Sotera Health Company (SHC) Earnings Call Transcript & Summary

Hello, and thanks for joining us. I'd like to welcome everyone to the Sotera Health call covering our results for the second quarter of 2023. Today's press release, along with the supplemental slides that go with it, can be accessed in the Investors portion of our site, soterahealth.com. This webcast is being recorded, and once it concludes, a replay will be posted in the Investors section of the Sotera Health website. Joining me on today's call are our Chairman and Chief Executive Officer, Michael Petras, and our Chief Financial Officer, Jon Lyons. Some of what we say during this call may count as forward-looking statements. The subjects covered in those statements carry risks and uncertainties, and because of them, actual results could end up differing materially from what we project or imply. For a fuller description of those risks and uncertainties, please see Sotera Health's SEC filings as well as the forward-looking statement slide near the start of the presentation. The company undertakes no obligation to update any forward-looking statements. I'd also note that on today's discussion, the company will present both GAAP and non-GAAP financial measures, among them adjusted net income, adjusted EBITDA, adjusted EPS, net debt, adjusted EBITDA margin, segment income margin and net leverage ratio, along with 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 and in the supplemental slides for this presentation. The operator will be helping us with the Q&A portion today. To make sure everyone gets a chance to ask questions, please keep yourself to one question and one follow-up. As always, if anything comes up after the call, don't hesitate to reach out to me and the Investor Relations team. With that, I'll hand the call over to Sotera Health Chairman and CEO, Michael Petras.

Hello, everyone, and thanks for being here on Sotera Health's call covering the second quarter of 2023. I want to briefly welcome John Lyons, who has just taken on the role of Chief Financial Officer. John joins us from Owens Corning, a global leader in building and construction materials worth $10 billion, where he held a range of executive positions. Before his tenure at Owens Corning, he spent time in multiple senior leadership roles at Cardinal Health, having started out in public accounting. John offers extensive financial expertise along with experience in the health care sector, so we at Sotera Health are delighted to have him join us. I'd also like to pause and express gratitude to Michael Biehl for everything he contributed while serving as interim CFO of Sotera Health. Michael, thank you for your dedication and backing throughout the past year and for steering the company's finance organization. As we shared earlier on June 30, roughly $408 million in settlement funds tied to the Illinois ethylene oxide claims came out of escrow, and on July 6, the claims against Sterigenics brought by the 879 claimants who chose to participate in the settlement were dismissed with prejudice. While our view remains that these claims lacked merit, we're glad the settlement has been completed 1 month earlier than anticipated, owing to our legal team's work, and with a 99.7% participation rate. Shortly, John will walk through our second quarter 2023 results in greater detail. But before that, I'd like to go over a few items from the quarter. Overall company revenues fell 4.3% and adjusted EBITDA dropped 5.6% relative to the second quarter of 2022, mainly because of the anticipated timing of Cobalt-60 harvest schedules at Nordion. Adjusted EPS for the quarter came in at $0.21, down $0.06 from the same period a year ago. Sterigenics, our biggest reporting segment, achieved 5.6% top-line growth in the second quarter of 2023. Sterigenics keeps serving our customers despite a difficult global economic outlook, with ongoing customer inventory and supply chain issues as well as inflation. Even though Sterigenics volumes are below what we planned, the Sterigenics team is carefully controlling costs, which helped drive a 310 basis point improvement in segment income margin versus the first quarter of this year. Over the quarter, the team finished two expansion projects, and they're still advancing our EO facility enhancements across North America; these enhancements, which lead the industry, reflect our dedication to ensuring best-in-class emission controls for our employees, customers and the communities where we operate. Nordion, our other reporting segment in the sterilization services business, saw a 37% year-over-year revenue drop because of the timing of Cobalt-60 harvest schedules; we have solid visibility into Nordion's revenue timing since it depends on harvest schedules from our Cobalt-60 suppliers. We've mentioned before that Nordion's revenue for 2023 is going to be quite uneven, with roughly 75% of it landing in the back half of the year and about 50% of the annual total coming in Q4. Nordion still gets some of its Cobalt-60 supply from Russia. Early in the year, we said a complete disruption of supply from Russia might have a 0% to 3% effect on Sotera Health's total 2023 revenues. Now, at this point in the year, we feel certain there's no risk at all that Russian supply will affect Sotera Health's total revenues for full year 2023. The Cobalt-60 supply chain is complicated, and I take pride in how our Nordion team keeps working to make sure it's available. Roughly 30% of the world's single-use medical devices are sterilized with Cobalt-60, which is essential to the global health care community. That's a strong illustration of the vital part we play in protecting health worldwide. Our lab testing and advisory service business, Nelson Labs, saw sequential growth and margins that widened by about 680 basis points versus the first quarter of this year. Second quarter 2023 revenues came in 2.8% under the prior year quarter, which had posted record revenues. Still, volumes remain difficult in our lab business; given volumes that came in softer than expected, the Nelson Labs team is working hard to manage costs while staying focused on quality and customer satisfaction. Because of the volume weakness at Sterigenics and Nelson Labs that we anticipate will persist, we're revising our full year 2023 outlook. We now anticipate full year net revenue growth of roughly 3% to 5% and full year adjusted EBITDA growth of roughly 3% to 6%; we're confident that weaker volumes and other market dynamics are accounted for in this revised range. We'll keep focusing on carrying out our strategy to serve customers worldwide as well as possible. Before John takes us through the financials in greater detail, I want to spend a moment emphasizing our mission of safeguarding Global Health, which sits at the core of what we do. We carry out government-mandated sterilization and validation testing for medical and pharmaceutical products that are used every single day. We provide Cobalt-60 to radiation oncology professionals so they can help treat brain cancer; beyond that, we offer essential technical and regulatory know-how to address our customers' product development and sterility requirements. Our vital services have helped protect millions of patients and health care providers across the globe. One illustration of how we shape our Global Health is our team at Nelson Labs Europe, which carried out extractable leachable studies for a single-use nasal spray employed as a life-saving rescue treatment for patients suffering an opioid overdose. In spring 2023, that product won FDA approval for the U.S. market. This FDA clearance carries real weight for society, since overdose deaths tied to synthetic opioids—fentanyl among them—sadly persist as a serious, long-standing issue in our communities. A further illustration of our teams delivering on our mission can be seen by following a video link on the Safeguarding Global Health slide within the second quarter 2023 earnings presentation we issued this morning, which is accessible through our Investor Relations website. I'd urge you to view his video to hear how Sterigenics and Nelson Labs collaborate to make certain that essential sterilization and validation testing get done so vaccines can be successfully delivered worldwide. At this point, Jon will take us through the financials.

Thanks, Michael. First off, I’m really thrilled to be part of Sotera Health, a company that occupies a truly distinctive spot within the worldwide health care supply chain. It’s a pleasure to collaborate with our skilled team, and I’m also eager to get to know many of you soon. To start, I’ll walk through the consolidated highlights for the second quarter of 2023, then give you some specifics on each business segment, plus updates regarding capital deployment and leverage. I’ll wrap up with a few further remarks about our revised outlook for 2023. Turning to our overall business across all segments, second-quarter revenue declined 4.3% year over year, totaling $255 million. When you strip out currency effects, the decline was 4.1%, as the foreign exchange pressures facing the company are becoming less severe. During our first-quarter call, we mentioned that we expect these FX headwinds to continue diminishing, and that foreign currency should become a tailwind during the second half of the year. Adjusted EBITDA landed at $128 million, a 5.6% decrease compared with the second quarter of 2022. Adjusted EBITDA margins reached 50.3%, down 73 basis points from where they stood in the second quarter of 2022. Compared with Q2 2022, reduced volume at Nordion and Nelson Labs is what caused the margin to fall. One thing worth stressing: EBITDA margins improved quarter over quarter in Q2, which reflects the gains at Sterigenics and Nelson that Michael discussed earlier, along with stronger volume from Nordion. Adjusted EPS came in at $0.21, which is $0.06 below the second quarter of 2022, and the reasons are weaker EBITDA plus greater interest expense than a year ago. For Q2 2023, net income reached $24 million, equal to $0.08 per diluted share, versus $30 million of net income, or $0.11 per diluted share, in Q2 2022. Interest expense as reported for the second quarter of 2023 totaled $31 million, roughly $17 million more than during the same period last year. This increase stems from elevated rates on debt tied to our variable rate, plus added interest from the $500 million term loan we closed during Q1 of this year. Turning now to how our segments performed: during the quarter, Sterigenics posted revenue growth of 5.6%, reaching $167 million, versus the second quarter a year earlier. What drove that Q2 2023 revenue growth was favorable pricing at 6.7%, along with favorable foreign exchange rate movements of nearly 1%, partly offset by an unfavorable volume and mix impact of 1.7%. Looking at the second quarter of 2023 against the same period a year earlier, our segment income rose 7.5%, reaching $91 million, while segment income margins climbed 100 basis points to 54.9%. The improvement was fueled by beneficial pricing, though that was partly countered by unfavorable volume and mix as well as inflation. At Nordion, revenue for the second quarter fell by roughly 37% to $32 million versus Q2 2022 — a decline we had anticipated given how the Cobalt-60 harvest schedules fell. That top-line decrease at Nordion stemmed from an unfavorable mix impact of approximately 39%, along with currency fluctuation effects of about 4%, while a 5.7% favorable pricing contribution helped offset some of that. Segment income fell 40.7% to somewhere around $18 million, while segment income margin dropped 380 basis points, landing at 55.6%, against the equivalent period a year earlier. The shifts in segment income and segment margin relative to the second quarter of 2022 stemmed from unfavorable volume and mix that favorable pricing helped offset; over at Nelson Labs, second quarter 2023 revenue came in 2.8% lower at $57 million versus the second quarter of 2022. Unfavorable volume and mix of 6.9% weighed on revenue, partly countered by a 3.6% pricing benefit and roughly 1% of favorable foreign currency movement. In the second quarter of 2023, Nelson Labs recorded segment income of $19 million, which was down 8.6%. Segment income margins also contracted, falling more than 200 basis points to 33.9%, compared with the same period in 2022. The decline stemmed from unfavorable volume and mix as well as inflation, although favorable pricing provided a partial offset. Turning now to cash generation, capital deployment, and net leverage: as Michael mentioned earlier, approximately $408 million in settlement funds related to the Illinois ethylene oxide claims was released from escrow on June 30, 2023. As a result, net cash used in operating activities came to roughly $303 million. Once you factor in that $408 million outflow, operating activities actually brought in over $100 million during the first half of 2023, which is on par with what we saw in the same stretch last year. As of June 30, 2023, our available liquidity stood at roughly $635 million, consisting of $263 million in unrestricted cash plus $372 million of borrowing room on our revolver. Our net leverage ratio wrapped up Q2 2023 at 4.2x, in line with expectations. That compares to 3.2x at the close of 2022, a jump driven by the fresh $500 million term loan connected to the ethylene oxide settlement along with the associated $408 million disbursement. Capex during the second quarter of 2023 totaled $53 million. Growth CapEx and facility enhancements drove the higher investment compared with Q2 of last year. Now on to guidance. We're revising the full year 2023 outlook we gave in February. Total revenues are now projected at $1.035 billion to $1.055 billion, down from our earlier range of $1.055 billion to $1.09 billion, which works out to an annual growth rate of roughly 3% to 5%. Looking at the quarterly shape, as Michael noted, we expect roughly half of Nordion's full year revenue to land in the fourth quarter. Beyond that, we anticipate Sterigenics volumes will rise slightly over the rest of the year, while Nelson Labs revenue stays fairly flat on a sequential basis. Looking at the whole year, our adjusted EBITDA guidance now sits between $520 million and $535 million, down from the earlier $530 million to $550 million range, which works out to roughly 3% to 6% growth on an annual basis. On taxes, we're now calling for 30% to 32%, compared with the 30% to 33% we had before. Weighted average diluted shares stay in the $283 million to $285 million band. Adjusted EPS holds at $0.78 to $0.86. Capital expenditures are now projected at $200 million to $215 million, putting us at the top end of the prior $185 million to $215 million range, mostly because of more capitalized interest stemming from higher borrowing costs. And finally, net leverage should end the year at or under 4x. With that, I'll hand the call over to Michael.

Appreciate that, John. Before we get into Q&A, I'd like to stress once more that Sotera Health remains concentrated on carrying out our strategy and stays committed to our purpose of Safeguarding Global Health. With that, operator, please go ahead and open the line for questions and answers.

You've got Brendan sitting in for Patrick. Thanks a lot for making the revised guidance so clear. I did want to ask about the EO settlement over in Illinois — with those 3 claimants who chose to opt out, do you have any sense of what the schedule looks like from here?

Morning, Brendan. This is Michael. No, we don't; we're waiting for the court to let us know the timelines and the scheduling plans. And just so that's clear for you and for others, we could have walked away from the deal, but we went ahead and looked at the claimants and the whole fact sheet around that, and we feel really confident about going forward with the settlement with those three opt-outs.

Great. Thank you. And then, second question is a follow-up on how should we think about pricing in the second half of the year given the reduced volumes?

We've said along this business is about 3.5% to 5% price. I think you ought to feel confident that it will be in that range looking forward.

Thanks. Morning, and well done, Jon. Pleasure to have you with us. Michael, regarding that quarter-over-quarter gain in Sterigenics margins, could you give us a bit more granular detail on what was behind it? And then, given the thinking that volumes there are going to come in somewhat weaker than what was perhaps first assumed, how much tweaking — or perhaps how many additional tweaks beyond what you're doing — gets made to that cost base near term to try to size it appropriately?

Morning, Sean. We'll keep being as efficient as we can be in how we run things as we look across each of the 3 businesses amid the volume softening; we've run into a few difficulties, as you've likely observed and picked up on elsewhere, with inventory destocking and the inventory positions of certain customers. Still, we feel fairly good regarding the margin levels and the steady performance we achieve from Sterigenics. There isn't a great deal of wiggle room in that cost base. There's a certain labor element inside those operations, yet they aren't big operations. Take any single facility — 30, 40 people at any one site; it's not as though there are 400, 500 at each site; so there are certain constraints around that. Even so, the team has performed really well on operating leverage, and we keep securing price in that business; so we feel good regarding the margin levels at Sterigenics.

All right, that's helpful. Now, regarding EO emissions and the rules around them, do you have anything further to share or any additional perspective on what the EPA has proposed and how the final version might shape up? Also, I'm curious whether you've had any dialogue with the EPA since those proposed rules came out?

We have. Comments were filed by us, and across the entire industry, I believe the total comes to roughly 40,000 comments. As we see it, the EPA is in the process of working on its consent orders. Our expectation, then, is that they will adopt some form of a NESHAP by March 2024. That's the timeline we're currently anticipating for final rules to appear. Through various trade groups, we've engaged in discussions with the regulators. They know what we and plenty of others have contributed.

Michael, in past discussions we've covered the sorts of volumes that the industry — the wider health care sector on the medtech side, and among medtech hospitals, and so forth — has been experiencing, and there's been discussion of gains in those volumes, and you've made remarks about a sort of mismatch between that and what you're observing. I was wondering whether you might address that, what leading indicators you're picking up on that lead you to believe the weakness you're going through will persist, and maybe it's pricing — do customers display any sensitivity toward the price you're implementing? And does that have any impact on volumes? Thanks.

Thanks, David. Hospital volumes have been recovering and coming back to levels seen before the pandemic, and in many aspects globally, that's what we observe, though we do notice inventory pressure among our customers. As I said during the prior quarter, we're watching that carry over into the current quarter; likely it will extend into the following quarter too. So we've been careful in how we consider our outlook on that front. That isn't to say we aren't witnessing gains in cardiac devices or orthopedic; it's simply that, taken as a whole, some categories are declining, especially PPE, or surgical kits and similar areas, where a lot of inventory has accumulated since everyone was rushing to obtain it throughout the COVID period; so please don't come away believing this is happening everywhere. We have meaningful customer growth across a great many customers in those categories I just mentioned. Regarding price, look, that's a discussion we're always having with customers, or whoever sits on the other side of it. We're confident in our capacity to keep securing price thanks to the excellent service we provide and how essential our services are. Still, that's invariably a sensitive discussion. Sterigenics had another solid quarter in the period, and on that side, volume and mix came in just slightly softer; however, we built that into how we're thinking going forward. And we believe, as I said a moment ago when asked, that the company overall will achieve 3.5% to 5% price, contingent on which business you mean, in our outlook.

All right. That makes sense. And on a somewhat connected note, though looking at the larger picture regarding your guidance: the margin effect in the updated guidance isn't much, yet it's actually a touch greater than previously. So essentially, you're removing expenses at a quicker pace than sales are falling. Could you elaborate a bit further on the specific places where that's possible without doing more harm to, or further undermining, revenue?

Sure, David. Around expenses, we'll keep doing the right things and ensure we maintain a balance of looking after our customers. That said, this isn't a cost-driven exercise; overall, this business, as we've discussed on numerous occasions, grows organically at a high single-digit rate; once we move past this unusual stretch — with the destocking and bioprocessing difficulties that exist — we're confident we can get back to those levels. I should say bioprocessing isn't a massive segment for us, yet it still affects us, especially on the Sterigenics side and somewhat at Nelson. Looking at our margin rates, we're fairly confident they'll come back to historical levels, just as happened in the quarter you just saw. The first quarter was unusually low, but as we've communicated before, that one is always the weakest quarter of our year. Still, I don't want you to picture this as some big machete hacking out a pile of costs; that's not what this business is about; we're confident we can keep growing this business at high single digits and navigate the current cycle we're in; so I just wanted to make that clear, David. We'll keep pushing efficiency — Mike and Joe especially — driving our operating efficiencies over time. And you might remember, near the end of last year, we added a significant amount of talent on the Nelson side to meet possible demand that we expected, since service is a real focus for us. Because that demand hasn't materialized as strongly as we'd hoped, we've sensibly allowed some of those head counts to come down through natural attrition. But please don't think we're being extremely aggressive and simply cutting a bunch of costs.

To build on what Windley asked, regarding the volume piece, you brought up bioprocessing a bit. Could you separate out where things were soft, between the med device side and the pharma non-devices portion of your business?

Luke, I'd put it this way: when it comes to bioprocessing, that shows up mainly in Sterigenics. It isn't a massive share, though it's a solid mix for us. That sector, as you've observed with certain customers of ours having spoken publicly over recent weeks, keeps facing volume challenges. So that should indicate where we're encountering it. We also have a bit of food and cosmetics on the Sterigenics side, which has been somewhat weaker in this cycle, plus medtech. Over on the lab side, it's med device along with some bioprocessing and a portion of the pharma side, biopharma especially.

All right. Is there any way to put a number on the drop in bioprocessing volumes? I just want some context, and then I've got a follow-up about your outlook.

Yeah. The decline is substantial — in the double-digit percentages, likely around 30%.