proceeds and the recent repricing of our term loan. As Michael noted, interest expense fell by about $35 million versus Q1 of the previous year. Our net leverage ratio keeps getting better, sitting at 4.1x on March 31 against 4.3x on December 31. In March we also completed a secondary offering, selling roughly 9% of shares already outstanding to the public. No new shares were issued through that secondary offering, and the company received no proceeds from it. Now to our 2021 outlook. I'd like to reaffirm the guidance given on our March 9 call while also offering extra detail on the remainder of the year. I'll begin with the quantitative summary and wrap up with our assumptions; for the full year 2021, we are reaffirming guidance of: total revenues between $890 million and $920 million, which represents growth of roughly 9% to 12%; adjusted EBITDA between $465 million and $485 million, representing growth of roughly 11% to 16%; a tax rate applicable to adjusted net income of about 28%; adjusted EPS between $0.78 and $0.86; and fully diluted share count between 281 million and 283 million shares on a weighted average basis. Quantitatively speaking, I want to restate that the rise in weighted average shares outstanding compared with last year stems mostly from our IPO in November 2020. We anticipate roughly $135 million in yearly interest expense savings coming from paying down our debt along with the repricing of our term loan, and that benefit shows up in our adjusted EPS guidance. Qualitatively speaking, here's what we're assuming: volumes keep normalizing across the year, and as Michael said, the trends we've seen so far point that way. We also discuss frequently how much Nordion's results can vary, largely because of the harvesting schedules for Cobalt-60. On the previous call, we noted our expectation of a fairly even split between first-half and second-half sales. Based on cobalt delivery schedules in Q2, that remains what we expect. That said, it's always possible that shifts in the harvest schedule for Cobalt-60 cause orders to move between quarters. On FX, our guidance has been and will continue to be grounded in the exchange rates in effect when we give updates. On capital deployment, our priorities for the rest of the year stay the same: growth initiatives, paying down debt, and strategic acquisitions we've identified. We still expect CapEx to land between $100 million and $110 million this year, including about $30 million set aside for previously planned special project spend tied to EO facility enhancements and Cobalt-60 supply development. Before handing the call back to Michael for closing remarks, I wanted to reinforce what he said earlier about how proud we are of the whole team. Their hard work comes through in our Q1 results and has helped put us in position for a solid 2021. Michael, over to you.

Thanks, Scott. Taking everything into account, we feel quite good about how we performed as 2021 got underway, particularly given the ongoing difficulties created by the worldwide pandemic. As ever, I'd like to express appreciation to the whole Sotera Health team for the strong work they delivered during this quarter. My thanks also go out to our customers and our investors for the support and partnership they keep giving us. Right now, operator, we'd like to begin the question-and-answer portion of the call.

Thanks — that's a strong way to kick off 2021. I've got a few questions, Mike and Scott, about some of the items you both brought up, particularly how the year is shaping up. And then, if there's time, I'd like to ask something broader about litigation. Regarding the money you've put into Nelson and into the Sterigenics sterilization part of the business, specifically on facilities, could you describe how those additions will be phased in, when they'll start contributing extra growth, and how all of that fits into the revenue growth plan you've set out for this year? Before we move on, I have one more question regarding litigation.

I appreciate you taking the question. Michael referenced nine capacity expansions currently underway at Sterigenics, and six of them should become operational within this year. When we discussed these expansions previously, we described them as typical of our normal investment cycle. So once this capacity comes online, I wouldn't expect it to alter the growth trajectory we've previously communicated. Again, these are ordinary capacity additions that support the level of growth we've said the company can achieve.

All right. Regarding Nelson, could you touch on the latest additions as well as the center of excellence? I realize this falls within your guidance, I assume it's included in your outlook for the year, but perhaps you could say whether that begins contributing right away in Q2 with respect to the acquisition, and also the timing pattern for the center of excellence — what effect does that have on Nelson's portion of the business?

Certainly. One point to remember regarding capacity expansions, whether at Sterigenics or at Nelson, is that after those expansions become operational, there's usually a ramp-up phase, a prolonged ramp-up spanning several quarters and at times even years before they achieve maximum utilization; we face rigorous qualification mandates prior to becoming operational, and beyond that, every one of our customers typically has its own qualification for the products they run through our site or the testing we perform on their behalf. Therefore I would not view these capacity expansions at either Nelson or Sterigenics as ones that will significantly affect results in 2021. A few of them will produce a certain incremental effect during the latter half of the year, and our guidance accounts for that. Your question was specifically about the center of excellence for Nelson Labs, and it should become operational in the latter half of the year and, once more, there will be some ramp up involved. Consequently, the incremental effect in 2021 would be limited.

Great. And then, if I may, regarding the litigation — I'd imagine you won't be eager to elaborate much, given that it's still active. But could you perhaps lay out for us certain developments from the quarter, along with the upcoming milestones, and explain how investors ought to view those within the broader picture of working through the various cases and eventually reaching some kind of resolution down the line on a few of the more recent ones?

Yes. Matt, this is Michael. Sure, I can address that. Regarding the litigation, the first place to look is probably Illinois, where things are moving through the legal process—discovery, depositions, that sort of thing. Our expectation had been that these might arrive at some point in 2021. Now it appears the initial trials are more likely to happen in 2022, and it's the first five cases that should come up at some point that year. No specific dates have been set yet. The court systems are quite congested as a result of COVID, and we're waiting our turn. From what I last heard, our five cases were among roughly 1,300 in the backlog in Illinois, or something along those lines. The speed at which they move through Illinois's court system is going to be a factor, but at minimum we're looking at something happening around the midpoint of 2022. Over in Georgia, the timeline looks comparable, with a similar kind of status update regarding the discovery process. No depositions have been taken there as of yet. Our present assumption and expectation is that this again unfolds later in 2022; should circumstances shift and things move faster, we'll be ready, but that's where our thinking stands right now. Then there's Santa Teresa, New Mexico — likely the most recent of these — which was the case filed by the AG. To clarify, that legal action wasn't aimed at shutting down our plant. It focused on implementing safeguards for emissions that weren't being managed. We've run operations at that location since 1989, and we've stayed in line with every applicable rule and regulation. Plus, I should mention it plays a vital role in health care—2.5 million devices get sterilized there each day. On top of that, we've collaborated over a great many years with our regulators and MED, and also with the federal region, the EPA, and neither of those entities is involved in the lawsuit. At some point later in May, a judge will hold a court hearing. A temporary restraining order was what they sought. Given how the schedule lined up, the judge went ahead and ruled against granting that temporary restraining order. Come later in May, we'll have a conversation as well as a hearing on a preliminary junction. Across all of these suits, we obviously hold a good deal of confidence about where we stand, but dealing with them is just part of reality. In the meantime, we simply continue running and operating the company. All of our facilities are still up and running, and we're providing essential medical and pharmaceutical products to the health care sector.

I want to add my congrats about how well the year has begun. Michael, you brought up demand recovering gradually, though it still differs by region; and Scott pointed out that a continued normalization served as one of the assumptions behind the guidance. Can you tell — perhaps in terms of volume — how near you are right now to where you stood before COVID? And could you also help us understand how sharp a rebound you're factoring in for the rest of the year?

Yes. So in past conversations we've shared the volume assumptions we use for these businesses. What I'd say is that each of the 3 sits under our usual expected run rates for volume, and that was anticipated. The first quarter landed in line with our thinking, a gradual recovery, and we believe it will grow as the year moves forward, Sean. The second quarter should be somewhat stronger than the first, and the third somewhat stronger than the second. And ideally, as the year wraps up, we begin returning to the more typical levels we observe for volumes and mix across the businesses. In my opening comments I did bring up geographic variation. The U.S. has rebounded somewhat better, since I believe vaccines have scaled up fairly fast here. Europe remains difficult. I think we're seeing that throughout many industries, not only health care; and we're also noticing comparable traits, so to speak, in Latin America, especially Brazil. So we aren't reaching the full volumes we'd like. But our — this matches how we constructed the plan for the year and what we told you previously. We expect this to build in the second quarter. It ought to be somewhat better. Still, we have to sort of watch how COVID plays out, especially in certain markets such as Europe and Latin America, and how fast they come online. So we're cautiously optimistic, but we're taking the right steps to ensure we're here to satisfy our customers whenever they have the demand.

All right. And then over at Nelson Labs, Scott, I believe you said 10 points of the growth came from more personal protective equipment testing. Since that seems tied to COVID, and since we're hopefully close to the end of all this, how should we think about growth trajectories and growth cadences on the Nelson Labs side for the rest of the year?

If you look at our guidance for the year, going back to that remark that we assumed volumes would normalize, we did factor in those protective barriers tests normalizing back to pre — or at least nearer to prepandemic levels, naturally offset by a step-up in other testing categories. So a modest headwind from protective barriers coming back down is definitely baked into our models. But like Michael said, the other testing categories — and keep in mind, Nelson provides more than 800 tests, testing categories — there's definitely an expectation that we'll get a tailwind from the remaining testing categories to help, or to more than offset that. So I think we'll be fine, and that's why we felt comfortable reaffirming our guidance. And we did note that we're already seeing demand pick up in certain categories tied to various product development efforts of ours, plenty of strong activity around antimicrobials that we think will last even past the pandemic, plus a number of other categories that are already starting to come back to life.

I want to piggyback on what Sean asked. Regarding the reopening, Scott, and what you said about Nelson, does activity shifting between segments also play a role — for example, moving from Nelson over to Sterigenics as things reopen? My thinking is that if PPE declines as much as it has been, or might decline once we reopen, do you see that being offset in certain cases by, let's say, Sterigenics instead? I simply wanted to get a handle on how reopening affects things across segments.

Assuming I've got your question right, I wouldn't frame it as some sort of direct offset connecting our businesses to one another. Instead, my approach would be to examine each business independently, and simply note that a normalization in activity for each of them is starting to appear and is something we anticipate seeing across the year. And looking at Q1 results, that's already becoming visible for every one of our businesses, and we expect it to keep going that way throughout the year.

All right. Then regarding the regulatory aspect, has the new administration had enough time in office for individuals to be appointed to positions that your government affairs team can engage with and start forming an impression? Do you possess any definitive insight into when EPA rules could be arriving — specifically, updated regulations?

Yes, David, Michael here. What I'd say is that we hold meetings and conversations with our regulators continuously across state, local, and federal levels. We — they have personnel occupying the roles who are leading the EPA, and those are capable individuals, and we have been engaging with them. From a scheduling standpoint, I'll share that NESHAP is the major standard for which we await fresh rules and regulations concerning ethylene oxide. As I've said repeatedly before, our hope existed in 2018; our hope existed in 2019, '20, and '21 that these updated regs would appear. What we're now being told is late 2022. That's what we're receiving from the regulators — that they anticipate these updated NESHAP requirements and rules will be issued in late 2022. I believe that simply illustrates how intricate this matter is, along with the numerous stakeholders engaged and the essential nature of EO. More than 50% of medical devices undergo sterilization using ethylene oxide, or 20 billion devices annually. No alternative for that material is known; and those handling this hazardous substance are doing so in a highly responsible manner. And I believe appreciation is growing among people regarding how intricate this matter is. So what we're currently being told, David, is late 2022 for the updated regs.

If I may squeeze in one additional question about that subject. In Atlanta, for instance, would you say your spending on the double scrubbing method and the stricter recapture strategy is easing worries among those filing these actions, in the instances where you've observed that?

What I can say is that the solutions we implemented in Atlanta give us confidence, they are performing effectively, and our customers are being taken care of; we already — we are going well beyond what regulators require. That simply provides even more assurance regarding our capacity to do so. I cannot address what motivates these other parties or how at ease they feel, since at times their motivations don't obviously line up with ours or with the wider health care sector; so here's what I'll say: our solution is one we believe in, and we keep pressing ahead, ensuring we act in a compliant way and deliver an essential service.

Perhaps regarding the balance sheet. You've clearly refinanced a portion of your debt, the yearly interest rate has declined, and there are genuine savings available to you. Could you discuss what kind of flexibility that provides — clearly, you've made a small inorganic investment. What are the priorities at this point? Clearly, you're continuing to reduce leverage toward that 2 to 4 range. You're nearly at that point, as opposed to perhaps continuing some of those bolt-on activities on the inorganic side. I'd really like to hear your overall perspective on that.

Yes, Patrick, Michael here. Then Scott can jump in with any additional specifics. Clearly, this company previously ran with fairly elevated leverage. As we mentioned in our opening remarks, we're now at 4.1x; we feel quite confident about our leverage levels and our flexibility; at the end of the quarter, we had $108 million, I believe, in cash on the balance sheet. Our priorities involve continuing to put money into this business for growth, reducing leverage, and pursuing strategic M&A. I believe our capital structure gives us the flexibility to achieve those goals, and we're optimistic about our capacity to keep driving the high single digits growth we've talked about previously.

All right. Moving to that same subject, you folks have mentioned that CapEx will be somewhat elevated across the coming few years, tied to securing additional Cobalt-60 supply sources, improvements to facilities, and EO sterilization. So how are you thinking about weighing those investments against capacity expansions and other inorganic opportunities?

Our capital deployment plan and approach is fairly detailed. We rank and prioritize them according to what the business demands and needs. We also collaborate across the team; there's an investment community on our side reviewing these opportunities; still, we're at ease with the visibility we've provided regarding cobalt development, yield facility enhancements, and going after organic and inorganic growth opportunities.

Yeah. I'd like to build on what was just said — take a look at the 2021 CapEx guidance we provided, which spans $100 million to $110 million. We've also said previously that roughly $30 million within that figure is tied to what we call "special projects," specifically cobalt development along with enhancements to the EO facility. Once those 2 special projects are funded, the remaining CapEx amount is fairly substantial compared with our historical spending, and it's definitely sufficient to keep putting money into growth initiatives so we can keep driving the top and bottom line at the levels we're used to.

And I appreciate the extra information you included in the script—that means a lot. To follow up regarding the Nordion investments, where does that ultimately lead? Is it a return to supply? Does it assist in making revenue harvesting there more even in its cadence? Or is new capacity unlocked for additional applications?

Yes. Matthew, this is Michael. Thank you for noticing the extra information you requested from us. We aim to be responsive, so I appreciate you noticing that. Looking at it from a cobalt development standpoint, we are—we are expanding capacity to support long-term growth for the industry that requires cobalt. That is what we are doing. My view is it will not even out fluctuation from one quarter to the next, since a great deal of that—or the majority of that—hinges on the utility and the timing of when they can harvest the cobalt out of the reactor. What we are constructing and putting money into, though, is obtaining additional cobalt for the long-term growth the industry requires; that is what the final outcome will be.

All right, and moving on to my second question: how are your customers—particularly the ones with medical licenses—approaching the topic of inventory? Historically, sterilization done under contract may have acted somewhat as a chokepoint. Are they attempting to position themselves early for the broader economic rebound? And do they show caution regarding how quickly that happens? Also, what sort of guidance are you providing about capacity and turnaround times as momentum picks up?

Sure. We are collaborating closely with our client base; what we observe is not stockpiling on any significant scale. Visibility on this is limited for us, Matthew, since we do not hold inventory on their behalf; even so, product is arriving in a consistent flow. We aren't witnessing any big surges of product being pushed in to preempt an inventory buildup or anything along those lines; we anticipate that gradual increase will persist; together with customers across the globe, we determine the appropriate capacity, the appropriate location, and the appropriate method for sterilizing what they make; this is an ongoing joint effort on our part. So what I'd say is, we aren't observing anything like massive inventory accumulation, though our visibility remains limited. Still, based on what moves through our sites and the amounts we handle there, that isn't happening right now.