Sotera Health Company (SHC) Earnings Call Transcript & Summary

All right. Good morning. Thanks, everyone, for joining the kickoff session of RBC's 2021 Global Healthcare Conference. I'm Sean Dodge, the health care, IT and pharma services analyst here at RBC. And I'm pleased to be joined by Michael Petras, who's the Chairman and Chief Executive Officer of our first presenting company of the day, Sotera Health; and their CFO, Scott Leffler. So special thanks to both of you for being here. So we're going to do -- Michael is going to give us about a 9-, 10-minute overview of the company, and then we'll move into the fireside portion of our presentation here. So Michael, I'll hand it over to you.

Yes. Great. Sean, thank you. I appreciate you having us out this morning, and welcome, everybody. I'll give you a quick overview of the company. Some of the statements I'll make today may be considered forward-looking statements. Please refer to our SEC filings for a description of the risks and uncertainties that could change our actual results to -- and it could materially differ. The company assumes no obligation to update the forward-looking statements. I'll discuss also non-GAAP financial measurements, including adjusted EBITDA, which are -- reconciliations could be found in this presentation, and a copy of this presentation will be on our website, soterahealth.com. I'll spend a couple of minutes on this slide. For some of you who may not be as familiar with our company, Sotera Health, we view our mission as safeguarding global health through sterilization services, lab testing and advisory services. What we do, on the left-hand side of the page, starting with sterilization services, we have 2 businesses that make up this part of our company, and that is Sterigenics and Nordion. What we do with Sterigenics is we provide terminal sterilization. So med device, pharma companies will make the product, they'll package it up, they'll ship it out. It will go through one of our facilities around the world, and we'll provide terminal sterilization through 3 key modalities, ethylene oxide, E-beam, X-ray or cobalt-60. This is a service business. Our second business in this grouping is Nordion. Nordion is the only business of our 3 that is a product business. And in this business, we supply cobalt-60. We're the world leader in supplying cobalt-60 and, as I mentioned, that is one of the key modalities for how you sterilize. So we sell cobalt to Sterigenics as well as other competitors around the world, but it's a key ingredient, if you will, that's used for sterilizing products in the terminal sterilization process. By having Nordion, we're the only vertically integrated player in the world for gamma irradiation or cobalt-60 irradiation. And then our third business is Nelson Labs. This is, again, a testing -- this is a service business here. And what we do in this business is we work with the med device and pharma companies to test, to make sure their products are safe and they meet the regulatory requirements. All 3 of these businesses are highly regulated and, in many cases, government-mandated mission-critical services. We have blue-chip customers with multiyear contracts, in many instances, 3- to 5-year contracts. We have over 60 facilities around the world. We have deep expertise in our teams and regulatory, technical know-how. We have significant levers for growth, both organically and inorganically, and culture really matters. In our company, we really assess our people on the values and the culture that is such a foundation for the company long term. What does all this lead to? It leads to a company that's grown revenue every single year since 2005 at Sotera Health. We've grown every single year our top line. Our adjusted EBITDA margins are 50-plus percent. We have strong cash flow generation, and we're well positioned to serve the global health care market. What's really unique about this asset is we do not sell to GPOs. We are not tied to payer reimbursement. I hope you can tell why we're so excited about this company. We think it's such a unique asset. On this next page here, this would just give you a flavor of some of the products that we go ahead and serve with our customers. Many of these products have a picture on this page. I won't go into great detail on this, but many of these products on this page, all through our shop in one of our service offerings, either in our sterilization, in using, in many instances, cobalt that comes from Nordion and then also testing that we perform over at Nelson Labs. You could see across the med device and pharma side, we play a critical role in helping get these products to market. If you look at our financial performance historically, what you see here on this page is 2018 and '19, we've had strong revenue growth and adjusted EBITDA and EPS growth. We continue to invest in organic growth opportunities, in additional capacity and expansion projects, which will continue to keep up with the demand for services that our customers are asking for. We've got several levers that we provide and take on to help us drive adjusted EBITDA. And really, if you look at our margin expansion, over 450 basis points of improvement since 2018. And we continue to focus on our adjusted EPS as we look at all of our costs across our banking needs. If you look at the first quarter, we just -- we announced last week, we had a strong start to the year. We had growth -- we reiterated our guidance for the total year. We said revenue would grow for the total year, 9% to 12% on top line, which would be the $890 million to $920 million in revenue. Our EBITDA growth would be -- 11% to 16% is the guidance that we provided in the outlook, to $465 million to $485 million. But as you can see on this page here, we had a strong first quarter, revenue up 13%, EBITDA up 15% and adjusted EPS up 80%. We believe this is a really unique asset because of the fact we have a strong financial profile. The revenue growth that I mentioned every single year since 2005, our margin rates, the barriers to entry in this business. We've got a track record. We have expertise. We have scale. We have a large and growing addressable market at $33 billion. A large portion of that is in our lab services, which is about $29 million. Our customers trust us in the size and scale we bring with our customers around the world. We do business with 40 of the top 50 med device companies in the world and 8 of the top 10 med device companies around the world. We've been able to execute on M&A. We've done 2 transformational deals where we bought Nordion and Nelson over the last several years and then 8 tuck-in acquisitions. And we're really optimistic, Sean, about where we sit with supply chain and the value we can bring across health care. So I just tried to give you a couple of minutes of an overview, and I'm happy to answer any questions that you'd like to cover.

Great. Yes, thank you. So where I wanted to begin, you all just reported Q1 results late last week. Maybe starting with a recap there. You mentioned a strong quarter, but there was still some lingering COVID-related headwinds in the Sterigenics business and then conversely, some real nice kind of tailwinds on the Nelson Labs side. Give us a quick overview of the visibility and maybe the confidence you have in the businesses, maybe a continued normalization on the Sterigenics side. And then how do you maintain the momentum on the Nelson side?

Yes. Great. I'll walk you through all 3 businesses from a COVID impact perspective. Sterigenics, I would say that business probably felt the most negative impact in 2020 from COVID just because of elective procedures shutting down. We saw a gradual improvement in volumes in the Sterigenics business throughout the first quarter. We expect a gradual improvement in the remainder of the year. We don't think it's going to come jumping right back in a strong manner to start the second quarter. We see this continued graduation of volumes. I would tell you, the U.S. is a little bit -- doing a little bit better than we're seeing in Latin America and Europe. But overall, we feel pretty confident about our billings in Sterigenics to see those volumes ramp up. On the Nelson Labs side, this is a business that saw the validation times -- more complex testing slowed down, the new products to R&D, we saw some of that slow down during the COVID time period, and not that we're completely out of COVID pandemic at this point in time. But we did see a pickup in PPE testing. And let me just give a little context on that. We always did PPE testing prior to COVID. What this does is we help customers with masks and gowns, for example, and helping them get those products to market and make sure they're safe and meet the regulatory requirements. When COVID hit in early 2020, we started to see that volume ramp-up in a pretty significant way. And some of our other tests were feeling the impact of COVID and the volumes coming down. We see that the PPE testing is starting to slow and come down, but we believe it's going to be over the historical levels that we had prior to COVID. We'll see it normalize at a level above that, but it won't be to the level it was during the peak of COVID. But we're also seeing our other volumes ramp up, particularly in the validation area. We're starting to see some of our more complex testing starting to ramp up. So we expect that to happen, on the PPE coming down. But overall, we feel pretty confident about our ability to offset that with other volumes we're going to see coming in the business. And then the last business I'll talk about is Nordion. And basically, Nordion, we haven't had orders canceled or anything of that nature. What really has happened is we just had geographic challenges, right? We'd be able to ship into Germany this week but not into France. And maybe we can't ship in the U.K., but we could ship into Italy. So the team has done a phenomenal job of working through the logistical challenges. But we're able to get the cobalt out and around the world where we need it. We had some timing delays, but no order cancellation. So I feel that business has pretty much normalized, just with some gymnastics. Terry and the logistics have done a phenomenal job and really meet the customers' needs during this time.

Okay. We're getting closer to the new medical device regulations becoming effective in Europe. Still supposed to happen in just a little over a week now. Now that we're kind of on the doorstep there, do you have any better sense of how this might impact you all? Initially, this was anticipated to be a tailwind more for the lab business. Any changes in view there? And then could this be something that provides a little bit of a tailwind for Sterigenics, too?

No. We're still optimistic that this will be a nice opportunity for the team at Nelson Labs. Their viewed as an authority in that med device testing space, and this will create more opportunities for them. We don't see a huge uplift in the Sterigenics side of the business. We still are pretty confident, though, that we'll see a rise in volumes over time with the Nelson Labs business.

Okay. The -- I guess, a big part of the Nelson Labs thesis was around the cross-selling opportunity. Maybe if you could talk a little bit more about that. How big is the opportunity on the Nelson Labs side? And then the -- I guess, the level of activity you're seeing there, how content are you with that? Any changes you're making to drive acceleration in cross-selling?

Yes. Being involved in this kind of process in the past, my days at General Electric, when I was involved in leading big cross-selling efforts across all the GE businesses for like the Olympics and some of the big projects around the world. I know it takes time from a cultural perspective to drive this. I think we're making nice progress as a team. Remember, about 40% -- approximately 40% of Nelson Labs business is really insurances. So there's a natural linkage already with Sterigenics. What we're really focused on here, Sean, is driving improved processes for our customers. So it could be streamlined end-to-end. We can reduce cycle times, turnaround times. So our customers see a real value proposition coming to work across Sotera Health and Nelson Labs and Sterigenics. So we're working on a lot of things around the handoff. I'll give you an example. As people are working around ethylene oxide and then looking at new cycles, how do we do quicker validations in conjunction with the Sterigenics business designed to new cycles and then the Nelson Labs team doing the validation around that. And what we want to do is figure out how to make it easy for these customers to be able to work with us across that site. We're doing stuff on quarterly dose audits that help customers as well. So we're just trying to be predictable and reliable here. I don't think you're going to turn around tomorrow and see our numbers way outperformed because of some cross-selling effort. But this is just how do we continue. We got about an 85% customer satisfaction rate in both Sterigenics and Nelson. How do we take that even higher? That's what we're trying to do in creating a unique value proposition for our customers.

Well -- so you talked about cross-selling being a little bit of a process. Mechanically, how does that happen? Are you displacing an incumbent vendor? Maybe just walk us through kind of -- what does the cross-selling process look like?

Yes. First of all, we've got a common CRM system across our enterprise for the Nelson and Sterigenics team. So we're able to have visibility to opportunities that are coming up, where we had joint account responsibility in some areas. And what you have is if a customer is working in the early front end of that value chain, on the supply chain with Nelson Labs, we may have some visibility there that could help inform the Sterigenics team about the sterilization needs. In some -- in many cases, this will be a new product coming out. It could displace somebody that was doing work with that, a previous lab in the past, or could just be the incremental volume is moving over to us in this particular opportunity. So what we try to do is coordinate it. So the touch points are aligned within the customer. And also our sales teams are aligned around these opportunities.

Okay. One of the accomplishments you all highlighted is just the progress you've made, diversifying the client base. [ You got the ] end market on the lab side. You got lot more exposure to the pharmaceutical industry. Just talk a little bit about that and what that kind of opens up for you going forward.

Yes. So we spend time every year, just about this cycle of the year, April, May, June, July, really looking at our 3-year strategic plans for each of the business units. And back in 2016 and in 2017, we really started segmenting our end markets, and we felt the opportunity was pretty robust for us to pursue the pharma side. And the Nelson Labs business was really the biggest opportunity, not that we didn't have a similar type of opportunity in Sterigenics, but we really set a focus on that. We've done a couple of strategic tuck-ins. We've been able to basically double the percent of total business that Nelson Labs does in pharma from where it was when we acquired that business in 2016. And as I mentioned in my opening, we have a $33 billion TAM across Sotera Health, $29 billion of that is in the lab services side, and a large portion of that, the vast majority is in pharma services. So we see opportunity for us to continue to expand our presence there with our customers.

The -- you've done a great job thus far of expanding margins in the Nelson Labs business. If we think about the pathway forward and the runway for more multiple or more -- excuse me, margin expansion, is it dependent on revenue growth and operating leverage? Or do you think there's still a lot of opportunities to enhance efficiency, enhance productivity? Are there still costs you can take out?

Yes. So I want to make it clear. This wasn't about ripping a bunch of costs out and making numbers. This is about growth and serving the customer and making sure we're doing this efficiently as possible. So when we bought that business in 2016, it was doing margins in the mid-20s, and now we're close to 40-plus percent margins in that business. And really what we've done there is really just professionalize it, create standards around given tests, how much labor should be deployed around that, really kind of setting the focus around productivity and operational excellence. And things like that is where we're really focused. We get some operating leverage with the volumes as well as price that falls through in that P&L. But really, it wasn't about -- I don't want to make -- I want to make sure people understand, this isn't about ripping a bunch of costs out to make bottom line numbers. This is about how to get better as this company continues to grow and making sure we're able to address turnaround times and quality and service, what our customers expect in that segment.

Okay. Maybe turning to the Sterigenics side. So if we start high level there, there's still about 40% of the global sterilization services are handled in-house. There had been a steady kind of slow shift towards outsourcing. How is -- how do you see that progressing going forward? How much runway do you think there remains in this kind of shift from in to outsource?

So today, we estimate about 43% is in-house. We've seen a gradual move to outsourcing over time over the last several years. I don't think you're going to wake up tomorrow and see those numbers swing materially in the short term. But over time, we think there's an opportunity for that continuing to be pushed to outsourcing. Just -- that's our core business. That's what we do. We don't make products. That's not our job. But we are really focused on providing sterilization services. I think customers, as regulations increase in that area, becomes more complicated. We think there may be more opportunities for more outsourcing of that service. But again, we haven't assumed big numbers shifting in a short period of time. We think, over time, gradually, there will be a couple of points over the next 3 to 4 or 5 years.

Okay. We talked earlier about the impact that COVID was having on the Sterigenics business. If we think about the capacity you have there and utilization, give us a sense of where you're at right now across your footprint as far as kind of capacity utilization goes. How much of an impact did COVID have? And how much room do you have to grow kind of within your current footprint, kind of setting the capacity expansion projects you have right now aside?

Yes. We were probably pre-COVID around that 80-plus percent kind of range. And today, I'd say we're about 73%, 75% in Sterigenics side. Mike and the team are continuing to look at capacity utilization and all the work that we're doing around operational excellence and streamlining our processes and looking at how to get more out of our existing capacity. That all is very helpful. But I'd say right now, we're probably in the 73% to 75% below where we were pre-COVID, but we see opportunities for that to continue to utilize that capacity as volumes ramp up.

Okay. And then you've got -- I think you've highlighted 6 -- on the Sterigenics side, 6 capacity expansion projects you're working on that are anticipated opening here in 2021. How much -- if we think about kind of the increase in your revenue-generating square footage, your revenue-generating capacity, give us a sense of how much footprint this adds. How much does this increase kind of that...

Yes. Sean, we don't get into particulars around volumes from incremental capacity. But a couple of things, I think, are important for you to understand and the broader investment community, is we target 20-plus percent IRRs when we do these programs. So that's kind of a threshold that we like to work towards on all these. That doesn't mean every single program has to be that, but we try to target that area. The other thing I would tell you is before we put this capacity in the ground, we like to get about 40% to 50% of that volume committed by customers before we start building and constructing that. That's general guidelines that we work with and towards. And I would tell you that, as we look at these opportunities, we look through that lens and making sure that we're there to take care of the customers, demands that they have.

Okay. The -- across your Sterigenics footprint, you're also making some efforts to upgrade -- curb your EO emissions and recapture kind of even more than what the government-mandated amounts are. How is -- give us a quick overview of that. How is that progressing? How many sites have you upgraded? And what are the kind of the time lines for the remainder?

Yes. We'll be doing that over the next several years. We don't control that time line necessarily. A lot of that also relies on local permitting, either environmental, air permitting or construction permits. We are working through our network here in the United States, as you referenced, one that's out there that everyone knows about is Atlanta. We put 3 big improvements in Atlanta: double scrub in the air, negative pressure and centralizing the discharge points. We will use that type of framework across all of our facilities in the United States. Those are progressing pretty well. But it does take time as we progress through each of our facilities. So we have a couple of them that are in process and nearly complete today. And then we have a few right behind it, and then we have others that are earlier stage that are more in the design work at this point in time. But we're working with our regulators across our network to pull that together in a timely fashion. And as you referenced, we feel like we're going to continue to lead the industry and far exceed the expectations of the regulations.

Okay. The -- we'll leave Sterigenics -- aside from -- maybe move on to Nordion. If we think kind of near term here, in 2020, you benefited there from a favorable price in cobalt-60 supply mix. Maybe just give us a sense of how we should be kind of thinking about that mix to evolve in 2021 and beyond.

Yes. I would tell you, all 3 of our businesses generate about 3% to 5% price per year. A lot of these are contractually built in. And I would tell you, Nordion is in that same range of 3.5% to 5% a year in price that they're able to realize. When we look at the cobalt supply, depending on where the harvest comes from, what utility or what given time, we may see some fluctuations in margins. We saw some good guys of that in 2020. We will at times see bad guys in mix, but just like you will, on sales mix. But overall, we're confident in our ability to expand margins and margin dollars in 2021 in the Nordion business. All 3 of our businesses for that matter will be expanding in 2021.

Okay. And you mentioned the benefits on the price. Maybe talk a little bit about the work you're doing there to increase your cobalt supply over time.

Yes. That's a capital investment that we've called out. This is a long-range business for us, very predictable, very stable. We're working on this long-range cobalt supply, 2026, 2030, 2035, 2040. We're making investments to continue to make sure there's ample supply of cobalt for the long run. So we're working with utility partners around the world and utility suppliers to make sure that we have a steady stream of cobalt supply. When I joined this business, our predominant supply of cobalt was from Canada and a little bit from Russia. We continue to rely on both those sources, but in addition to that, we buy cobalt from India. We buy it from China and other parts of the world, in addition to Canada and Russia. And as we look at other development opportunities, we look to expand that base. So we're really optimistic about where we're going with the cobalt supply, which is so important, as a large percent of the terminal sterilization market relies on cobalt. And we feel we're uniquely positioned because of the fact we're the only globally vertically integrated cobalt irradiation business in the world.

Okay. And then maybe in our last minute or so here, now post-IPO leverage has come down quite a bit. Michael, you mentioned a series of tuck-in acquisitions you all have done over the last couple of years. Give us just a quick overview or maybe your thoughts on M&A tuck-ins, where you think some of the kind of the bigger opportunities are, where you're going to focus kind of capital deployment.

Yes. Sean, you referenced leverage. I want to touch upon that. When we were coming out of IPO, we're at 7x leverage, we committed that we would be in the 2 to 4x leverage over the long term. And right now, we finished the last quarter at 4.1. So we're well on our way with the targets that we committed. We continue to be curious and inquisitive around acquisition opportunities. We see opportunities across all 3 of our businesses, Nelson probably having the most, but not exclusively. We feel that we're going to be able to continue to invest in this business for organic growth, deleveraging and strategic M&A. So we feel we're pretty well positioned in this area.

All right. Great. Well, we're out of time, so we'll leave it there. Again, Michael, we appreciate having you here, and good luck.

It's good. Hey, Sean, thanks for your time, and thanks for having us this morning. Have a great day. Bye-bye.