Sotera Health Company (SHC) Earnings Call Transcript & Summary

How's that? Yes, there we go. All right. Good morning. Thanks, everybody, for joining us here at RBC's global healthcare conference. I'm Sean Dodge, the health care IT, health care services analyst here at RBC, and I'm joined by our next presenting company, Sotera Health. And here on behalf of the company is their CFO, Scott Leffler. So Scott, a special thanks for making it out to be here with us today. Do you want to start by giving us a brief overview of the company? So I want to pass it to you and let you do that.

Sure. That sounds great. So first of all, Sean, thanks for hosting us. Thanks to you and RBC for hosting us at this event. And to all of you who are interested in learning more about the company, I just want to thank you very much for your interest as well. As Sean said, I'm Scott Leffler. I'm the company's Chief Financial Officer, and I've been with the company for a little over 5 years now. And the Sotera Health journey has been an extraordinary one to be a part of. At Sotera Health, our mission is safeguarding global health, and we do that through our industry-leading position, providing terminal sterilization services and microbiological testing services to the pharmaceutical and medical device industries as well as some other end markets that we serve. We go to market through our three business segments. Our first segment, which is our largest segment, is called Sterigenics, and Sterigenics is one of the global leaders in terminal sterilization services. In terminal sterilization, you are looking to neutralize 999,999 out of every million harmful bacteria that could be on a medical device or other product or pharmaceutical. There are several different technologies that are primarily used in order to deliver that service, and we are a global leader in each of those three technologies. And I'll just give you a quick overview of what each of those are. The first one is using ethylene oxide gas in order to sterilize a product. The second one is using radiation, using machine-generated radiation from a machine called an E-Beam. And then the third technology that's commonly used is using gamma irradiation, which is emitted by a radioactive material called cobalt-60 you deploy in the field in order to sterilize medical devices and pharmaceutical products. Sterigenics goes to market through a global network of about of 48 facilities around the world. We are doing business with 40 out of the top 50 medical device OEMs and 8 out of the top 10 pharmaceutical companies. For Sterigenics, they have over 90% of their revenue under long-term contracts, and those contracts are often characterized by minimum volume commitments, sometimes take-or-pay obligations as well as generally built-in annual price escalators. And those price escalators generally have a feature that also -- especially relevant in today's inflationary environment and have inflation protection that are embedded in them. And so we feel like our business is very well positioned to do well in an inflationary environment like we're seeing right now in the marketplace. So that's Sterigenics. And of the three technologies for Sterigenics that I mentioned, the last one I mentioned was using gamma irradiation to sterilize medical devices. I'm going to use that one as a segue into our second business unit, which is called Nordion, because there is one critical input for the modality of sterilization that I was just mentioning, and that critical input is a radioactive material called cobalt-60. Nordion, our second business unit, is the world's leading provider of radioactive cobalt-60, which is primarily used in the sterilization industry. And so Nordion is selling their product both to Sterigenics on an intercompany basis and also to third-party customers in the sterilization industry with some other end market applications as well. So the presence of Nordion in our portfolio means that we are the only global vertically integrated sterilizer for the gamma irradiation modality, which, again, is one of the major modalities used in the industry. Our third business unit is called Nelson Labs, and Nelson Labs is a provider of microbiological testing services both, again, to the medical device and pharmaceutical industry. And they're providing testing services both on a special project and routine basis that really impact the entire product life cycle for both medical devices and pharmaceuticals. The suite of services that Nelson Labs is providing, they're providing over 700 different categories of testing services that, again, are impacting the entire product life cycle. And Nelson market goes to -- Nelson Labs goes to market through a global network of labs as well in order to provide whatever testing services our customers may need in whatever geography they may need it. So that's the composition of our business unit portfolio and our service offerings. When you look at the financial performance of the business, we have a consistent track record of growth especially anchored by the significant proportion of our revenue that's delivered under long-term contracts. We have grown revenue every single year on record that goes back at least 2005, which is when our record-keeping begins. We have grown through the most challenging of macro environments. We grew during the financial crisis, 2008/2009. We grew in 2020 during the onset of the pandemic. And we didn't just grow during 2020, we grew during each quarter of 2020, including during the initial periods of the most intense lockdown. And so it gives you a sense for the consistency of the revenue-generating model. But then when you look at it from a profitability standpoint, we have industry-leading margin profile. Our adjusted EBITDA margins are over 50% for 2021. We believe we have line of sight to not only maintaining but continuing to build on our margin profile over time. As a public company now, we have reported 6 quarters, and all 6 of those quarters we reported as a public company have reflected double-digit top line and double-digit bottom line growth. So it gives you a good sense for the potential that this business brings but also the consistency of the offering in terms of the service and also the financial performance that goes with it. We're a values-based culture focused on integrity, delivering our product in a manner that meets the quality standards of our customers in order to deliver on that mission of safeguarding global health. So Sean, that's just a quick overview of who we are and happy to go deeper into whatever areas you'd like to go.

Sounds great. So maybe starting with your cobalt-600 supply, which you talked about as being part of the Nordion business.

Sure.

That's the area that we're getting most questions from investors now because there is a proportion of that, that you do source from Russia. So far, you said there haven't been any supply disruptions. But maybe just talk about how you're managing that. Is it getting more difficult? And how we should be thinking about kind of cobalt-60 supply going forward.

Sure. Sure. And if it's okay, just for anybody that might be newer to the story, I'll give a little bit more background on the cobalt-60 supply chain. As I mentioned, Nordion is the industry leader or the global leader in delivering cobalt-60 to the marketplace. It's a very delicate supply chain that requires a tremendous amount of expertise in order to orchestrate, and Nordion does orchestrate the entire cobalt-60 supply chain, from the time that cobalt-59 is mined out of the ground to the time that it goes through the encapsulation process where it's ready for insertion into a nuclear reactor, where, with the nuclear reactors with whom we have long-term partnerships, it is converted over time from cobalt-59 into cobalt-60. Comes out radioactive; we are then able to repackage it in a form that's usable out in the industry, and then it's useful for the sterilization of medical devices. So you can probably imagine that that's a supply chain that requires a tremendous amount of expertise in order to manage, and that expertise is a significant part of the competitive advantage that Nordion brings to the marketplace. Over the years, we have gone to extraordinary lengths to further diversify and increase the supply chain of cobalt-60. Originally, Nordion relied on Canadian suppliers for almost all of their supply chain. Over the years, they diversified the supply chain to include supply from Russia, China, Argentina and India. And so as we've said in our disclosures, about 20% -- over the long term, about 20% of our supply does come from Russia. That can vary up or down from period to period. But naturally, when the Russia-Ukraine situation developed a couple of months ago, then there was concern over that portion of our supply. Now this gets back to the comment I made a minute ago around the differentiator that Nordion has in terms of their ability to handle a complex material like radioactive cobalt-60. A big part of it is the logistics and compliance areas of dealing with radioactive material. And so in this more challenging macro environment, we've been able to deploy those capabilities in order to ensure that anyone in a decision-making position with respect to sanctions-related risk would understand the criticality of cobalt-60 to the health care supply chain. And so where we sit today in terms of direct sanctions risk on cobalt-60, it hasn't been impacted. Now direct sanctions risk is only one of the areas of challenge with respect to maintaining the supply for cobalt-60 from Russia. The second area is just financial hurdles because obviously, a lot of the sanctions that are being imposed on Russia, they might not impact cobalt-60 directly, but to the extent they impact our ability to transact with one of our suppliers, then that could be a hurdle as well. And what we can say to date is that even with all of the financial-related hurdles that have unfolded, that also has not impacted our supply for cobalt-60. And then the third challenge area is logistics. And again, this is an area where Nordion's team has a capability that is second to none in terms of managing the global transport of radioactive material. And so even with a smaller number of service providers that are available and other logistical hurdles that have come up, we have been able to maintain our supply of cobalt-60. Now it's a fluid situation. Obviously, every day you encounter some other challenges that may impact the environment. But where we sit today, there's been no interruption in our supply for cobalt-60, and we remain optimistic that it will remain that way.

Okay. Great. And you have been and you're now accelerating the investments you're making into Nordion to further diversify and kind of deepen that supply chain. Maybe just talk about the lead times on that. How quickly can you move the needle when it comes to something like cobalt-60 supply?

Sure. And so these investments -- just for anyone that doesn't have the background, these are investments that we're making in increasing and further diversifying the long-term supply for cobalt-60 to us and to the marketplace. And these are investments that we embarked upon long before Russia-Ukraine was in the headline. We've already been undertaking these investments for several years, and we've made announcements over the last several years around investing in new capacity in Canada, in Romania. And for the first time in the history of the industry, we're investing in cobalt-60 production capability here in the United States to have a domestic supply. And so these are investments, again, that we're just looking to do as part of the long-term investment in building out this product base for the industry. But Nordion -- we often joke that Nordion is a business that is managed not on a day-to-day, quarter-to-quarter or year-to-year basis, Nordion is a business that is managed on a decade-to-decade basis. And that being the case, making significant investments like this that involve infrastructure in existing nuclear reactors is not an easy task and it's not a short-term task either. And so the investments that we're making are probably not going to be delivering new capacity for at least 5 years or so.

Okay. If we turn to Nelson Labs. That's another area we spend a lot of time talking with investors about. You've been fighting some headwinds in the last few quarters as a lot of the COVID-related work you've been doing has tapered off. Maybe just give us a little bit more -- maybe an update on where we are in that kind of handoff from COVID work to non-COVID work and then the visibility you have on that going into the back half of the year.

Sure. Sure. And so the way that the pandemic has impacted Nelson Labs has been very nuanced. Initially, when the pandemic hit, then there were two different forces impacting Nelson Labs. A lot of the typical parts of their business, testing related and new product development or even some of the routine testing related to rollout of existing products, those were impacted and faced their own headwinds just based on the general lockdown environment and other pandemic -- ancillary pandemic impacts. A lot of the testing that Nelson Labs does also relates to regulatory compliance and quality control procedures and things like that. And in an environment like this, what we found is that some of the regulators or testing standard-setting bodies haven't been as quick to roll out refreshes to the regulatory environment possibly because of their own internal challenges or possibly because of a concern over disrupting the marketplace in any way. And so what that means is that it has created a little bit of a disruption to the normal revenue stream for Nelson Labs in those areas. So with the onset of the pandemic, you had these disruptive elements. And then the big positive element you had is that there was an awful lot of testing that came in that related to testing for new PPE that was being introduced to the marketplace where they would be looking for somebody like Nelson Labs to assess the efficacy of their product before they then introduce it to the marketplace. So easy to see how that would create a medium-term -- short- or medium-term tailwind for Nelson that we have now seen unwinding for several quarters. And in fact, in the most recently reported quarter, we reported almost an 11% revenue headwind for Nelson Labs that was directly related to pandemic-related testing almost all of which is PPE; also impacting the margin profile, where there was a positive mix element when we got the PPE testing to the tune of several hundred basis points of margin expansion, and now as we unwind the top line, that has a dilutive impact on the margin profile as well. And so we're in this transitional stage right now where these several different headwind areas, including impacts from the labor market, which have a disproportionate impact on a business like Nelson Labs, it's very labor intensive, we're in the process now of unwinding those headwinds at the same time that we're having a big impact from unwinding that PPE testing. So all that to say that we believe that what we saw here in Q1 of this year, the quarter we just reported, really was the low point for Nelson Labs in terms of both the revenue headwind and the margin headwind associated with some of those moving pieces. For example, we said that Omicron had a tremendous impact on both our top line and margin profile in Q1. Just to go one level deeper in terms of the operating model, you need frontline microbiologists and lab technicians to be showing up for work in order to do a lot of these testing services that then translate to revenue recognized by the business. So when you're in kind of an unusual situation with Omicron, it's great that Omicron was a less severe strain of the virus. But nonetheless, it had an extraordinary and disproportionate impact on absenteeism in Q1. So what we found is that we had a lot of people that were just on the payroll and not generating revenue. So we referenced that specific effect as adding an incremental 300 basis point headwind for us in Q1. Now obviously, that's not representative of any fundamental disruption in the business over the longer term. And we believe for that specific driver, we have great line of sight to recovering at least that element of the margin compression already here in Q2. And then for some of the other moving pieces that we're still looking to normalize, we would expect to see the rest of that normalization occur throughout the second half of the year.

Okay. If we just turn quickly to Sterigenics. So performance at Sterigenics in the first quarter was really strong. Walk us through what's been helping there. There's obviously lots of debates around how quickly things like procedures and volumes snap back. What are you hearing from clients around their need for sterilization services going forward?

The demand environment for Sterigenics has remained robust pretty much throughout the entire pandemic environment. And if anything, it's gotten stronger over time. The best evidence I can give you of our long-term demand environment is the consistency with which we've been talking about capacity expansion projects that we are -- we began rolling some of them out last year. We have more that are on the schedule for this year. And then we also recently announced that we're launching two new greenfields, which is the largest scale of investment that Sterigenics can make. It's the first time that we've ever had more than one greenfields underway at the same time, and we're kicking those off here in 2022 and expecting both of them to come online by 2024. So in terms of the long-term demand environment, it's absolutely robust. In terms of the short- and medium-term environment, just a reminder that some of my -- regarding some of my introductory comments. It's a very reliable and stable revenue base with over 90% of our sales under long-term contracts. We also have the benefit of operating in an industry that's got -- in terms of the industry structure, it is often a capacity-constrained environment. And our revenue stream is diversified across a revenue base of literally thousands of customers, many, many thousands of product lines. And so even to the extent that you might have some kind of variability when you think about end market, hospital activity, procedural volumes, even to the extent that you might have some area, for example discretionary procedures, that might be impacted in the near term, our revenue base is so well diversified across all of the customers' products and end applications that are out there in the space that really we end up typically being insulated from some of those shorter-term variability drivers.

Okay. And then we've got about 5 minutes left. So the next thing I want to talk about is the other area we spend a lot of time speaking with investors about. And that's the ongoing litigation in Illinois. So we've got the first -- or the trial set to begin soon. Decisions, I think you said mid to late August or when the first one will happen.

Sure.

But maybe just a little bit of background on it, and then just kind of thoughts going into those and maybe how good of an indicator that first trial is for maybe how some of the subsequent ones go.

Sure. Well, as far as the complete background on it, that's more of a 3-hour discussion rather than a 3-minute discussion. And we do have an extraordinary amount of detail in our public disclosures, but fundamentally, there is some amount of incremental attention that for several years now has been placed on the ethylene oxide modality of sterilization. There is an evolving environment in terms of different views as far as what are the acceptable exposure levels to ethylene oxide gas and then the regulations around those. And so again, probably limited as far as how much detail I can go into right now in the time we have. But suffice to say that there is an expectation that there will be some change to the regulations around operations that use ethylene oxide gas. We're making significant investments in our own infrastructure in order to ensure that we are at the forefront of deploying the best technology that's available as far as emission control system so that when the new regulations come out, we're better positioned than anybody to actually do even better in that environment because we believe that the capabilities we have when it comes to complying with complex and burdensome regulations are actually one of our competitive differentiators. And so we look forward to the opportunity to demonstrate that as the regulations unfold. Now as far as litigation, as you mentioned, there is some amount of litigation that's out there relating to this topic. I'm talking about the -- a moment ago, my comments were more forward looking in nature around our efforts to ensure that we're always in a leadership position in terms of compliance. On a backward-looking basis, there are some claims that relate to alleged exposure around particularly our facility in Illinois. We absolutely feel that the company has always been in the right as far as making the appropriate efforts and investments in its operations. That situation has been unfolding now for several years. And as you said, in July is when the first of those cases is going to go to trial. I just want to emphasize that while there's a large quantum of cases that are outstanding in that area, it's not a class action type of situation. And so each case, they may -- some of them may be consolidated for administrative purposes, but each case should kind of have its own day in court in terms of an opportunity to make your arguments in front of a jury. Obviously, we feel very strongly about the strength of our position, but it is a -- each one of these is going to be a jury trial, and it's going to be up to the jury to make the final determination. But again, we feel very strongly about our positions there.

Okay. Great. I guess the last thing we can touch on quickly in our last 1.5 minutes here, you mentioned inflation is something that affects a lot on the Nelson Lab side, but all of your businesses. Maybe just give us a little bit of the overview there, the levers that you have to be able to kind of mitigate the impacts on those two businesses.

Sure. Well, so a reminder that 2 of our 3 businesses are service businesses, and so they're insulated from a lot of the inflationary pressure that -- in terms of commodity. And we don't have a lot of exposure to transport costs and things like that. What little transport exposure we have is generally a pass-through to our customers. And so for the service-oriented businesses, really our largest inflationary pressure -- there's going to be some amount of pressure that comes from utilities and a small amount of lab supply and things like that. But really, the largest exposure area is labor. Overall as a company, around 40% to 45% of our cost of goods sold is labor as a company. And it's an even higher concentration when you look at it specifically for Nelson Labs as a business unit for the reasons that I mentioned earlier in terms of reliance on lab technicians and microbiologists in order to actually do the tests that you're talking about. So when you hear about inflationary headlines for us, really it's the wage pressure that's the biggest impact. Even for Nordion, which is a product-oriented business, the nuanced nature of the supply chain for cobalt-60 means that they're reasonably isolated from inflationary pressures. In terms of the ability to pass that through, we always say that we are better positioned than most businesses to do well in an inflationary environment because so much of our revenue is contract based, and the nuances of many of those contracts is that we have protections in order to be able to pass through incremental inflationary cost pressure to our customers. And when you look at our MD&A and comments that we made in our earnings calls, we generally carve out price contributions from our businesses. And what you would have seen or heard in our most recent earnings call for Q1 results is that we did see an uptick in price contribution in order to ensure that we're able to maintain our margin profile as a company, and we feel good about that for the rest of the year as well.

Okay. Perfect.

Good.

We're out of time, so we'll leave it there. Scott, thanks again.

Thanks, Sean. Really appreciate it. Thanks to all of you.