Sotera Health Company (SHC) Earnings Call Transcript & Summary

Well, good morning. I'd like to welcome everyone to the KeyBanc Life Sciences and MedTech Investor Forum. My name is Matt Mishan, I'm a senior med tech analyst here, and I'm pleased to be joined by Sotera Health, who is represented today by Chairman and CEO, Michael Petras. Michael welcome, and thank you for joining us.

Good morning, Matt.

I'm going to start us off, but this is going to be 100% Q&A. If you do have questions that can be submitted directly to me by typing into the box below the video screen and I can then relay. Michael, I'll start with the first question. In our view, there's now an opportunity to kind of refocus investors on the positive underlying fundamentals of Sotera's business model. Could you just start off by discussing at like a high level, what the revenue growth and margin profile for Sotera looks like over the medium to long term?

Yes. Matt, and thank you to yourself and KeyBanc. Before we begin, I'd like to remind everyone that some of the statements I make today will be forward-looking statements. Please refer to our most recent 10-K filed with the SEC for discussions of risks and uncertainties that could cause our actual results to differ materially from those projected or implied in the forward-looking statements. We assume no obligation to update the forward-looking statements. During discussion, we'll talk about non-GAAP financial measures, including adjusted EBITDA, adjusted net income, adjusted EPS and net leverage. Please refer to our filings in the SEC or Sotera Health website. So now we get that aside, Matt, let me just say, from a company perspective, this is a great company. It plays a critical role in safeguarding global health. We provide mission-critical services to many of the med device and pharma companies around the world. And when I look at the long-range prospects of this company, this is an organic high single-digit organic growing company. It's got great ability to continue to have sticky relationships with our customers, grow top line, have very high margin rates. We've grown this business every single year since 2005. And we have adjusted EBITDA margins of 50-plus percent, and we just have great relationships with our customers who rely on us for critical services.

From a macro perspective, kind of how would you compare the current environment and kind of your level of visibility to kind of start 2023 versus what you had to deal with over the last couple of years?

I'd say it's a little better than it was a year ago, probably better as the year progresses. We projected that we grow the business 5% to 9% for the year in 2023. But we've also made sure that people understand, the first quarter is always the slowest quarter we had in the year. In particular, when we talked about our guidance for 2023, we called out Nordion where Nordion is going to be very lumpy this year, we're at 75% of the revenue approximately will be in the second half of the year. The first quarter alone for that Nordion business will be very, very small revenue. I mean really small revenue amounts just because of the lumpiness in how we work with our supply chain and getting cobalt. But the first quarter will be a lighter quarter for the company in total because Sterigenics, Nelson and Nordion, all 3 have like quarters but exceptionally low for the Nordion, but we see 5% to 9% for the year.

Yes. When I think about that 5% to 9%, I think the 9%, that high single-digit growth is what you normally expect for Sotera. It's basically where you've come in the last couple of years. The low end seems a little bit conservative. How should we consider -- be considering some of the moving pieces kind of within that range?

Yes. I would say it's going to be dependent -- a lot of it's going to be dependent upon how quickly volumes ramp up. When I look at the 3 businesses, as I mentioned on Nordion, we've got this lumpiness and presuming you aren't as familiar with the business. We get cobalt from nuclear reactors that their primary purpose in life is to generate electricity. So we harvest the cobalt at the time that the utility goes down for maintenance or shutdown. And that will be very lumpy. As I mentioned, most of that revenue will come in the second half of the year. But for Nelson and Sterigenics, we feel really good about where we are on that and our visibility on the Nordion side. On the Nelson and Sterigenics side, it's really going to be how quickly volumes ramp and what that looks like. A lot of customers are in a state of flux with their supply chain. We do see that, to your question earlier about 2023, we see that stabilizing better in '23 than it was in '22, but it's not perfect yet. But I'd say the biggest factor is really the volume activity in '23 that will help us around that range of guidance we gave of 5% to 9%.

Okay. I think that's fair. Could you also discuss some of the headwinds around the initial range for EBITDA? I mean you typically would get some leverage on EBITDA to sales growth. And this year, it's sort of your EBITDA growth is growing in line with sales growth. So how are you thinking about it?

Yes. So I'd tell you, first of all, the business does 50-plus percent, that's 5-0, 50-plus percent adjusted EBITDA. So the business continues to perform. For us, it's about how do we continue to grow revenue and margin dollars. That's ultimately the key measurement. That's what we're going to use to invest back in the business. So I'd tell you that's all going to be very strong with strong several hundreds of millions of dollars of cash flow in the year. From a margin perspective, you got a couple of things, inflation that we're still working through predominantly on the labor and utility side as we catch up with some of our contracts that will play in. And then we also have some mixed components, particularly around our costing side with some of the cobalt supply coming in. And then lastly, I'd say we continue to invest in the business, to continue to make sure we have the people in place to continue to long-range growth. So the most important thing for us is expanding margin dollars and revenue dollars.

It doesn't sound like it because as you talk about 2023, but do you think the company was distracted by the noise over the last 6 months how difficult was it as a manager to keep the team focused?

Yes. Matt, when I step back and look at the company went public in 2020, November 2020, and all the things we talked about the company, high single-digit organic growth, good margins, sticky customer relationships, critical role in health care, all that has played out. In between, as you referenced, we've had a lot going on in the legal side. It's been frustrating at times because the company didn't do anything wrong. We continue to abide by all the roles and rights. So I'd say there's some distraction but how you try to run the company is keep that contained in the legal department to keep people that need to be involved in that litigation and try to keep the rest of the team focused on running the business day to day. And I got to give the team a lot of credit. Through all these cycles. We had a global pandemic. We have litigation -- by the way, the litigations has been going on since '18. And so it's not just a 6-month thing. And I give the team a ton of credit for continuing to operate in this environment and deliver results and take care of our customers. I mean our customer satisfaction scores are very high, our Net Promoter Score, our service rates. So overall, I'm really proud of the team. It has been frustrating have to deal with this litigation, but overall, the team has done a really good job.

Okay. When I think about Sterigenics, I just think about it like a good, steady, high single-digit growth business, like as you had described. Is the growth algorithm still volume plus price plus capacity expansions? Are those the key moving pieces that people should be considering as you kind of build up to that growth?

Yes. We take on that business, as you referenced, high single-digits growth. We've got volume and mix that come in that play as well as price. We get about I'd say around 4% price in that business a year. Last year run a little higher because of inflation, which we said we'd be able to offset and we did. But that business, there's a lot of -- we've got expansions going out of that business, but we're also driving a lot of internal process improvement in getting more yield out of our existing capacity. So I give that the team is really focused on. Mike and the team are doing a really nice job in continuing to take care of customers. We just saw our satisfaction scores come back, which are really high once again. So yes, I'd say the business is a good, solid high single digits with good margins.

What does it mean that you get more yield at a better capacity, does it mean less CapEx investment moving forward, better leverage of those facilities?

Yes, better leverage of those facilities. But we ultimately look at for point better yield. We're trying to improve our operations. So you've got a chamber that you load product into the time between chambers and making sure you don't have a bunch of empty time there or you look at our radiators where you put cobalt in and you got [indiscernible] making sure you don't have empty [indiscernible], we're doing all kinds of things that drive process improvement in lean and simplifying our operations to try to get better utilization of our existing assets.

You have medical device customers and then you have biopharma customers that have products go through your facilities. How should we think about that like that breakdown? Are you impacted by the same like near-term dynamics as kind one of your competitors described on their last call around biopharma?

Yes. We do business with 40 of the top 50 med device and 9 top 10 pharma companies in the world. I would tell you that we have presence in biopharma and good days and bad days, we don't have as much exposure as some of our competitors do. I wish we had a better market position than we did today. We continue to work on that. One of the benefits to that, Matt, is when the market isn't as strong, you don't feel as much of the downturn as maybe your competitors do. But when the markets are strong, as they have been through the past couple of years, our competitors have probably done better than us because of the growth in that biopharma area. So it's one that's important to us long term, and strategically I would just say, at this point in the cycle, we don't have as much presence there as others. And we'll see some softening, but not near the impact of others.

In the office next to me, the other -- one of our other analyst is going through life science tools companies and talking about growth of bioproduction. And it seems like a very good end market. Just when you think about the single-use bioproduction and how that's changing, how should that go through your -- is that now more likely to go through your facilities before it gets to like a biopharma manufacturing plant? I mean how big of a lay your growth could that be for...

Yes. That's a really nice opportunity. That market grows and they go to single-use disposables in the manufacturing process. They go to shorter run cycles and more changeovers. There's all kinds of bags and disposables that come in -- in bioreactor kits that come into play and that creates an opportunity for us in sterilization as well as testing.

Okay. Can you put something in the context some of the capacity expansion projects you've made or are undergoing in Sterigenics at this point?

Yes. Sterigenics, we continue to invest in long-term capacity. What we try to do there is we target 15% to 20% ROIs on those programs, 15% if it's on the greenfield, if it's an expansion of existing, it tends more towards the 20%. We've gone live with 5 expansions over the past 2 years. I'd tell you there are 7 of them that are in process now, and those are anywhere from all modalities in any geographies around the world. But we try to be very disciplined on capital deployment and making sure that we have commitments with our customers as we move forward on those capacity expansions. But we have a healthy diet of expansions that will come together between '23 and '24.

I mean historically, you've had a pretty good return on the sterilization facilities. Do you expect a bigger return on the facilities now given the higher risk or that you've seen inherently in the business over the last couple of years?

No, I don't. At this point, as I just referenced, we try to target 15% to 20%. I think that's still in that range of where we're looking at. You've got puts and takes on that. You obviously have got construction costs that are going up. So that's something we got to continue to be mindful of as well.

Were any of these investments delayed? Are there anything been put on hold over the last couple of years as you kind of work through the litigation or has it been business as usual?

No, we continue to deploy CapEx. I think this year, we've given guidance of $185 million to $215 million. Last year was a pretty solid number. in capital expenditures. We continue to invest in the business. Our customers need us, they keep coming to us for demand, and we want to make sure we're in a position to service them.

And is there any particular area you're investing in from a technology perspective in gamma, E-Beam and X-ray? Or are -- in addition, are you continuing to invest in ethylene oxide capacity for your customers?

Investing in all those ones you just referenced, E-Beam X-ray, gamma and yield, in all modalities in all geographies.

All right. We've been waiting for the EPA forever to put on a regulation called NESHAP. Just can you please explain what this is and kind of when the last time these regulations were updated?

Yes. So NESHAP, which is the rule that applies for emissions for sterilizers. When I'm drawing a blank on what exactly that last one was but it's been many, many years since it's been updated. So we're waiting for that. We've been patiently waiting, all this information has been presented out there about ethylene oxide being more dangerous than originally thought. That started coming to light in 2016. Obviously, we started feeling some of that in one of our facilities in '18. But here we are in 2023, and we still, to this day, do not have new rules or regulations from the federal government, very frustrating for us. We're hopeful that they get these rules out very soon.

What do you think clarity would mean for Sterigenics and for the industry?

I think clarity would be just tell us what kind of emission levels and control efficiency, you want to get out of these facilities and then leave it up to the industry to go solve it. We feel very confident in our position. We've been way out in front of this. We've been putting improvements in these facilities for the last couple of years, and we feel very good that Sterigenics will continue to be at the top range of performers and emission controls around these facilities regardless of what NESHAP comes out with.

Okay. When you look at the market and the competitive landscape, you really have 2 main competitors in the OEMs themselves. Over the next couple of years, is there an opportunity here to shift away from the OEMs and more towards outsourcing?

There is. There's always been that opportunity. We see a mixed bag on this. There are some folks that have invested in internal capacity and continue to do that because they feel it's really important in their business. But then there's many customers who don't. And they come to us or you might have another group, Matt, that has a combination of in-house and outsourced but as they're growing more they're not putting incremental money in necessarily in the new capacity, they're looking for us to pick up that growth. So I feel really good about the position of a contract sterilizer and our ability to grow long term.

Okay. Moving over to Nordion. I think you explained the volatility on a quarterly basis well just depends upon when things are harvested. And it's on a schedule, so you relatively know kind of when you're going to get delivery. Any reason that shouldn't track relatively in line with Sterigenics on a full year basis?

So we -- one thing that may be helpful. We've given guidance on this business that it will continue to grow long term. Your price is on the low end of our range of -- I'm sorry, the high end of our pricing range. And then our volume mix is on the low end of our range. So what that means is about 4% to 5% on price per year, and then it's on the 0% to 2% on volume. There is a relationship between Nordion and Sterigenics. Obviously, Nordion is a supplier of cobalt for Sterigenics. So when there is a delay in cobalt going to Nordion, it impacts Sterigenics in the quarterly sequence to some degree as well.

Just curious why it's just your 2% of volumes -- medical device volume may be a little bit stronger than on a market basis?

What I'm referencing there is Nordion's cobalt volume in mix. That's what I'm referring to. Yes. Thanks for your clarification.

Part of the supply comes from Russia, a place where I'm not planning on doing any channel checks anytime soon. While there's no near-term disruption. I mean you've framed a worst-case scenario, again, like 0% to 3% of revenue if something changed. Is that status quo at this point? And I think most importantly, from our perspective, is what is the time frame around the investments that you're making that diversify and enhance your supply?

Yes. First, I'd tell you, the whole geopolitical situation where Russia and Ukraine is very troubling, right? As a company, we employees that have relations and families back in Ukraine. So that's a really challenging situation. For us, though, it's really important to the global health care system that we're supplying cobalt because of how dependent upon all these surgical procedures and medical devices and pharma products around the world are for Cobalt. We do buy cobalt from Russia. We said this year, if we were to be impacted by supply out of Russia, it would be 0% to 3% impact to Sotera Health revenue. So Matt, to your point, just minutes ago, there is a knockdown impact to the revenue of Sterigenics if we can't get cobalt through Nordion. So 0% to 3%. Ironically, that's the same number of the risk profile we've put up for 2022, and we had no impact from Russia in 2022. We just want to make sure investors know that in the event that something changes dramatically, where we cannot get cobalt from Russia, that would be the bracketed impact on the company. Overall, the team has done a phenomenal job in working through making sure we're compliant with all the rules and regs if it's in Russia, if it's in U.K., if it's in EU and Canada, the U.S., we make sure we're compliant those rules and regs and where we get cobalt from Russia. As far as development, part of our elevated CapEx last year, this year and next year will be around cobalt development. We are working actively to diversify and grow the amount of cobalt we're able to get. To date, Canada is a big supplier to us for cobalt. One of the programs that we're working on is expanding capacity in Canada. And so we're working on that. We should see some of that start to play out in '26 to '28, depending on timing of when the products comes up. And then we're also doing development with Westinghouse to really open up a whole new base of reactor technology and a new platform here in the U.S. we think that could be the late '20s into 2030s before we start to see cobalt. So these are long-range development programs, but we have a steady supply and diversified supply today. We buy cobalt from China, India, Canada, Russia, Argentina, and we'll continue to do that.

Shifting over to Nelson Labs. What gives you confidence that this business can start to show level of improvement as the year progresses? And then just eventually, potentially being accretive to growth. I believe you go back a couple of years, Nelson was a growth driver for Sotera?

Yes. So if you look at Nelson last year, they grew in the fourth quarter, they grew about 2.7% or so like that, and then on top of that about 2.5% of FX impact. So that business grew in the fourth quarter alone, I think it was like 5% in total, if I remember correctly. I want to give some context. This is an outstanding business. In this business, we have over 800 tests that we do for med device and pharma companies. And what we do is we help make sure the products are safe and the products need regulatory requirements. We're an independent lab. We've got facilities all around the world. Great business. This business, we bought it in '16. Although many who don't have the benefit of seeing the margins back prior to our IPO days, I could just tell you, we've done a great job really expanding and professionalizing and growing that business. We took it public in 2020, as you know, the company, but we continue to grow in that business. What happened is during -- in that business, really early days, pre-IPO. Obviously, you guys didn't have visibility to all those numbers, but that business is in the low 20% mark, 20% EBITDA margins. And today, that business has settled out and around the 35, mid-30s to high 30s range. The last several quarters have been mid-30s. That business continues to grow. And what happened during COVID is, this business was growing pre-COVID very steady, margins expanding, nice growth trajectory. And then what happened is we got called upon by our customers to help with PPE testing and the business went from here to here. It really stepped up in volume and margin because it was a very healthy mix. As COVID were off, that business started to come back to normalizing. We're still coming into this business that's got nice solid growth and margins in the mid-30s in the high 30s. So I would tell you we're just back to more normalized. We got through the COVID bump, which has been a positive, and the team has really worked through that. So we -- first quarter will be a weak quarter. It always is in that business on revenue and margins just because of the fact that loading of people and everything else because you're coming off a good fourth quarter, and it always seems to slow down first quarter from seasonality. But overall, this is a steady business that it's got great relationships with customers, high quality and service are the 2 big differentiators there and our deep expertise.

And this goes to the group that was formed by multiple acquisitions for you. How much integration work is kind of left to be done in this segment to kind of bring it all together?

When you look at the Nelson Labs, we continue to integrate and make that better. Most IT systems are in line to come together. We're looking at putting a lab information management system across the whole enterprise that we're in different phases as part of our CapEx improvements and investments that we're making. We're going to do an expansion in our pharma capabilities in 2023. So there'll be some further integration of some of the acquisitions. But overall, we keep investing in that business for growth.

Okay. Shifting over to litigation in the final 10. Starting with Illinois, just what are the key dates could that investors really need to pay attention to over the next few months?

Yes. I would tell you a couple of things. First thing is we went out and raised the capital with the term loan. We were able to bring that money in. So we've got that completed already. We expect the plaintiffs' executive council, which represents the vast majority of the plaintiffs to be going out to their individual clients recommendations of settlement amounts, allocating at $408 million. That's the way to think of that. And then on May 1, we have to put the $408 million in the escrow. And then I think you could expect in late July, mid early August, you'll start to see us fund the payments. And at the point, those are the kind of the big ones. So this month and in the next month, you'll see the plaintiffs firms going to their people which we won't have a lot of visibility to that until it comes back, then we will fund the escrow on May 1 and then the payments should go out late July, August.

And when you think about the potential outcomes of the plaintiff's claims decisions, can you just kind of walk through that? And I'm just assuming it's not a yes or no answer. There's multiple different ways this could go.

Yes. So there's 882 claims currently. So when you look at it, there's 4 plaintiff, trial plaintiff, if you will. They're going to take a larger portion of the $408 million. Those 4 plaintiffs, including the very first trial Kamuda, that -- those 4 plaintiffs have signed already and committed to the dollar amounts. The remaining dollars will then go out to the rest of the plaintiffs. It will come back. And ultimately, what happens is everybody falls in line, and that's option one, everybody falls in line and we pay out the money in all the cases are dismissed and we're closed out of these 800-plus cases in Illinois, sorry. The second way is there's -- remember, the plaintiffs firms have committed that they would bring 98.6% of the plaintiffs to the table in the settlement. That's part of the deal. If they come in less than that, then the company has the ability to waive that right. So they come in at 98% and maybe instead of 12 people opting out 13 or 14 did, it's our sole discretion of the company if we opt out. So that would be the second scenario if we do that. Next decision we have to make. And then the third one is if we ultimately do opt out and say, hey, we're not going to go forward because not enough plaintiffs have signed up or they haven't been able to fulfill their end agreement, then we're back to going after the trials in the case. Remember, this is a business the plaintiff firms are -- the original causation here, okay? The sciences and support their position. It's just $408 million, and that's the business that they're in. We feel pretty highly confident that plaintiff firms will figure out how to get the plaintiffs in line.

Yes, it's a good transition to Georgia where they have to decide whether or not there is general and specific causation first. I just want to understand the procedural differences in Georgia. How do they first decide the causation? Is it a special judge? Is it a panel that does that? And then if they were to say, we do see that there could be causation, does that then go to a jury trial, or are the cases grouped after? I just want to understand the procedure on how that might work.

Okay. So first thing I tell you, there's, let's call 310 cases. I don't know the exact number, slightly over 300 cases. One case is in one county and that will run through a different process. And that case will take place in October of this year, okay? That's a little unique. It's one case. It's closed out. There won't be any more case in that county. It had something to do with the corporate records and how they were kept for that one case, okay? The remaining 309 cases, that's what you're referencing, those are in top county. So they're going to go through Phase 1 general causation, in Phase II specific causation, okay? General causation is could -- so what will happen is the judge is going to have -- instead of like in Illinois, where everybody was free for all, and you're throwing all this in front of a jury and they're trying to understand science and emission controls and causation, everything else. The judge is saying, I'm going to review this. And you have to prove to me first in Phase I that there's general causation. This facility with this low amount of EO emissions could potentially cause the damages that are claimed here. That Phase 1 will go from the judge in the fourth quarter of 2024 as of right now, okay? The second Phase, let's say the cases come in, that there's going to be -- I think there's 10 cases in the Phase I. The judge will go through and say, could this facility on a general causation basis caused this injury? If you pass through that toll gate and the judge concludes, yes, and it could be 1 case, 10 cases, 0 cases anywhere in between. Then it goes to Phase 2. Phase 2 specific causation, now we start to get into Mrs. Smith, could she specifically have gotten cancer from us, right? She lived there 3 miles away. She's been there 17 years. She's got breast cancer. So now it's specific in that. That we anticipate would be October 2025 is the timing of when Phase 2 would go, okay? And then if you pass that toll gate, so now you're at 10, you maybe get them to 7, now you get to Phase 2. And then ultimately, if it's determined that the case can stand through causation, then it will go to trial in the spring of '26, okay? That is the first time that we have a trial by jury. So the judge is doing all the work on the front end, deep into the literature and understand the science and all the engineering, okay? Very different approach. I will also tell you A couple of things that are different about Georgia to keep in mind. One, there's a Daubert standard, which is a much higher standard of opinion that's allowed in the court versus the Frye standard. In Illinois, you had a Frye standard, which I think there's 5 or 6 states in the country that have that. It's a pretty low threshold for opinions of information along the courtroom. Daubert is a much higher standard. I would also tell you this causation approach is different. And I would also tell you there's a cap on punitive damages in Georgia. So just last week, there's a cap of $250,000 on punitive damages in Georgia in the whole state. That was being challenged in the Georgia Supreme Court is it was constitutional out of cap and State Court last week ruled if you're allowed to have a cap on punitive damage of $250,000, okay? So sorry, you're exhausting all my legal knowledge. I'm not a lawyer, so I'm just giving you the best that I've been able to be informed and educate on the subject.

In the last few minutes that we have that maybe we will move over to some other areas then. Is the long-term strategic plan still to eventually expand the TAM with M&A targeted towards biopharma services?

Yes. I would tell you, we have a $33 billion TAM and about $11 billion SAM. We'll continue to expand within both of those. But I would say we've got a lot of growth opportunity in $11 billion SAM, particularly in the lab space. If you look at that, again, these numbers are a little dated, but it's about $7 billion and $11 billion is in the pharma -- I'm sorry, in the lab space. And you look at the Nelson Lab business, the Nelson lab business is a couple of hundred million dollars. So we take a lot of room for growth in those markets.

Okay. And the final question, how is like the CFO search going at this point? Not trying to move everything along, but I think it's been almost a year at this point. I think -- naming a permanent CFO would be, I think a positive for Sotera?

Yes. Yes. I would say it's been a crazy labor market. And obviously, we've had some complications of altering the search. Obviously, looking at -- the recruiter reminds me, this is like 3 researchers in 1. I first started out, Michael, was we had litigation risk and -- but the person was signed up to come in board and then you get the Kamuda verdict and those people said, hey, listen, a little too much risk. And then you get people that came in and said, the stocks at $6. I got a lot of upside, the company is grossly undervalued. And then you settle in January, and now you got to be back to ]. So I would just tell you, we're seeing some good candidates, but we're being very disciplined about this. It's got to be the right fit. Right now, it's been a challenging environment for finance and IT jobs, as you probably have heard from others. But we're in a good spot. The company hasn't missed a beat. Michael Biehl is doing a great job. He's got, I guess, 30 years of public company experience, and we're doing fine. We're going to continue to search. It will be July, it will be 1 year. I've actually interviewed some candidates again this week. But overall, we're fine. It's a priority for us, but I can tell you we're in a really good spot with Michael and the team. We have a solid team. We haven't missed a beat, as you can see to date.

All right. Excellent. Michael, with that, thank you so much for joining and supporting the conference and kind of we'll call it an end of the meeting.

Great. Thank you, Matt. Good to see you. Thanks for your time and support.

Right.