Sotera Health Company (SHC) Earnings Call Transcript & Summary

Hello everyone, and thank you for joining us. I want to extend a welcome to all of you for this call discussing Sotera Health's fourth-quarter 2022 results. You can find today's press release and the accompanying supplemental slides in the investor section of our website, soterahealth.com. A recording is being made of this webcast, and a replay will be posted in the investor section of the Sotera Health website. With me today are Michael Petras, our Chairman & Chief Executive Officer, and Michael Biehl, our Interim Chief Financial Officer. Certain things we say on this call may be considered forward-looking statements. Those statements involve risks and uncertainties, and because of them, actual results could end up differing materially from what's projected or implied. If you'd like a description of those risks and uncertainties, take a look at Sotera Health's SEC filings and the forward looking statement slide at the start of this presentation. No obligation is assumed by the company to update any such forward-looking statements. Also, please note that during 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. You can find a reconciliation of GAAP to non-GAAP measures for all relevant periods in the schedules attached to the company's press release as well as in its supplemental slides. During today's Q&A session, the operator will be helping out. To make sure everyone gets a chance to ask something, we ask that you stick to a single question plus one additional follow-up. And as usual, should anything come up after we wrap up, don't hesitate to get in touch with me or anyone on the investor relations team. At this point, I'm handing things over to Michael Petras, who serves as Chairman and CEO of Sotera Health.

Hello, everyone, and good morning. You're joining us for Sotera Health's call about our results in the fourth quarter of 2022. Earlier today, we announced yet another quarter where both our top and bottom lines improved versus the prior year. Since our public listing in November of 2020, every single quarter has brought gains on both the top and bottom lines, which demonstrates how strong and resilient our business model is. As I said when we spoke on the third quarter earnings call, although conditions in parts of the wider macro environment have gotten better, certain headwinds remain. Our mission continues to be protecting global health while we pursue growth and profitability for shareholders. Shortly, Michael Biehl is going to take you deeper into the numbers, but before that, let me highlight a few things about what we delivered in Q4 and across the entire year. Compared with the fourth quarter of 2021, our total revenue was up 4.3%, while adjusted EBITDA climbed 4%. For the quarter, adjusted EPS landed at $0.25 — that's $0.02 better than what we recorded in the same stretch last year. Looking at the whole year, revenue increased 7.8% and adjusted EBITDA gained 5.2% over the previous year. It's a source of pride for me that we've now grown revenue annually without interruption going all the way back to 2005, which is when we started keeping track of that figure. Now let me turn to the results for each business unit. Sterigenics, our biggest reporting segment, achieved 7.6% top line growth in the quarter. Demand was solid across every modality for the segment. For the full year, Sterigenics grew revenue by 9.6%. In line with our Sterigenics strategy, we're investing heavily in extra capacity throughout our global network. At present, Sterigenics has seven capacity expansions under way spanning all major geographies and modalities. Beyond that, we're moving forward with EO emission control upgrades at our North American facilities. These enhancements lead the industry and reflect our continued commitment to best-in-class operations for our employees, our customers, and the communities where we operate. Nordion, the other reporting segment within our sterilization services business, had a good year. Early in 2022, we noted that a complete halt of Cobalt-60 supply from Russia might affect total Sotera Health revenues by as much as 3%. I'm happy to report that the Nordion team managed this geopolitical risk exceptionally well during 2022 and sidestepped the possible 3% revenue risk tied to Russian-supplied Cobalt-60. We've consistently said Nordion's revenues are lumpy because of when Cobalt-60 harvest supply schedules fall. As anticipated for the quarter, Nordion's revenue fell 7.1%, driven by the timing of those Cobalt-60 harvest schedules. Looking over a longer horizon, Nordion's revenue stream holds very steady. For the year, Nordion revenues climbed 9.3%. For our lab testing and advisory service division, Nelson Labs, 2022 proved to be a challenging year. Fourth-quarter 2022 revenue was up almost 3% compared with the prior-year period, and for the full year, revenues climbed about 2%, which comes to 4.4% when measured on a constant currency basis. I'd like to say how pleased I am with the way the Nelson team navigated the labor and supply chain challenges that confronted us during 2022. When you weigh everything together, 2022 was a solid year for Sotera Health despite all the uncertainty created by macroeconomic pressures and geopolitical developments. As we'd intended, our deployment of capital reached a level never seen before in this company's history — funds directed at capacity growth, Cobalt work, EO emission control improvements, and numerous operational excellence efforts spanning each of our businesses. Spending on that scale shows just how committed this company is to expanding. Beyond that, we closed the year with a strong balance sheet, ending at 3.2x net leverage, which sits well within the 2x-4x range we aim for over the long term. As everyone heard in last week's press release, Sotera Health finished issuing a $500 million Term Loan B. We plan to direct the proceeds from this extra debt financing, together with the cash reserves we already held, toward three things: covering the $408 million ethylene oxide litigation settlement in Cook County, Illinois; reducing what we currently owe on our revolving credit facility in order to strengthen liquidity even more; and other general corporate needs. The market showed remarkably strong appetite for this issuance, which we're pleased about, and it positions us with solid liquidity as we move ahead. Sure, this additional debt will initially lift our net leverage ratio to just over four times, but we expect it to return within our long-term goal of two to four times before 2023 is over. Now, on the Illinois EO settlement, the Plaintiffs' Executive Committee says things are still moving along as planned, and participation rates should be known by the end of April or early May. We've set May first to put funds into an escrow account for the settlement, and if nearly all eligible claimants take part, we anticipate wrapping up the settlement and getting the settled cases dismissed by late July or early August. Before we move on, I want to spend a moment highlighting how our ESG efforts advanced during the year that just ended. Looking back at the distance we've traveled over the last twelve months, I take real pride in what the team has delivered. As part of going public, our board established ESG oversight through the Nominating and Corporate Governance Committee. A cross-functional ESG committee was created internally, and it reports directly to me; we also named two experienced senior executives to serve as co-chairs, tasked with guiding how we identify and roll out ESG initiatives that align with our broader business strategy. Across 2022, we notched up a wide range of corporate responsibility wins. Let me walk through a handful of the particular initiatives. On the environmental side, we rolled out uniform EHS measurements spanning all of our operations worldwide. We introduced a fresh worldwide EHS policy alongside an expanded EHS leadership team, and brought in an outside software provider to help us set baseline EHS metrics. Beyond that, we're still putting money into cutting-edge emissions control technology at our EO sites. Turning to human capital, culture, and our communities, our yearly worldwide employee engagement survey wrapped up with an 84% response rate. We also started the Sotera Health Women's Network, which grows out of work at Nelson Labs around cultivating female leaders, and we extended that reach across the whole company. We also created a fresh careers site and wrapped up our Leading For Our Future leadership development initiative, whose project team concentrated on ESG efforts. During 2022, we additionally unveiled a new corporate responsibility website and issued our inaugural corporate responsibility report. Beyond operational and financial results, these ESG efforts together made for an impressive and extremely busy year for the team; we're eager to share updates on our ESG progress during upcoming calls. Turning to 2023, our priorities will remain our focus. Among them are putting money into organic growth, encompassing capacity additions, infrastructure improvements, and funding for Cobalt-60 development programs. We'll keep making investments to upgrade our North American EO emission control systems. We remain committed to running our operations as well as possible, which translates into improved service for customers across all our segments. We are going to keep a tight rein on how we spend capital, and throughout this year we intend to bring down the amount of debt on our balance sheet. In addition, we are providing guidance for 2023 for the first time today. Looking at the whole of 2023, our projection is for total revenues of $1.055 billion-$1.090 billion, which represents growth of approximately 5%-9%. We expect adjusted EBITDA of $530 million-$550 million, which works out to growth of about 5%-9%. We forecast adjusted EPS of $0.78-$0.86, which would be a decline of 10%-19%, attributable to greater interest expense as well as an expected increase in our adjusted net income tax rate. At this point, Michael Biehl is going to take us through the financials in more detail.

Thank you, Michael Biehl. To start, I'll go over the highlights for the fourth quarter of 2022 on a consolidated basis, and after that I'll give you some specifics on each business segment, plus updates regarding capital deployment and leverage. Then I'll wrap up with a few more details about what we expect for 2023. Looking at the total company on a consolidated basis, revenues for the fourth quarter rose 4.3% versus the same period a year earlier, reaching $252 million. On a constant currency basis, that works out to growth of 7.2%. Adjusted EBITDA increased 4% from the fourth quarter of 2021, coming in at $130 million. Adjusted EBITDA margins came to 51.5%, which is a modest decrease versus fourth quarter 2021 levels. Our operating performance produced adjusted EPS of $0.25, which is up $0.02 from the fourth quarter of 2021. The fourth quarter of 2022 showed a net loss of $320 million, or $1.14 per diluted share, and that figure includes a $408 million legal reserve taken during the quarter. That compares with net income of $36 million, or $1.13 per diluted share, in the fourth quarter of 2021. This legal reserve relates to the binding term sheets that would settle the ethylene oxide claims in Cook County, Illinois. The $32 million of reported interest expense is weighed down by a mark-to-market loss on certain outstanding interest rate hedges, for which we did not elect hedge accounting. We've taken the impact of that loss out of our adjusted earnings per share. If you exclude that loss, interest expense for the fourth quarter was roughly $25 million. Now let's look more closely at how our segments performed; during the fourth quarter, Sterigenics turned in another strong quarter, with revenue growth of about 8% to $162 million and segment income growth of 7% to $89 million, both compared with the fourth quarter of last year. Measured on a constant currency basis, Sterigenics increased revenues by more than 10% versus the fourth quarter of last year. The drivers of revenue growth in the fourth quarter were favorable pricing of 5.6% and favorable volume and mix of almost 5%, partly offset by unfavorable movements in foreign currency exchange rates of 2.6%. Versus the fourth quarter of 2021, segment income margins shrank by 20 basis points to 55.1%, which was driven by the timing of pricing actions relative to realized inflation. On a sequential basis, margins did get better in every quarter of 2022. Nordion's revenue for the fourth quarter fell by roughly 7% to $34 million compared with the fourth quarter of 2021, a decline driven by the timing of Cobalt-60 supply schedules. Nordion segment income fell by more than 5% to $20 million versus the same period last year; on a constant currency basis, Nordion's fourth quarter revenue was down 3% compared with the same period last year. The change in Nordion's revenue versus the fourth quarter of 2021 came from a volume decline of nearly 14%. There were headwinds tied to changes in foreign currency exchange rates of over 4%, offset by favorable pricing of 11%. Nordion's margins were 59.5%, an improvement of 130 basis points from fourth quarter 2021 margin levels, which was driven by pricing contributions, partly offset by mix. Turning to Nelson Labs: in Q4 of 2022, revenue came in at $56 million, up 2.7% from the same period in 2021. Segment income reached $20 million, which was under 1% better than Q4 of 2021; when you strip out currency effects, Nelson Labs posted revenue growth of 5.3% versus last year's fourth quarter. Several factors shaped that Q4 2022 revenue growth: pricing contributed a 5.5% lift, while foreign exchange rate movements created a 2.6% drag that partly canceled it out. Margins at Nelson Labs for Q4 2022 narrowed to 36.3%, roughly 90 basis points below where they stood in Q4 2021; inflation and added headcount brought on in expectation of higher volumes drove this pullback, with pricing gains offsetting some of it. Despite that year-over-year margin contraction, Q4 2022 still represented the strongest margin rate of the entire year, expanding 180 basis points relative to Q3. Before I move into highlights on capital deployment and net leverage, let me say a few words about cash generation. Because the services we provide are so essential and our business model remains strong, we produced $278 million in operating cash flow across 2022. That solid cash flow lets us cover operating requirements and put money toward future growth. At December 31, 2022, our cash stood at $396 million, with more than $475 million in available liquidity, and net leverage dropped to 3.2x adjusted EBITDA; back in November, we drew $200 million against a revolving credit facility to bolster liquidity for litigation needs, and that amount sat as cash on the balance sheet when the year closed. We repaid this revolver draw in Q1 of 2023 using cash on hand plus proceeds from the recent $500 million Term Loan B financing, which we took out mainly to fund the Illinois EO litigation settlement. Our CapEx totaled $72 million in Q4 and $182 million for the full year 2022. Growth CapEx and facility upgrades accounted for the higher investment levels in 2022. Inflationary pressure plus some opportunistic spending designated for 2023 pushed our investments past the $170 million top end of our 2022 guidance range. Now I'd like to offer more detail on our 2023 outlook. I'll begin with a quantitative summary, then wrap up with our assumptions. For the full year 2023, we anticipate total revenues landing in a range of $1.055 billion-$1.090 billion, which works out to an annual growth rate of 5%-9%. Adjusted EBITDA should fall in a range of $530 million-$550 million, again equating to an annual growth rate of 5%-9%. The effective tax rate on adjusted net income should land in a range of 30%-33%. I want to give some context on why that's higher than the prior year's rate. As many of you probably remember, 2017 U.S. tax reform introduced caps on interest deductibility. U.S. tax reform also brought a change in 2022 under which that deductibility would face further limits. When you put that together with the higher interest expense we're seeing from rising rates, plus the substantial carry-forwards of nondeductible interest left over from earlier years, the result has been a bigger valuation allowance and a higher effective tax rate for 2023. We're looking at adjusted EPS in the $0.78-$0.86 range. That's a decline of 10%-19%, mostly caused by greater interest expense and the higher tax rate. On a weighted average basis, fully diluted share count should land somewhere in the 283 million-285 million shares range. CapEx should come in between $185 million and $250 million, which reflects the elevated investments we keep making for growth as we fund capacity expansions at Sterigenics and Nelson Labs, and also put money into EO emission enhancements in North America and Cobalt-60 development projects at Nordion. Once the $500 million Term Loan B closes, our leverage is going to rise a bit past the two-four times target range we've stated for the long term. We should be back inside that range by the end of 2023. Qualitatively speaking, here's what we're assuming. Labor market and inflationary pressures should persist into 2023, and we'll likely see some lingering indirect effects from supply chain disruptions. Russia probably faces additional sanctions as the war in Ukraine enters its second year; our view is that Nordion can keep working through these difficulties. Regulators worldwide recognize how vital Cobalt-60 made in Russia is to healthcare globally. Michael is going to address the risk tied to any interruption of Cobalt-60 supply coming from Russia shortly. Turning to how the quarters will be shaped, let me say a few words about each business unit; Sterigenics, our biggest and steadiest business, should see softer volumes and margins in Q1, which is normal, then pick up volumes and margin expansion over the remaining quarters. As is typical, Nordion's financial phasing largely follows the harvest and shipment schedules for Cobalt-60. 2023 is going to be especially uneven, since nearly all of the first half 2023 revenues and segment income will land in the second quarter, and roughly 75% of Nordion revenues and 80% of segment income will come in the back half of the year. Going back to a pre-pandemic quarterly pattern, Nelson Labs should post lower margins in the first quarter of 2023 and then expand them as the year goes on. We see margins returning to normal run rate levels, in the mid to high thirties, during the back half of the year. On foreign currency, our guidance assumes rates at the end of 2022 stay fairly steady throughout the year. When it comes to capital deployment, growth initiatives, de-leveraging the balance sheet, and long-term strategic acquisitions remain our priorities; no acquisitions are baked into our guidance. Michael, I'll hand the call back to you now.

Thank you, Michael. Before we move into the question and answer portion, I'd like to touch on the matter of Nordion's procurement of Cobalt-60 from Russia, something we have talked about before. Nordion has maintained an outreach effort at all times to make sure that governments and regulators across the world grasp how vital Cobalt-60 manufactured in Russia is to the healthcare community, since roughly 30% of medical devices worldwide are sterilized through gamma radiation. We stay in ongoing communication with those officials and are watching the geopolitical landscape closely so that the Cobalt-60 supply is protected. Right now, we keep receiving Cobalt-60 from Russia and are confident that we can go on obtaining Cobalt-60 from Russia. Our 2023 guidance reflects what we presently know about sanctions that were announced earlier by the U.S., the U.K., Canada, and the European Union. Having said that, nobody can say for certain how events and sanctions targeting Russia will play out over the short, mid, or long term. Were there to be a complete interruption of Cobalt-60 supply from Russia, we would anticipate an effect amounting to between 0 and 3% of total Sotera Health 2023 revenue. That matches the guidance we first gave in 2022, during which we saw no impact. Before we shift into the Q&A session, let me stress once more that Sotera Health is still well positioned for growth on both the top and bottom line in 2023. All in all, we feel quite good about where the company stands now and where it is headed. With that, operator, please open the call for Q&A.

Yeah. Thanks, morning to you. Regarding the outlook, Michael, you mentioned that Nelson's second-half weighting is unusual. Could you elaborate a bit further on how much visibility you actually have there? I suppose with Nordion, since there's a harvesting schedule, we know fairly precisely when that will land. For Sterigenics and Nelson, are the anticipated ramps driven simply by higher volumes, or have you implemented pricing measures that will take effect later and thus contribute more toward the back half? Is this additionally new capacity coming online this year? Please just address what's behind that significant second-half concentration.

Yeah. Alright, excellent. Concerning our remarks about the second half, Sean, the 75% of revenue and 80% of segment income figures were in relation to Nordion. For Sterigenics, you'll observe a business that is steady, strong, and consistent across the year. Higher volumes will lift margins. As I mentioned during my remarks, margins tend to be somewhat softer in the first quarter, yet that will keep improving as the year goes on. On the Nelson Labs side, growth will appear as the year advances, you know, moving from the first quarter, which is always typically a bit lighter, but the second, third, and fourth quarters are going to be, you know, solid quarters with solid volumes. Yes, regarding your pricing question, as we've said previously, you know, certain contracts of ours renew at various times throughout the year, and those will begin to roll out and take effect as the year moves forward too. In general, our biggest business, Sterigenics, I just want to ensure you grasp this, will see consistent year-over-year growth all through the year.

All right, that's helpful. Regarding Nordion, you mentioned once more that overall revenue is heavily weighted toward the latter six months of the year. As for the share anticipated to arrive from Russia, at what point during the year should that occur? Based on what you can see in terms of the harvesting schedule, I suppose, does Russia add fairly consistently across the twelve months, or does that supply portion cluster notably in one or two specific quarters?

Yes, I can't remember precisely which quarter that cadence falls in, but I can say it isn't the major factor behind what we described happening in the back half, if that's what you're asking. That has more to do with timing around certain other supply harvest schedules; it's not-

Okay.

Question based. Yeah.

Okay. great. Thank you again.

Thank you, Sean.

Appreciate you taking the questions. Michael, perhaps only a single one regarding the litigation front. It's good to see the settlement in Illinois, you know. Could you discuss, I suppose, how things work there concerning the opt-ins, specifically around attempting to determine the schedule. After that, you know, maybe just a brief update on what we ought to consider regarding the remaining litigation. I just want to be certain that we've got all the potential catalysts in our heads past this particular one, and whether this shifts your perspective on a few of the other cases still pending.

Right. Patrick, regarding Illinois and that settlement, the amount is $408 million. According to what the Plaintiffs' representatives have promised, there would be a 98.6% participation rate. When you calculate it, roughly 12 people are in a position to opt out. At a high level, here's how the process operates: a claims administrator was appointed not long ago. That process is completely separate from us. A claims administrator gets hired by them. The money is allocated to the Plaintiffs by the claims administrator, then they return to us likely in late April or early May; following that we get 30 days... Pardon me. Once the initial figures are sent out to the Plaintiffs, they have 30 days in which to evaluate it. It'll reach us in late April or early May. We'll have the chance to evaluate it. Our expectation is that this wraps up at some point in late July or early August; the $408 million has to be placed by us into an escrow account on May first. That's essentially how it functions at a high level. The four individuals referred to as trial plaintiffs — Kamuda, Schumacher and Fornek — have already put their signatures down and committed on their respective numbers; that covers Illinois. Regarding the other litigation, let me be clear, when it comes to New Mexico, no personal injury cases exist there. In Georgia, a single personal injury case is set to arise in 2023, and as for the remaining ones, the timeline is fairly extended, since the approach in Georgia will differ from what was seen in Illinois. In Georgia, the initial step requires going through a phase I to establish general causation, and following that, it moves to phase II for specific causation. That's a very different method from the one taken in Illinois.

Got it. Alright, thanks. Perhaps a brief question regarding the margin side. So Nelson, clearly you've been following those margins over the past few quarters. It sounds like returning to the typical run rate during the back half. Could you discuss that increase? Is it simply the staffing challenges, volumes coming back to normal, what brings you to that point? Just a fast one, the interest expense. I didn't catch the precise figure for 23. I may have overlooked it. If you could provide that, it would be wonderful.

All right, I'll handle the margin-related questions, and afterward Michael Biehl can take any questions about interest. When it comes to Nelson's margin, if you examine it, over the past 3 quarters we've sort of settled into that mid-thirties area, correct? Around 36, 35. As you know, we saw solid sequential gains from the third quarter to the fourth quarter. The first quarter always winds up being the weakest margin, simply due to volumes and the way they land, plus seasonality has some effect. We feel quite good about what the Nelson team has accomplished. Keep in mind, something we brought up during our previous quarterly call is that we chose to add staff, expecting somewhat higher volume, yet we didn't cut back on staffing, since one of our main priorities is ensuring we handle service rates and turnaround times well. I'm genuinely happy with how our Net Promoter Score has progressed there, along with our overall turnaround time. Funny enough, I was just reviewing the past week. Our customer satisfaction scores came in, our annual survey covering both Sterigenics and Nelson, and both delivered very strong results. I have confidence in what we're doing there, and we're finding some encouraging pockets of growth. Looking at margin, we expect the first quarter will be somewhat lighter, but we see this business landing in the mid to high thirties, as I mentioned before.

Okay.

When it comes to interest expense, our projection for 2023 falls somewhere between $160 million and $167 million, calculated on a cash basis — does that address what you were asking?

It does. Thank you, guys.

Thanks, Patrick.

Morning. I want to ask something else about Nelson Labs. My recollection is that during the IPO process, when you were first coming to the market, your expectation was that this would be a business growing at a double-digit rate and serving as something of an engine for the company. So looking ahead over a longer horizon, where do you see Nelson Labs standing today in terms of the growth it can deliver for you?

Matthew, our view across the long range is that this business will land in the high single digits to low double digits. As you may recall, we described how the company overall realizes roughly 3.5%-5% in price, varying by business. Nelson tends to sit toward the lower portion of that range, at 3.5%-4%. Beyond that, volume and mix add enough to bring you into the high single digits to low double digits. Our confidence in the long range projections for that business remains intact.

When do you expect to return to that level? What's the obstacle right now? It appears that a number of your clients would be closer to normal by now when it comes to moving a product through something like FDA.

Yeah. We, as you're aware, across 2022, we had, if you look back on it, PPE served as a major growth engine during 2021 and partway through 2022, offering excellent mix, strong margins, and volume. After that, we needed to shift our workforce around to meet what customers required. Once that unfolded, we noticed additional testing decelerating within the validation segment. That has begun to recover somewhat and trend positively. I'd say validation volume has been the major factor, along with the labor difficulties that I believe the majority of labs are struggling with. I feel quite positive about the efforts Joel and the team are making regarding cost and price management, and on the service front; it truly comes through in what our customers report to us via the customer sat work. Broadly speaking, directionally, it's. We have certain areas performing exceptionally well. On the whole, I believe there's considerable momentum, and simply the collaboration we have with Sterigenics around validation, coordination, and assisting in enhancing customer turnaround times, plus a real emphasis on sterility assurance, has proven quite beneficial for both organizations.

Okay. Appreciate it.

Good. Thanks for sending those in. Just regarding the... a few things about the guidance. Could you help me understand — was that possible 0%-3% impact from Cobalt-60 factored in? Did you build that into your guidance?

No, it wasn't.

Okay, that works. Regarding the Atlanta personal injury litigation — when that gets going, it seems reasonable to expect the proceedings will run for quite a while, particularly because causation has to be proven in separate stages. I'm just trying to figure out the timeline for the case that begins in 2023, and how the rest come in over the course of 2024.

Yes, Luke — one case is in 2023. Right now, October 2023 is the scheduled date. As you mentioned, the later cases will stretch out over a long stretch of time. They're located in another county, and as I said, there will be two phases. General causation comes first, then specific causation, and that will need somewhat more time to unfold.

Okay. I mean,

24, 25, I would think.

All right, okay. Honestly, that answers my question, since with the others it was essentially one case each month, while this particular case...

Right