Sotera Health Company (SHC) Earnings Call Transcript & Summary

Good morning, everyone, and thanks for joining us. This is the call covering Sotera Health's results for the third quarter of 2022. Today's press release, along with the supplemental slides that go with it, is available on the Investors page of our site, soterahealth.com. The webcast is being recorded, and a replay will be posted in the Investors section of the Sotera Health website. Joining me on the call are Michael Petras, our Chairman and Chief Executive Officer, and Michael Biehl, our Interim Chief Financial Officer. Some of what the company says during this call may count as forward-looking statements. The matters those statements address carry risks and uncertainties that could make actual results differ materially from what is projected or implied. For a description of these risks and uncertainties, please see Sotera Health's SEC filings and the forward-looking statements slide near the start of its presentation. The company undertakes no obligation to update any such forward-looking statements. Please be aware that in today's discussion, the company will present both GAAP and non-GAAP financial measures, among them adjusted EBITDA, adjusted EPS, net debt, net leverage ratio, and constant currency comparisons. Reconciliations of GAAP to non-GAAP measures for all relevant periods can be found in the schedules attached to the company's press release and in the supplemental slides. The operator will be helping with the Q&A portion of today's call. <<operator_script>> I'll now hand the call over to Sotera Health's Chairman and CEO, Michael Peters.

Hello, everyone, and thanks for joining Sotera Health's Q3 2022 earnings call this morning. I'm pleased to share that we've once again achieved growth on both revenue and earnings versus the prior year. This marks the eighth consecutive quarter of top- and bottom-line gains since we became a publicly traded company. Given the macro backdrop we're operating in, our team has performed admirably. Some parts of the wider economy are showing modest signs of recovery, while others remain uneven — which makes delivering steady growth even tougher, and therefore an even bigger achievement. I'd like to express my gratitude to the Sotera Health team for embodying our values every single day. Provided we remain dedicated to carrying out our plan, taking care of our customers, and staying true to our values, I have confidence that we will continue delivering strong results. Michael Biehl will share further specifics about our financial performance shortly. Before that, though, I want to call out a few highlights from our third quarter results: we posted total revenue growth of 10% and adjusted EBITDA growth of 7.3%, measured against the third quarter of 2021. When viewed on a constant currency basis, revenue rose by 13.2%, since FX remains a considerable headwind. Adjusted EPS for the quarter came in at $0.23, which represents a $0.02 improvement versus the same period a year ago. Relative to the first nine months of 2021, revenue for the year to date is up 9%, equivalent to 11.3% growth when measured in constant currency. I'll now turn to what we're seeing across the businesses. At Sterigenics, our biggest reporting segment, the team turned in another operationally strong quarter while continuing its work to counter inflationary pressures being felt around the world. Demand is solid throughout all major modalities in both medical device and bioprocessing products; for the year to date, Sterigenics has posted double-digit growth on both the top and bottom lines, a testament to the strength of the business model. Sterigenics keeps making headway on its capacity expansion programs and facility enhancements. Three expansions were finished in 2022, among them our latest shift into a cutting-edge EO plant in Canada, which supports rising demand from customers. The other seven expansions currently underway — two of them greenfields — should become operational at differing times across roughly the coming 24 months. Progress also remains steady on the EO mission control upgrades we are rolling out throughout our U.S. network. One more facility wrapped up during the quarter. These investments, which lead the industry, reflect our continuing dedication to keeping best-in-class operations for our employees, customers, and the communities where we operate. Nordion, which is our remaining reporting segment in the sterilization services business, is still enjoying a robust year, and you can see that in the double-digit growth on both the top and bottom lines for the third quarter as well as year to date. Throughout this year I've noted that the Nordion team has done an outstanding job navigating a difficult geopolitical environment and has successfully lowered the risk surrounding cobalt-60 shipments for 2022. At this point in the year, we have completely eliminated any chance of disruption to Russian supply during 2022. As we've mentioned previously, revenue at Nordion comes in unevenly owing to the timing of nuclear reactor supply schedules. We still think the remainder of 2022 will play out the way we previously described, but we expect things to stay uneven going into 2023. Revenue at Nelson Labs, our lab testing advisory service business, rose more than 7% versus the third quarter of 2021. We're happy with that growth over the prior-year quarter, though demand recovery in certain testing services has come back more slowly than we expected. A few testing areas have done well, but others haven't ramped up as fast. Over the past two quarters, Nelson Labs brought on staff in anticipation of additional volume. Unfortunately, demand for certain testing services hasn't picked up strongly, which has put some pressure on margins. Even so, with staffing numbers having steadied, we've seen better results on customer service metrics and higher overall satisfaction ratings from customers. I'd add that specialists in this line of work are difficult to recruit, and at Nelson Labs we count ourselves lucky to have held on to such capable people. Our confidence is high that Nelson Labs is positioned well to absorb added demand as customers keep navigating the macroeconomic headwinds that are out there. As of today, with three quarters of the year behind us and solid visibility through year-end, we are revising our full-year 2022 outlook to reflect the macroeconomic pressures I referenced, along with the more gradual recovery at Nelson Labs. So for the full year, we're looking at net revenue growth of 7% to 8%, and adjusted EBITDA growth of 4% to 6%. We've also tightened our capex range for the year to $150 million to $170 million. We still feel really good about where Sotera Health can go. Our strategy remains the same, and we're executing with an eye toward long-term growth. The work we do is vital to protecting global health, and what we offer is essential to a great many healthcare companies. Before handing things over to Michael Biehl, I'd like to share a few recent examples that show how we carry out that mission of safeguarding global health. One testing area I'd like to call out is extractables and leachables testing, which we refer to as E&L testing. This kind of testing is needed for pharma products as well as medical devices. Nelson Labs holds a leading position in this growing test segment. This mission-critical analytical chemistry testing identifies the presence of potentially harmful compounds that could be present in drug delivery and container closure systems. In medical device extractables testing, we evaluate the potential biological hazards that a patient could experience with use of the product. Toxicological assessments of feeding tubes for neonatal patients are one illustration of this testing. Nelson Labs carries out these evaluations in order to find compounds that would reach unsafe levels for infants. After that, Nelson Labs works alongside the client to resolve any issues, ensuring safe usage moving forward. A significant portion of the E&L testing takes place at our Leuven, Belgium location, serving clients globally; this further demonstrates how Nelson Labs strives to better serve customers and protect worldwide health. At Sterigenics, one of our EO sites provides sterilization for the sole enhanced interventional cardiac replacement system designed for patients facing a severe dual diagnosis of aortic stenosis and aortic regurgitation. Through humanitarian assistance programs, these medical devices are being utilized by the U.S. FDA and the Canadian Ministry of Health to save patients' lives. Once more we're glad to highlight these cases showing how the Sotera Health team works so healthcare gets delivered consistently, reliably, and safely each day. Michael Biehl will now walk us through the financials in greater depth.

Thanks, Michael. First off, I'll go over the consolidated highlights for Q3 2022, and after that I'll provide specifics for each business segment, plus updates on capital deployment and leverage. I'll wrap up with a few additional details regarding our revised 2022 outlook. Looking at the consolidated total company basis, revenue was up 10% compared with the third quarter of last year, hitting $249 million; on a constant currency basis, that equates to 13% growth. Adjusted EBITDA grew 7.3% versus Q3 2021, coming in at $125 million. Adjusted EBITDA margins were 50.3%, representing a 127-basis-point decrease relative to third quarter 2021 levels. Compared with the third quarter of 2021, the decline in adjusted EBITDA margin stemmed primarily from these factors. The first was an adverse effect at Nelson Labs caused by hiring additional staff ahead of expected higher volumes, along with weaker margins from several acquisitions we completed recently as those businesses are folded into the company as a whole. The second was the mismatch in timing between pricing measures and actual inflation at Sterigenics. Favorable volume, mix, and pricing at Nordion partially counterbalanced both of those. Adjusted earnings per share came to $0.23 on the strength of our operating performance, which is $0.02 higher than in the third quarter of 2021. For the third quarter of 2022, diluted EPS was $0.09, down $0.01 compared with the same quarter a year earlier. Our reported interest expense came in at $23 million, but that figure is weighed down by a mark-to-market loss on certain outstanding interest rate hedges, since we didn't elect hedge accounting for them; the impact of that loss has been stripped out of our adjusted earnings per share. Once you set that loss aside, interest expense for Q3 was roughly $20 million. Turning now to how our segments did: Sterigenics turned in another robust quarter operationally in Q3, posting 9% revenue growth to $158 million and 8% growth in segment income to $86 million versus the third quarter a year ago. At constant currency, Sterigenics revenue rose 12% and segment income rose 11% compared with last year's third quarter. When it came to what drove revenue higher in the third quarter, we saw a 6% benefit from favorable pricing along with close to 6% from favorable volume and mix, though unfavorable foreign currency headwinds of 3.3% offset part of that. Compared with the third quarter of 2021, segment income margins narrowed 30 basis points to 54.3%, which came from the timing of contractual pricing actions relative to realized inflation. On a sequential basis, margins did show improvement from the second quarter 2022 levels. As Michael noted, demand is solid across every modality, since our customers keep depending on Sterigenics for mission-critical services. Nordion delivered a strong third quarter, with revenue up 22% to roughly $35 million versus the third quarter of 2021. Nordion's segment income rose over 24%, reaching $20 million versus the prior year's comparable period. In constant currency terms, Nordion posted a 25% revenue increase and a 27% segment income increase relative to last year's third quarter. The segment's top line gained from volume and mix expansion of nearly 18%, along with 7% from pricing, while foreign currency exchange produced a 2.8% headwind in the quarter. That unusually strong growth at Nordion versus the third quarter of 2021 mirrors the lumpiness we referenced earlier, related to the timing of nuclear reactor supply schedules. Nordion's margins were 57.9%, up 110 basis points from Q3 2021 margin levels. Better margins came from three things: higher volume, a better product mix, and pricing. Now for Nelson Labs: revenue in the third quarter of 2022 increased 7.3% to $56 million compared with the third quarter of 2021. Segment income was $19 million, which was 8% unfavorable versus Q3 2021. Excluding currency effects, Nelson Labs grew revenues 11%, while segment income declined by 4% compared to the third quarter of last year. Third quarter 2022 revenue growth got a 6.3% boost from pricing and close to a 6% lift from our recent acquisition. Foreign currency exchange headwinds of 3.5% partly offset those gains. Nelson Labs' Q3 2022 margins fell to 34.5%, roughly 580 basis points below the margin levels seen in Q3 2021. The drop stemmed from adding staff ahead of expected higher volumes, and we now anticipate that staffing will carry into the fourth quarter. Beyond that, the third quarter was affected by dilution from acquisitions completed recently and by an unfavorable revenue mix, though favorable pricing partly offset these factors. Our revised 2022 outlook, which we provided today, incorporates these trends. Before I share highlights on capital deployment and net leverage, I want to address cash generation. Sotera Health takes pride in delivering mission-critical services to the healthcare industry through its sterilization and lab testing offerings. Thanks to the essential services we provide and the resilience of our business model, we produced operating cash flow of $50 million to $70 million per quarter throughout 2022. That lets us cover operating requirements and put money into future growth, entirely out of operating cash flow. At September 30, 2022, our cash stood at $165 million, and available liquidity exceeded $440 million. Net leverage for the quarter declined to 3.3x adjusted EBITDA. Third-quarter 2022 CapEx came to $39 million, in line with the higher spending levels we told you to expect for full-year 2022. Investment levels are still climbing because of growth CapEx and facility upgrades, and we remain on schedule to put $150 million to $170 million into the business during 2022. Now I want to summarize our revised full-year 2022 outlook, which captures the trends we're observing and expect to keep affecting the months ahead. For full-year 2022, we have revised total net revenues to a range of $995 million to $1.005 billion < >, which represents roughly 7% to 8% growth year over year. Our adjusted EBITDA range is now $500 million to $510 million, which works out to roughly 4% to 6% growth for the year; baked into that guidance is an extra 1% headwind from foreign currency beyond what we told you last quarter, plus a slower rebound in some testing categories at Nelson Labs. We've brought our adjusted net income effective tax rate down to about 28%. Adjusted EPS should now come in between $0.91 and $0.95, which captures the adjusted EBITDA flow through along with the effective tax rate change. As things stand, we expect net leverage to finish the year somewhere between 3.2x and 3.3x, though that depends on any debt changes tied to appellate bonding, which Michael will discuss further. All the other pieces of the outlook we gave earlier are unchanged. Michael, I'll hand the call back to you now.

Thank you, Michael. Before we begin the Q&A, I'd like to brief you on the Illinois EO litigation, since many of you understandably have questions about it. Because I respect the court system as the appropriate forum where all parties and their counsel should be resolving these complex matters, I will not comment further beyond this briefing. As the media has widely covered, this September a jury in the first EO trial in Cook County, Illinois, returned a verdict in favor of the plaintiff, Susan Kamuda, awarding compensatory damages, punitive damages, and prejudgment interest that together total $358.7 million against our subsidiaries Sterigenics U.S. LLC and Sotera Health LLC. Sterigenics U.S. operates ethylene oxide and gamma sterilization sites throughout the country. The holding company for Sterigenics U.S. is Sotera Health LLC, which sits under Sotera Health Company as a subsidiary. Our view is that neither the facts, the science, nor the law backs the verdict or the damage awards, and we intend to contest them aggressively via every suitable post-trial motion and appeal. On October 25, we began that effort by submitting a motion for post-trial relief to the trial court. Both the verdict and the damages awarded are addressed in that motion for post-trial relief. As a first step, the motion for post-trial relief requested that the court enter judgment in favor or, failing that, order a new trial. The request for this relief rests on several grounds: the trial evidence did not suffice to sustain the verdict; the trial court made many errors in its rulings and on significant motions; there were numerous mistakes concerning whether evidence could be admitted; and the jury instructions contained many errors. In addition, the post-trial motion asked the trial court to lower the compensatory damages, arguing that the award was too high and lacked evidentiary support. Third, in the post-trial relief motion, we ask the trial court to vacate or reduce the punitive damages award, arguing that the strict threshold for letting a jury award punitive damages was not satisfied and that the evidence did not support the jury's award. Without going into details, the motion sets out our position that no credible scientific studies suggest—let alone establish—that exposure to the EO levels Mrs. Kamuda alleges can cause cancer or does cause cancer. In this case, the trial court made several rulings that improperly hindered our defense—especially regarding the absence of causation—and that otherwise resulted in a trial that was unbalanced and unfair. The compensatory damages came in at nearly twice the amount the plaintiffs' lawyers requested at trial; they were excessive and were driven in significant part by evidence and argument that should never have reached the jury. The strict, high standard for awarding punitive damages was not satisfied, and the punitive damage awards bore no proportion to the alleged misconduct. The motion for post-trial relief, together with any appeals that follow, ought to keep the Kamuda judgment unenforceable—including the citations and means Mrs. Kamuda's lawyers attached before that motion was filed against Sterigenics U.S., Sotera Health LLC, our parent company, and numerous other subsidiaries of ours. Clearly, these reflect the company's use of the verdicts in the issues tied to the verdict. Mrs. Kamuda and those representing her hold different views. Should our post-trial motions fail, we plan to bring these serious issues before the appellate courts. Losses in this case could range anywhere from $0 to $358.7 million, plus possible post-judgment interest. Even so, the company does not consider liability to the plaintiff probable once all appropriate post-trial relief motions and appeals are ruled on, so no reserve has been recorded. If and when appeals become necessary, Sterigenics U.S. Sotera Health LLC will also have to secure a surety bond or some other form of security for as long as the appeals remain pending. The ultimate size of that bond rests with the courts, and if the governing rules are applied in the usual way to outcomes that are less atypical, it might climb to 150% of the judgment — unless the trial or appellate courts conclude that a lower amount is fairer and more fitting in light of all the circumstances. We are in the process of arranging the bond or other security and anticipate being able to do so, although we will have to work through the present condition of the capital markets. Regarding how long the review of this initial EO case might take, we want to push the post-trial process forward as quickly as possible. Even so, it's hard to forecast precise schedules with confidence. Resolving motions and appeals requires at least several months and can occasionally stretch beyond a year. Meanwhile, the second EO trial is proceeding in Cook County with a separate judge and jury, and it is presently anticipated to wrap up around the middle of November. A third trial has been slated to commence in January 2023, while a fourth is due to begin in April 2023; each of these involves an individual plaintiff, with only that plaintiff's own claims being litigated. Court calendars shift over time, so those trial dates will be looked at again by the courts as part of the broader case management schedules. As things stand—though this could change—we don't anticipate that the five separate Illinois trials that had been set to start in January 2023 will go forward then. Also, during a recent hearing, the court signaled its view that claims from small groups of plaintiffs ought to be heard together, beginning in late May 2023. The parties have been told to confer in order to determine which plaintiffs' claims might be tried jointly, given that the specifics of the individual claims are alike. We should have a clearer picture by mid-November regarding whether joint trials can happen and when they would be placed on the calendar. Yet regardless of whether those joint trials move forward, they stay separate suits—this latest procedural step does not convert them into class actions. And last, as we announced earlier today, we're glad to have a veteran executive and widely admired litigator, Alex Dimitrief, joining our executive team as general counsel. Alex was raised in Illinois and spent 20 years as a litigator in Kirkland & Ellis LLP's Chicago office. Alex and I worked side by side after he departed K&E and came to G.E. Alex possesses a superb legal intellect, has succeeded as a litigator, and stands as a defender of integrity where law and justice are concerned. We look forward to Alex's experience, contributions, and advice on the EO cases. Several key points bear repeating. Sotera Health honors the legal system and the plaintiffs' right to present their cases. Still, we respectfully view the result of the first EO trial as unjust and lacking support in the facts, the science, or the law; we plan to keep defending Sterigenics U.S. LLC and Sotera Health LLC vigorously against these claims. Our company holds an essential place in healthcare. We run our operations with deep respect for our legal, regulatory, and other obligations, and our employees run our facilities in a safe, responsible, and compliant manner. What has driven Sotera Health's consistent, outstanding results over such a long stretch—and what leaves me very hopeful about what lies ahead for 2022 and later—is how committed our people are to this company, to our mission, to the customers we serve, and to the communities in which we do business. With that said, operator Denise, please open the line so we can take questions.

Yeah. Thanks. Good morning and < >. In Nelson, you said one factor squeezing margins during the quarter was added staffing in anticipation of greater volumes. I guess if you could give a bit more detail on that. What sort of visibility do you have on < > growth if you look further out?

Yeah. Good morning, Sean. Can you hear me okay? Because you were cutting out a little during your question, but I think I caught the gist of it. Can you hear me okay?

Yes, you come through loud and clear. So that was simply…

Understood. I believe I have the question; it concerned Nelson rather than labor < >, that's what you're asking, correct?

Yeah, with higher volumes expected, how much visibility there is into that < > and the volumes.

Yes. Thanks, Sean. So Nelson's business doesn't have visibility as strong as what the other business has. Obviously, out of the business units, Nordion has the most visibility. Nelson's visibility is lower. And as we said, coming out of 2021 and rolling into 2022, labor challenges and staffing challenges were pretty difficult. We've managed to stabilize that, but the volume just hasn't come through as much as we wanted. So, we lost some productivity in the quarter, which pressured the margins. But overall, the business is doing pretty well. As we've referenced, the Net Promoter Score in overall turnaround times and service has been much better.

All right. And still on Nelson, you brought up a few items that are weighing on < > foreign exchange. Could you share < >? Right now, is the staffing increase pretty much the largest drag, or the main effect on Nelson's margins?

Yeah, yes. The labor productivity piece is the largest drag. And then, as we said, there's some product mix, and currency does have some effect too, but that's the biggest driver, in that order.

All right, great. Thanks for taking the question.

Yeah. Sean, bear in mind too that included in that mix is the protective barrier component. It's down 50% year-over-year, and that was a pretty high mix. Even though, as we've said, we're now at more normalized levels going forward, it was still down 50% in the quarter versus the same quarter last year.

This is Jason, sitting in for Patrick. I have just one question about Nordion, perhaps. You said you had removed geopolitical risk for the whole of 2022, yet 2023 could bring some lumpiness. So how should we view the possible risks when it comes to sourcing cobalt from locations such as Russia, perhaps in the coming year?

Yes. Jason, I appreciate the question. Yes, as we mentioned, we are confident about our position regarding cobalt supply for 2022. We won't go into much detail about 2023. Once we turn the quarter, we will be in a position to provide guidance for the full year and sort of how we view things. But now and then, with any of our cobalt supply, we have to navigate difficult or varying opportunities that arise over the course of the year. What we intended to highlight is that it will be lumpy, as it was this year; it is not a steady, even harvest schedule from the reactors each and every quarter. There will be variation in that. At times it could be significant, which is why lumpiness has become our new official term over on the Nordion side.

And then perhaps one more regarding the litigation beyond Willowbrook. I suppose, how ought we to view litigation moving forward across some of those other assorted trials that you have had occurring here over the next few months?

Yeah, what I'd say to you is that each of those sits at a different, various stage in the process. Georgia is going to have a case that goes to trial late next year, and then the remaining Georgia cases plus New Mexico are going to fall beyond 2024 on the litigation that you see, similar to the Illinois litigation.

Thank you.

Thanks for taking the questions. Appreciate it. I've got one fundamental question and then one about facility. So for the first one, I'm just hoping for a bit more clarity on the Nelson Labs side. I believe the wording was limited recovery, and then waiting for customer demand to reaccelerate. I'm just hoping you could give a bit more color on, kind of systemically, what's still holding back recovery on the Nelson Labs side, and then what you're looking for to change when it comes to customer demand for it to reaccelerate.

Yeah. Phil, it's Michael. Here's what I'd note: as the prepared remarks mentioned, the Nelson business has grown somewhat. It simply hasn't gotten back to the levels we'd hoped for. Routine testing is performing strongly, and extractable and leachable testing—which I mentioned earlier—is also doing very well. What's recovering more slowly is some of the validation work and the more complex testing. When we speak with customers, that reflects somewhat slower development activity on their end, which would normally drive that work. Even so, our outlook on that business's future growth remains positive—it simply hasn't reached the level we anticipated during this year's second half.

Sorry to press the point, but what exactly is causing that recovery to be slower? Is it the FDA timelines, or what would you identify as the reason customer demand hasn't picked back up as quickly as you'd have expected?

What I'd say is that certain customer efforts around new products, or requalifying existing ones, have moved somewhat slowly; one specific customer of ours is dealing with an FDA matter they're working through, and that's creating some difficulties too. So there's a bit of uncertainty where the FDA is concerned, but customer-specific activities are also part of what's driving that.

All right. That was genuinely useful. Thank you. On the second item, we saw two notices of violation at Southern California facilities that your company runs. I'd like to know whether you can say anything about what happened there, and about any interruption you've experienced up to now or expect because of the talks with the local regulator? Thanks.

No, we are — yes, thank you. So we're in touch with South Coast. We have two sites in the L.A. area that sit roughly beside each other, plus one in Ontario; we keep collaborating with the regulators — in L.A., there's a process and a forward plan we've agreed on for the improvements we're deploying across the United States. And in Ontario, discussions with them are ongoing. Those facilities remain in operation, and we keep serving our customers every single day with the millions of devices we sterilize there.

All right, and at this moment, is there anything pointing to a legal exposure in Southern California for either one of the plants?

No, we're still running that facility. As you're aware, legal risk is always present, yet we keep those facilities running, or we keep looking after the customers, and as we speak we're operating at full strength at those facilities.

All right. Thanks, Michael. I appreciate that.

Thanks. Yes, Phil. Denise, do we have any further questions waiting in the queue?