Sotera Health Company (SHC) Earnings Call Transcript & Summary

Good morning, everybody. My name is Luke Sergott. I cover life sciences tools and diagnostics at Barclays. If you're not in Miami, you don't lose a voice, how are you going to prove you were there. So with me, I have Michael Petras, CEO of Sotera Health. Thanks again, for making it down. Packed house on a Thursday, we're wrapping up the conference, and you guys are bringing it home for us. So, I guess we could start if you want to give a couple high-level thoughts or something prepared there, and then we could dig in some questions, if you like.

Yes. Great. Thanks, Luke, for having us, and appreciate your support and Barclays Group overall. Happy to be here. Before we begin, some of the statements I'm going to make are made considered forward-looking statements. Please refer to our SEC filings for a description of the risks and uncertainties that could cause our actual results to differ materially from those projected or implied. The company assume no obligation to update forward-looking statements, there is discussion. We'll talk about certain non-GAAP terms, including adjusted EBITDA, adjusted net income, adjusted EPS and net leverage, please refer to our SEC filings. But overall, happy to be here, happy to get a chance to get out and talk to some investors, and you gave an update on the company.

Yes. So, let's start there, and go over kind of the high-level takeaways from how you guys ended the year. It's not -- it wasn't without any headwinds, but you still managed to beat your guy put up some really good -- still really strong growth, despite the medical device industry being a little softer than some we're expecting from a recovery standpoint. So walk through the puts and takes as you ended the year, and then how that launches you off into the beginning of this year.

Yes. We -- the thing is great about the business, we continue and consistently grow. We've grown every single year since 2005, even through all these economic cycles. And last year was a year with a lot of dynamics. But overall, we finished off pretty well. Sterigenics continues to perform through all the different cycles. They had a very good performance ending '22. You look at the Nelson business, our lab business, that business, it was a crazy year coming off the pandemic. The first quarter had a lot of labor challenges that more stabilized in the second half of the year. Volumes aren't exactly where we'd like them to see in that business, nor Sterigenics, but improving. And then on the Nordion side, that business, in particular, the curveball they got thrown at them last year was the Russia supply. They buy cobalt from Russia. And the geopolitical landscape had a significant turn in February, March as many of us know. But, I would tell you, they did a fantastic job navigating through that. So overall, we're happy about that, and we feel good roll in the 2023.

All right. So let's talk about some of the labor shortage. You guys called that out on the call as well, and that's kind of baked into your -- the cadence of your guidance. Is that across all Nelson and Sterigenics, or is that just primarily hitting Nelson right now?

So, we had the challenges with labor, if I kind of walk you through the Nordion business has done a pretty good job and the labor market has been pretty stable. It's not a really large team there, a couple of global sites. On the Nelson side, in Sterigenics, we saw labor challenges as most industries did with increases in wage rates and shortages of labor. That really -- we start seeing that in late fourth quarter '21. As we went through '22 and obviously, the beginning of '22, there was a big COVID challenge with the relapse there. So we felt that a little bit more in January. And then, as the year progressed, February, March, April of last year, the labor markets were pretty tight in the U.S. There was a lot of people not engaged in employment. And that got better, as the year went on. I'd say overall, we're in a pretty good spot on wages and labor around Europe has had a little bit of a late reaction around the labor side. We're seeing wage increases. They're more of the statutory driven. But overall, the legacy has stabilized pretty well. I actually just had reduced again yesterday in overall labor [indiscernible] .

And on the [indiscernible] inflation, how many more levers do you guys have from a pricing perspective to offset that?

Yes. So most of the wage increases we've seen, we plan for, and we're able to go ahead and offset pricing based on how our contracts are set up. There'll be some lag in how that happens. But if you look at the overall business across the company, we've got 50 -- just over 50-plus percent adjusted EBITDA margins. We're not having significant expansion in margin rates, but we're holding our own pretty well because of our ability to use price to offset inflation. And remember, the places we see inflation in our business is really threefold. It's -- we get a little bit in direct materials with cobalt Neo, but it's mostly on utility and labor spend. We planned for that, as best as we can more stable.

Yes. On -- sticking on the margin side. So you guys have baked into the guide conservatively assuming Nordion weakness due to the Russia supply. And so the margin there is going to be impacted at least in the near term. So talk about the dynamics throughout the year, and how you guys are modeling and thinking about the actual ramp of cadence?

Yes, all 3 businesses will be in a good spot, as far as margin rates in 2023. Nordion what you're referencing in particular, the way Nordion works is you get cobalt out of nuclear reactors. In those reactors, what they do day to day is they generate electricity. And so when they shut down for maintenance or refurbishment, that's when we are able to harvest the cobalt, out of there. That schedule is really needed to buy the utility. And the way it's set up for 2023, which we have really good visibility on, approximately 75% of the revenue in Nordion will be in the second half of this year, okay? A very small portion -- a very small portion of revenue will occur in the in the first quarter. But overall, the margin rate will be fine throughout the course. When it's all said and down across the business and Nordion will be fine. It's just the timing of when the revenue will go up this year.

Yes. And you guys were talking about diversifying outside of getting it from Russia, I guess, the time frame on how that -- how you guys are planning for that?

Yes, that's a longer-range project. That's part of our CapEx increases over this year or last year, a little bit in the future years. We are working with utilities to go ahead and expand our cobalt supply. A couple of things that we've discussed publicly is the involvement with the Canadian. We do a lot of work with OPG, Ontario Power Group, and we're looking to put cobalt into the Darlington reactors, that's a big project that we're working actively with them. That will take several years before it comes out, with development effort. And then, you used to put cobalt in, I kind of see you put the bread in the oven and not very technically put the bread in the oven and then after a period of time, you pull the [indiscernible] with cobalt, right? So that takes 18 months to 3 years. So first, you got to get to the development actually was going to be several years. And then after that, you put the cobalt [indiscernible] at least 18 months to 3 years. I would tell you, we're several years out. And then the second big area we're doing cobalt development is in a partnership with Westinghouse. We work with Westinghouse to get engaged with several U.S. utilities. But I think, you ought to be thinking the late '20s, in the early 30s when that's kind of the time line.

I got you. And you're not very technical. So, we can talk about Nelson Labs a little bit. You mentioned earlier that the volumes aren't back to where you want them to be. So, I mean this is the QC testing on the back of the sterilization before they go out, right? And so, centralizing all of that, how much of those volumes that you would like to come -- that you would like to improve are coming from Sterigenics versus being outsourced to you guys?

Yes. I would tell you that about 40% of that business is to really assurance lot release kind of routine testing. That business has done okay. The volumes aren't great. It comes from Sterigenics but also other sterilizers as well. We're -- the other half of that business is more in validation, more complex testing, and that's tied to R&D, new product development. And overall, that business has done pretty well. We have pockets that are stronger than others. We do a lot of work in extractables and leachables, analytical chemistry that does very well for us. But I would say that, the volumes in the new product testing stuff what we saw wasn't as strong as we hoped for in 2022 coming out of COVID from the supply chain engineering challenges. But overall, that business, we continue to see [ areas ]. We do about 800 tests in that business, all pharma and med device related testing.

Are there any particular areas that are soft than others, like so like talking about like indications from either pharma or across the benefit device indication?

Yes. I see the medical device has been a bit choppy in that business. Also last year, we referenced a couple of times during our calls that there's a couple of areas that we do testing that our customers are waiting on FDA to give clarification. In fact, what they want as far as the requirements, which will impact the protocols we put in place. We saw some of those delays in '22, but that started to normalize, as we got to the back half of the year.

This is the validation.

Yes. Exactly.

And so kind of walk through some of those tests on the value, is it like -- thinking about medical device at either works or it doesn't?

Yes, let me give you an example. One of the things that we do that now a lot of people recognize is scopes. So scopes for endoscopies, colonoscopies. We're the guy that helps put the instructions for you. So think about it, if you're a scope manufacturer those scopes are going to be used at the point of care, surgery center, outside center, we are the folks that put the instructions for use together with the FDA in conjunction with the customer, that when a practitioner and a health system uses that scope, then they go to reuse it. There are steps and protocols that they have to file to make sure it's clean. That is -- that's the work that we do to be an independent lab to validate that those scopes are clean, and okay, there's no microorganism in that nature. So something like that, I'm going to make it up. I don't know exactly in particular. But in the past, you had to do 7 steps, mean the independent test to make sure or the FDA was saying, "Hey, we want you to now 20 test -- 20 steps. And then there was some discussion back and forth in the industry, and they settled on 12. I'm just assuming it as an example. That was some of the issue. The customers didn't want to be sending testing in for 20 steps, anyone to do 12 -- and anyone to do 12 and turn around, I have to come back and do 8 more. So that was some of the stuff that last year cost some challenges. But we got -- some of those rigs got clarified now, but we're starting to see that volume the latter half of '22 will start to material. But that's an example.

Yes. And so you guys end up materializing in on catch up when we're thinking about the ramp here in '23 for Nelson, is it going to look like the rest of the business will be back half weighted? Or is it -- or we should expect?

Well, I don't think any of the businesses will be as heavily weighted as we saw what we're projecting with Nordion. All 3 of the businesses have a -- well, this year, Nordion is going to have a very low first quarter. But as I mentioned, 75% of the revenue in the second half of the year. The other 2 businesses traditionally have a lower first quarter. So we'll see that. But then the rest of the year will kind of bounce out. But I don't think, you should expect it to go from here to here significantly, but it will be a steady increase as the year progresses.

Perfect. Perfect. And on your margin guide, you guys are assuming 80 basis points contraction there. Walk us through the different dynamics and bucket out the different puts and takes you see.

When we look at it, the business will still be 50-plus percent adjusted EBITDA margins when we look at it. There's some timing of inflation that comes in and roll out throughout the year in our ability to offset the contracts. It's not that we're not going to get it. It's the timing of it, right? We may be experiencing inflation in the area next customer's contract might not be renewed until next year, second quarter or something of that nature. So there's some timing on that. We also have some mix that will impact it, and then also some investments that we're making in the business, as well as some of the costs to help us from our strategic growth. Those are the things that will drive it. But overall, margins will be very strong at the company.

Okay. Let's turn over a little bit to the litigation side. You guys settled the cases. Give us an update there on the opt-in rates, and you guys also have the opportunity there to back out of the settlement, certain, [indiscernible]. So kind of walk us through the dynamics.

Yes. So let me give context for some folks that might be as close to it. We had litigation in Illinois. We announced that in January 9 or so that we have reached agreement on a settlement for approximately 870 cases. It will be $408 million in total. There -- it's kind of broken into 2 buckets. There's 4 plaintiffs, the trial plaintiffs should you will. Some of the larger cases, they get an outsized portion of that settlement amount. And then the remaining 866 plus cases will come together. So the 4 have signed up and they're all committed. Those are the larger settlement, the remaining 866 or so. What's happening right now is the plaintiff firms are going out to their clients and they're helping them to buy that money. And, we should see something guessing -- I'm getting confused on days, probably late April, May, we should start to see some more visibility of the participation rates. The plaintiff firms have committed 98.6% of the plaintiffs will sign up, that's their goal. And what they've committed to a contract to us. That means 12 plaintiffs can opt out, but there's some conditions around opting out, that we put in place that out of the 12 opt outs, they cannot be a certain criteria that we've laid out as they are. We have the ability to walk in the deal. If they can't deliver the 98.6%, we have the ability to walk in the deal. I don't think we're going to have issues either. There will be some things we'll have to work to. But overall, we should be able to wrap this up in the August 19 time period.

Yes. I guess like what would happen is for you guys to walk on the deal because it seems like a pretty decent outcome for everybody.

Well, first, I'd say decent outcome. I'm really disappointed that we had to pay any money because there's no science position here. But, just I want to be clear, this has a start for me that's going to be there a long time because paying anybody $400 million is a lot of money. I would just -- we have built the flexibility that they don't get the participation rate 98.6%, that gives us such great sight and our optionality, if we go forward with the deal or not.

Yes. All right. So outside of the...

We anticipate delivering it all. They signed up for it in the older client base.

I mean, opting out money.

I think its our business.

Yes, all right. So let's talk a little bit about the upcoming Atlanta side of the cases. Higher burden of prudent -- higher burden of proof over there. So talk about what that means and the data that's made to support their claims against you guys and what you guys have already produced?

Recognize how Illinois played out, a very different standard on expert testimony and what's allowed in evidence, and it's a much lower threshold and also the causations, a much lower threshold in Illinois than there was in Georgia, there is in Georgia. And also Georgia has got a cap on punitive damages, which I think is a really important thing. It's a cap of $250,000 which ironically was being challenged in the State Supreme Court in Georgia, which yesterday, the state court ruled that the captains being flagged to place it's constitutional. So that's another good outcome. I would just tell you that in Illinois, it was a free for all, the way the judge ran the case, in our opinion, you could read our motions for post-trial release. We had a lot of issues. It was pretty much people get in there talking about things they were an extra time, they were putting the information that wasn't relevant to the case. There's a whole different approach. They did discovery depositions and then pretty much do everything into the first trial. In Georgia, it's going to be a very different approach. There's a higher standard of scientific experts, in what they're allowed to present. And then in addition to that, the Georgia courts are going through a process in Cobb County, where they first have to prove general causation, which means they have to prove that it is potential, that a facility admitting this low amount of EO could potentially cause cancer. If the case gets through that, then the second case is they get into a specific causation, Mrs. Jones, breast cancer, 22 years this [ month ] of exposure, that's the next piece. And if they get through 2 hurdles, general causation and specific causation, then there's a trial. The first 2 steps have to go through a kind of a court before a judge before they go to an actual trial for maturity. We're in Illinois, this poor jury of 12 people, how to take all this information and try to sort through all these different people talking as if they were experts they want to lodge information. Georgia is taking a very different approach. I think, that's probably what you're referencing was [indiscernible].

Because on those 2 phases, in one of those breaks, then...

The case is out.

And to all cases get kicked out?

So what's happened is if taking 10 cases, the workers kind of ones that will be I don't know -- I wouldn't call the bellwether, but they're kind of guide cases that they want to work through first. That's the first 10 cases that the case. Yes. And they work through those and see if they get through the first 2 phases of general and specific causation.

Okay. And then could you give us a lay out some timing there from what we should expect?

One case that -- again, one case, that take you a different path, that plays out in 2023. And then all the other ones that I referenced, we have one case in one county and 300-plus cases in the other county, and the causation pieces of 300-plus cases, and that will take place in '24, but we have some time.

4 Okay. And the -- any update on your strategy on settling all those like you did with Illinois or -- we're just going to wait to see how they play out the [indiscernible]?

Yes. We see -- listen, we've proven out, clearly, you saw with the second trial, when the scientists put out there in fact, there's no [indiscernible], it was ruled in our favor 12 to 0. We feel pretty confident, that the facts and that these are state facilities is some money at this low level does not cause cancer. And we felt the need, as a business decision for us in Illinois because that buys media coverage. The other thing was really unique about Illinois is we had a runway verdict in the first case in Illinois also requires a bond of 150% of the verdict. So we lost that first case $363 million. We had to put a bond for $540 million to have the right to go to the appeal court, which is just absolutely literate, okay? So we had about $540 million of to go tell the courts that they were wrong. And if you read our motion of post-trial release, you'll see all the issues there. So when we just step back and look at it from a business decision, the right thing was to try to end the situation in Illinois.

Yes, it is becoming burden. All right. Let's talk a little bit about in the last couple of minutes here. Your LRP and maintaining that high single digits. Talk about the share gains versus pricing and your internal volume growth with existing customers. Walk us through the different dynamics on the [indiscernible].

So if you look at the business, we see the company grow high single digits organically. If you go through geography, you've got 3.5% to 5% price and then the rest is made up of volume and mix. If you take the Sterigenics business, they'll be rate in the middle of that pricing bucket around 4%. And last year, they ran a little hotter close 6% price because of the inflation that they were offsetting. But if you look at Sterigenics, it should be about 4% price and then the [indiscernible] it makes you think you high single digits. Then you take Nelson Labs. Nelson Labs will be about 3.5% or on the lower end of that price, about 3.5% to 4%, and then the [indiscernible] will mix will get to the mid- to high single digits. And then on the Nordion kind of look at the math on Nordion, Nordion would be low volumes, low volume mix, 0% to 2%, and they'll be on the higher end of the range of about 5% on price. So that we put them all together, and you get a business that's to 3.5% to 5% on price and the balance made up to get to high single-digit organic growth environment mix.

Yes. The other picture is on the -- your margin structure is very, very healthy. But you always get the margin expansion coming from Nordion. So talk about how that has played out versus your initial -- you guys at the IPO and you're talking about expansion from there?

All the businesses are performing. We obviously, as I referenced earlier, we had the Nelson, where we had -- that business has continued to steadily increase. We had the big step-up in margins back in '20 or -- late '20 and into '21 because of the COVID bump and some of the testing we had in [ PPE ], which was very high mix to get us into the low 40s. But it's settled down with a more normalized range in the mid-30s to high late 30s. But the all 3 businesses you guys already on 50-plus percent, you get Sterigenics 50-plus percent. And we get great operating leverages in those businesses. And again, I think the bigger point is, this just talks about the stickiness of our relationships with our customers, the importance is mission-critical service. It's -- the margins are great and everything, but it defines that -- the millions of lives that we see every day with critical services we offer. I think that's a more important thing that just the margin rates. And this is an unbelievable business that Safeguard Global Health, that's what's really important.

Fair enough. Fair enough. And lastly, speaking of Safeguarding Global Health, the nation regulations than they [indiscernible]? So any update there. I mean these things have been supposed to be coming like since 2020. So, I mean do you guys have any visibility into what's going on?

No. We keep hearing from the regulators, it's coming any months now. So we can see it's kind of interesting to me that the EPA is running around all these communities telling them, EOs more dangers than we thought. We've been looking at this since 2018, we'll get back to you through new rules. We want the new rules. We want the new rules 2018, '19, '20 on that, the business predicting more regulations come out of the EPA. But we feel very comfortable about the improvements we're putting in our facilities. They might change some things and put some additional regulations that we don't anticipate, but I feel very confident that we're going to be at the top end of the industry and our ability to perform and meet those requirements that come out, and we're waiting on that regulation is disappointing. We haven't seen it yet. And we're runner -- run around to own communities to be worried, but they don't get many solutions.

What do you think the capture rate is going to settle down today? Capture rate so like around exists in the [ 19' ] time right now?

Yes. It all depends. It varies by state and it depends if you're talking about process [indiscernible] fusion emissions. I think ultimately, they're going to have some type of solution and that's got negative pressure as part of it, and how far they go along that continuum on. But we're prepared as if they're going to have to put this -- if they think about facility and put the whole thing under bubble, we're prepared for that.

Fair enough. All right. Thank you.

All right. Thank you. Good to see you.