Sotera Health Company (SHC) Earnings Call Transcript & Summary

Thank you, everybody, for joining us today. I'm Casey Woodring from the life science tools and diagnostic team here at JPMorgan. I'm pleased to introduce Sotera Health CEO, Michael Petras. Michael is going to be doing a corporate presentation, then we're going to do a Q&A session afterwards. So with that, floor is yours.

Great. Thanks. Thanks, Casey. Thanks for having us here today. Before we begin, some of the statements I make today may be 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 materially be different from those implied or projected. The discussion will also talk about non-GAAP financial measures, including adjusted EBITDA, adjusted net income, adjusted EPS and net leverage. Please refer to our filings for reconciliation. For some of you who may not be as familiar with the company. Sotera Health is an outstanding company. We view our mission as Safeguarding Global Health. The word Sotera comes from the Greek goddess of safety called Soteria. And that's really what we see our company all about is providing safe solutions for our customers. It's an outstanding business where our employees live every day the mission of the company of Safeguarding Global Health. To take you through exactly what we do, I'll do a brief overview for some of you may not be as familiar with the company. On the sterilization services side, we have 2 businesses. One is Sterigenics, one is Nordion. In the Sterigenics business here, this is our largest business segment. We have about 40 -- approximately 48, 50 facilities around the world, and we provide terminal sterilization to the world's leading companies in med device and pharma companies. Customers drop off their products to us, and we provide terminal sterilization within our facility and then they pick the product up. We don't own the product. We don't take consignment of the product. We don't pay for the transportation in or out, but we provide a critical service of providing terminal sterilization. And we do that through one of 3 key modalities, either ethylene oxide, electron beam X-ray or Cobalt-60 gamma radiation. That leads me to our second business, Nordion. Our Nordion business is the only one of our 3 business that's a product business. And in this business, we sell Cobalt-60, which is one of the key ingredients for sterilization. We sell to ourselves at Sterigenics, and we also sell to our competitors around the world. Cobalt's used for treatment of cancer, but it's also used in sterilization for making sure you have safe products that have no microorganisms, and that's one of the ways that Sterigenics sterilizes using Nordion cobalt. We've got about 40 customers in this business, about 400 to 500 shipments a year versus the Sterigenics business has several thousand customers a year in sterilizing thousands and thousands of products and hundreds of thousands of -- millions of cubic feet of product sterilized. Our third business is Nelson Labs. Our Nelson Labs is one of the leading microbiological and analytical chemistry labs in the world. We do approximately 800 tests for med device and pharma companies. Again, this is a service business, not a product business. We provide critical tests to make sure the products are safe and meet the regulatory requirements. So that's what we do in the company. How we do it? We provide these mission-critical services that are often government mandated and government regulated. We sell to blue-chip customers. We do business with 40 of the top 50 med device companies in the world, 9 of the top 10 pharma companies in the world. We have facilities located around the world. In total, we have approximately 63 facilities across the company. As I mentioned earlier, we have about 48 to 50 of them within the Sterigenics business, the remainder are Nordion and our lab business. Key is having these global facilities in providing one-stop shop for our customers around the world, and they get access to all our facilities. Our integrated quality systems, our reporting systems, allow customers to deal with us around the globe. We have deep regulatory expertise. This business is built for long-term growth organically and inorganically. And I'd tell you one of the key ingredients are the values of our company in the core foundation. What does this all lead to? It leads to a business that's grown every single year since 2005. So earlier this morning, we announced our revenue for 2023. We came in -- we've announced that we're going to be -- our revenue is going to come in between $1.04 billion and $1.05 billion, would be in that range. Again, that will be another year of consecutive growth within this company. Our adjusted EBITDA through the third quarter was 50-plus percent margin. That's 5-0. We've got a big TAM. We've got a very complex business, highly regulated, with a consistent cash flow projections and ability to deliver on cash flow growth year in and year out. We're very well positioned. If you want to be in the health care -- if you want exposure to health care, this is a great business. We're not tied to reimbursement. We do not sell the hospital systems. Our customers are med device and pharma companies. Very difficult business to replicate. Really unique position we have in Safeguarding Global Health. On this chart, you see all the different products in categories in pharma and med device that we impact. We're involved in helping get these products to market, helping them stay in the marketplace by providing these critical services I just referenced on the previous page. Lots of these products come in contact with you on any given day. Like myself, some of these joints are wearing out, so you see an example here of orthopedics, right? If it's your knees, as I felt going up on the stairs here today, or your shoulder or your hips. Think about the power of what we do. We help these companies put together their sterility plans, through Nelson Labs, we'll help them figure out the right sterility plans. We will then sterilize them in a facility by Sterigenics using Cobalt-60 from Nordion. And then at the end, we'll have Nelson Labs do testing to make sure the products are free of any microorganisms. That talks to you about the end-to-end capabilities we have across Sotera Health that really helps our customers. I can give you numerous examples across these pages, but that's just one example of how our services are so critical. It's less than 5% of total cost for a manufacturer, but it helps them get billions of dollars of product sales in the marketplace because of the services that we offer across Sotera Health. Our customers rely upon us. It's very important. We've got over 5,000 customers around the world in approximately 60-plus locations in 65 countries around the world. As I mentioned, we do business with the top med device and pharma companies in the world. We have over 900-plus laboratory tests. And really, when I look at the foundation of the company, it's this integrated network we have, the end-to-end service offers I just referenced. We continue to have growth year in and year out and we're able to meet the regulatory needs of our customers. When our customers have a challenge, they come to us to help them get through the tough times. What does the growth look like in this business? Over the long run, we see this business as high single-digit organic growth. Let me walk you through the logarithm of how we get there. On the Nordion side of the business, we see low- to mid-single digits in volume and mix. On the Sterigenics side, we see volume and mix in mid- to high single digits, in volume and mix. In Nelson Labs, mid- to high single digit in volume and mix. On pricing. Throughout the company, we have the ability to get 3.5% to 5% price per year. This ties back to some of the strengths I told you earlier about the company in the global contracts, the sticky relationships that we have with our customers around the world. When you look at that 3.5% to 5% price range increase year in and year out, I would tell you that Nelson Labs is in the low end of the range, about 3.5% to 4%, Sterigenics would be in the middle of that range, about 4%, and then Nordion would be in the higher end of that range at approximately 5% price per year. What does this all translate to is what you see on the right-hand side of the chart. As I look at where the company is coming out of '23, we look into 2024, I don't see us achieving this long-range growth in 2024. We'll get into our specific forecast when we do first quarter. At the end of February, when we do the fourth quarter earnings, we will give a projection and outlook for 2024. I don't see us at these levels of growth in 2024. We'll have a slow recovery as we start to get in. These are longer-term projections, but we believe this business is set up for long-term growth. From a financial review now, I'll transition and just give you a perspective from 2019 to 2022. We've grown 9% on a compound annual growth rate. As I mentioned, we've got long-term customer relationships averaging over a decade across our top 25 customers. We have very high renewal rates. Over 90% of our sterilization services -- sterilization services, remember, is a combination of Sterigenics and Nordion. Over 90% of that revenue or $700 million are tied to multiyear contracts with our customers. On an adjusted EBITDA basis, you see the 10% growth over the last several years, 50% margin rates over the last 3 -- each of the last 3 years. We've really differentiated service capabilities that allow us to achieve this, and we're able to benefit -- our margins are able to benefit from our operating leverage, our operational excellence and favorable price year in and year out. It's an outstanding business participating in a big market with consistent growth and sustainable margins. This chart here, I won't go into a ton of detail here. This is a chart that we showed at the third quarter earnings call in just giving an update on where we were versus 2022 and where the year finished out. We had an overall strong performance through 3 quarters of the year, strong capital position and strong cash. We had a couple of other activities that I'll get into on the next page, but overall, you could see the growth in revenues and adjusted EBITDA year-over-year as well as margin enrichment through 3 quarters of the year. On a net leverage basis, our long-term goal is to be 2 to 4x net leverage. We were tending towards a little -- towards a lower 3% -- 3x as we were at this point last year. We took on additional debt earlier in the year to settle some of the litigation, and we drifted over 4% (sic) [ 4x ]. Our guide for 2023 is we would be at or below 4x by the end of the year. We see the ability to continue to deleverage the company as we continue to grow our EBITDA and expand. On capital expenditures, in 2022, we spent approximately $182 million. In 2023 through the third quarter, we had $150 million of CapEx. We guided for the total year approximately $200 million to $215 million for 2023. We also recently have stated that we expect 2024 to be at a similar elevated level before we see a significant step down in '25 and then even the lower level in 2026. The key areas across the business that's driving our CapEx, I'll walk you through each of these. We have significant capacity expansions within the Sterigenics business. Here, what we do is when we put on customers, we work with our customers for additional capacity. We work with them to get a commitment for approximately 40% of the incremental capacity we put in place. We target 20% IRR. We had approximately 9 capacity expansion programs over the last couple of years. We have 3 left, one of which will be coming live in the first quarter of 2024, and a second one will be coming on in 2025, and the third one in 2026, the last 2 being greenfields. We continue to make investments in our EO facility enhancements. These are the enhancements that are required to keep up with the new EPA expected regulations that will come out in the first quarter of 2024. We've spent approximately $30 million in 2023 through 3 quarters. We expect it -- to continue to have spend in the fourth quarter, and then it's more spend in 2024. The other major development in CapEx is going into cobalt development. So we work -- remember how this business works, we get cobalt from nuclear reactors that then we take to our facility in Ottawa, Canada. We process this in a usable form for the industry, and then we transport that cobalt around the world. Very complicated, highly regulated business, moving radioactive materials around the world. That is really what Nordion is great at. We have not done a cobalt development program since 2003. So we are doing a cobalt development program that we're in the midst of right now. We'll have the capital, again, that falls in line in 2024 and then also 2025 before it steps down further in 2026. And then the last place that we're expanding is in the Nelson Lab business. We continue to invest. This is not near as capital-intensive a business as the Sterigenics capacity. We have great returns. Again, we target on all our programs 20-plus percent IRR, but the Nelson Lab business, we've done expansions over the last couple of years, particularly around our pharma and our pharma capabilities. We're also in the midst of putting a new lab information management system. I'd like to take a minute and update you on the litigation, because several of you've had questions around ethylene oxide litigation and some of the time lines associated with that. So I'll walk you through each of the jurisdictions where we've been involved in some of that and just give you a quick update. In Cook County, Illinois, as you know, last year at this conference, I announced that we had reached a settlement for $408 million with 880 claimants in Illinois. So at that point in time, there were 3 claimants that had opted out of the settlement, but -- I think it was 879 or so had agreed at that point in time out of the 882. One of the claimants came back to us by the end of the year deadline and decided to opt in, so we were left with 2 claimants that have opted out. And then we've got 14 new cases that have come in. We have no visibility on those cases at all at this point in time, because the courts have not worked them up at all and the plaintiff fact sheets haven't been provided to us. We feel pretty confident where we're sitting in the Illinois situation, with most of that, [ in fact, ] almost nearly all of it closed out. We also, in Illinois, got a court issued order for insurance reimbursement for $75 million. So this is insurance policy where our defense costs, we believe, are due to us by the insurance company. There was a debate in the courts ruled in our favor on that for $75.5 million. We have an additional claim for $32 million that's pending. We're hopeful that we'll be over $100 million in total claims that will be owed to us by the insurers. This is not going to be resolved immediately. I do want to be clear, as many of you know, you've dealt with insurance companies, this will be another couple of rounds of battles, but we feel very good about the initial court rulings in our position. On Atlanta, Georgia, there are approximately 300 cases or so in Georgia. We settled 79 of those late last year. And we just this week paid out the settlement of $35 million to 79 claimants. The remaining 220 cases will go to the courts. Now as you may recall from some of my past comments, this is going to be handled in a different way, lot more focus on science and causation. The courts are going to take them through a Phase I general causation and a Phase II specific causation. If the 10 cases get through that, those first 2 phases, they'll ultimately go to a full trial in front of a jury. At the last update I gave you, we expected Phase I hearings to start in late third quarter or fourth quarter of 2024. Those as well as Phase II have all been deferred to 2025, so we do not see any trials in Georgia occurring in 2024. On Santa Teresa, there was approximately 7 claims brought against us in December of 2020 from the Attorney General. 6 of those have been dismissed. One of them is still being debated in the court. We feel confident about our position. There's one personal injury case in New Mexico that's been moved to federal court. So I would just -- I want to reiterate, the company continues to operate safely in a compliant manner with all the regulatory requirements, and we're going to continue to vigorously defend ourselves against each EO claims. I'd like to give you a quick brief update on our efforts on ESG. Corporate responsibility is very important to the company. We recently just published our corporate responsibility report at the end of the year. This really follows and is aligned with our mission and our vision and values of the company. Our value -- the values are so fundamental to our employees. We assess all our employees on their performance as well as the values, but our mission, as I mentioned, is very clear and very front and center with our employees, which is Safeguarding Global Health. From a governance perspective, ESG is being overseen by our nominee in corporate governance. Ann Klee chairs that committee and used to be in charge of ESG and EHS for the General Electric Company. We have full board oversight report outs on an ongoing basis. We did an outreach last year to over 60% of our outstanding shares, not our affiliated shareholders such as the private equity firms, but all other shareholders. We did a 60% outreach. And then I'd also tell you, we added Karen Flynn, our newest Board member. She comes from experiences at Catalent and West, which is very important because of her experiences in the pharma services area, which is strategically important to what we're trying to do as a company. So we're thrilled to have Karen as a new independent director. And from an ESG and executive management perspective, I have 2 co-leaders on my senior leadership team, Kristin and Matt, who lead ESG reporting to me on that, and then we have regular updates with the Board. As I mentioned, we published our corporate responsibility report in December, and we also issued our human rights policy in January of 2024. So I've given you a great overview of the company. I'd like to summarize here some of the key points I want to make sure everybody takes away. We have a strong financial profile in this company. We've grown revenue every single year since 2005. This company continues to perform during any economic cycle. Great company growing every single year since 2005, 50-plus percent EBITDA margins. We do this because of how important we are to our customers, the criticality of our services and our performance day in and day out. We have deep expertise in this business and scale. We have a large market that we participate in that's growing. We've got -- these are highly regulated businesses, and we have the ability to operate within this. You cannot just wake up tomorrow morning and say, "I want to run a sterilization facility. I want to build one in my backyard," okay? Or, "I want to get into the cobalt business." You don't go down the street to Home Depot or Lowe's and buy a container, throw cobalt in it and drop it in a FedEx envelope. It doesn't work that way. These are highly regulated radioactive materials. We have containers that are 10,000 pounds in weight, with concrete, castings around them and shields. These are highly regulated complex business where we ship cobalt around the world, and you have Nelson Labs, which is doing over 900 tests. In med device and pharma, we're really the expert in helping customers get out of trouble. I was pleased over the holidays, I got a note from our division leader. He set me a note from one of our key customers in the diabetes where he was saying, "We had a real problem here. We were on a verge of a recall. And we sent you guys some samples, so we need help and understand what happened." And we responded to that. And they said, "We've been doing business with Nelson labs for 15 years. This is outstanding in how you guys helped us through the holiday season and get through a real crisis that we had going inside." That's what this company does. It helps take care of customers and their customers and keeping patients safe and Safeguarding Global Health. We've got a platform here geared for long-term growth. We continue to invest for organic growth. but we've also done acquisitions. We've done 11 transactions over the last several years, true transformational in the Nelson and Nordion, and then 9 bolt-on acquisitions. We have an experienced management team that's focused on how to drive free cash flow across the company and make sure we're making the right calls on capital deployment, but not forgetting our purpose, which is really in our mission, which is Safeguarding Global Health. So with that, Casey, I'm happy to open up for any questions that you may have.

Great. All right. That was a great overview. Maybe just to start on that preannouncement, you reiterated the midpoint of your guide and tightened the range for the year, implying a beat in 4Q relative to consensus. Can you just talk about what you saw in the quarter between your 3 business units relative to your expectations?

Yes. I won't get into the particulars on the fourth quarter because we haven't announced the full P&L., but at this point, we did give out the revenue numbers. We feel confident in where we're at. As I'd mentioned in my comments here today, we don't see 2024 as the long-term growth numbers for the business. We didn't see a material increase in volumes in the fourth quarter, but we're confident in our ability to execute and deliver on the total year growth, which we conveyed this morning.

Maybe just following up on that quickly. You said you didn't see a material increase, but would you say that volumes stabilized in the quarter?

Yes. I would say -- if you remember, 2023, we had a situation where I call lumpiness, but Nordion had 75% of the revenue in the back half of the year, which we had signaled early on in the year. The team did an outstanding job executing against that. So that -- they gave you a bigger fourth quarter than typical. I would tell you the Sterigenics and Nelson side, you didn't see a material increase in volumes as the year progressed.

Okay. So on the volume side, last year, it's been softer due to inventory destocking. You talked about the mid-single to high single-digit volume and mix growth contemplated in your long-term guide. You're not going to do that next year. Just what's the right volume and mix growth rate to assume for next year? How long are these destocking impacts going to linger into 2024? And how should we weigh that versus sort of the comp dynamic coming up?

Yes. We expect -- again, I'll get into 2024's guide in -- at the 27th or 28th, whenever we do our earnings for the fourth quarter, but we expect the company to deliver growth again, just like we have in -- since 2005, every single year. We expect that to happen again in '24. And as far as the longer, it'll be a little lower than I said to you, our long-range forecast, but we feel confident about it. And when you look across where we are with customers, we have thousands of customers in the Sterigenics and the Nelson Labs side. Thousands of customers, thousands of products across many categories, if it's orthopedic, if it's urology, if it's wound care, you see labware, bioprocessing. There's lots of puts and takes. I think a lot of you in this room as you talk to other investments that you have, it's tough to know exactly where these customers are. We don't see it materially getting worse from an inventory destocking level, and we're hopeful that the procedural volumes continue to be strong, which will be the benefit to both Sterigenics and Nelson.

Got it. That's helpful. So pricing across the business in '23 is coming above the 3.5% to 5% normal range. You've said that you raised prices mainly due to inflation. Just maybe walk through how you're thinking about pricing. Is that going to come back down to the normal range? If there's a lingering volume impact, would you take price actions next year? Is that really -- decision really based on inflation? Maybe just walk through pricing.

Yes. So our business has about 3.5% to 5% pricing per year. We've been historically running at that rate the last year, so it's been a little higher than that, because of inflation, some timing of like when cobalt came in, for example. When some of the higher-cost cobalt came in, we had higher prices to offset some of that. We'll -- we have -- we will see in -- when we look forward in 2024, I think it will be more in that range of the 3.5% to 5%, give or take a little bit on the Nordion side.

Okay. Maybe just shifting over to Sterigenics specifically. Would you characterize the recent performance as solely related to destocking efforts by your customers? Or would you characterize some of the softness as an underlying demand shift? What's your confidence in that long-term trajectory in the Sterigenics business and that volume growth that is contemplated in your long-term guide?

Very confident in long-term growth of Sterigenics. So that business, remember, it's 2/3 of our business approximately. It's 50-plus percent adjusted EBITDA margins. It gets somewhere about 4% price per year, and volume and mix, as we said, should be mid- to high single digits organically. This business, it's not like you have plus 10% volume, minus 20% volume. It's not huge swings. It's plus or minus a couple of points, right? So this year, it was down -- in '23, it was down a couple percent, but it gives up a couple of percent pretty easily. So I think it's plus or minus a couple of percent here and there. We feel good about the long-range outlook on Sterigenics and how the volumes will shape out.

You've characterized the destocking headwinds is broad-based across customer segments in medtech, pharma and then tools and bioprocessing within Sterigenics. Can you talk about how customer conversations have been between those different groups? I feel like there's been some disparate commentary from those companies in terms of the magnitude of destocking headwinds and the timing that they expect those will abate. So just wondering if you have any kind of perspective or visibility in terms of when that recovery will happen?

Yes. It's tough to get exact clarity from the customers. We engage with them quite a bit. Remember, we're dealing across many different categories. If it's orthopedic, urology, wound care, cardiac, labware, bioprocessing. So you're a different state. If you even look at some of the things being communicated on bioprocessing right now in the marketplace, you have 4 or 5 big players there, and they all have a different place of where they are in the cycle. We've had some categories who are doing really well in and continue to grow, and we haven't seen as big an impact. In some of the general hospital categories, we've seen some challenges on it, and we're probably over-indexed in that category in particular, where some of our customers had significant inventory. They're having problems getting supplied during COVID. They put multiple orders on multiple vendors and ultimately all that came in, and then their takeaway maybe wasn't as quick up as they had hoped on the outgo. So I'd say overall that we don't see the inventory level getting a lot worse. It's kind of stabilized, but it is a mixed bag when talking to our customers. Even if you take some of the big multinationals, global companies, they've got broad categories, right? They may have diabetes, they may have wound care, they may have pharma, they may have orthopedics. So it really varies within the company and their individual plants that sometimes are bought as part of consolidation for enrollment, and they don't have consistent process across all of them.

Has the landscape changed at all in terms of in-sourcing versus outsourcing in the sterilization market? What do you think penetration looks like for outsourced sterilization right now? And how do you see those trending both in the near and long term? Just kind of curious if in-house sterilization is something companies can do to cut costs right now, given the macro? Or is there not enough capacity? And then maybe longer term, you've talked before about the potential for outsourcing penetration tailwinds on the back of the new EPA guidelines. Just maybe talk about outsourcing penetration rates over time.

Casey, you have like 5 questions in there, and I want to try to try to make sure I got them all here. 57-43, outsourced, insourced. That's what we estimated at. Over the last 6 years that I've been here, we've seen that move about 1% or 2%. We don't see big shifts occurring. I think one thing that could impact this over time is EO regulation. So we expect the new NESHAP rules, which is the rule for sterilization and emissions out of facilities on ethylene oxide, we expect those to come in March. And with that, it will be interesting to see what the outcome is, if people decide to close up shop, they decide to outsource more or they decide to put the capital investment in. So I think that's a big wildcard here at play. And we are not anticipating a big shift to outsourcing, but that could be an upside over time that comes our direction. We'll continue to monitor that.

Maybe following up on that, the EO site enhancements you've made, I think you're sustaining the same level of CapEx spend in this regard next year before those investments drop off in '25. How comfortable are you with those projections for next year? Is there a range of scenarios for EO facility CapEx in terms of wherever the finalized NESHAP ruling falls? And then why would site upgrades go to zero? Will there not be a need to kind of continuously work to curb emissions? Or kind of how should we think about that?

Yes. I would say that we generally feel that the facility enhancement dollars that we put forth in '23 will be relatively close to the same dollar amounts in 2024. The one exception would be if we get a big surprise on the new requirements, but we don't expect that, and we don't expect it to have a material impact beyond the $100 million plus that we've spent on these facility enhancements, or by the time we're done, we will be spending on these facilities. Overall, we do continually do improvements in these facilities we have for 30-plus years of continuing to make sure we operate in a compliant manner and continue to do continuous improvement. We will continue to make investments, but that's typically captured within our maintenance bucket of CapEx every year ongoing.

So just...

We call out the facility enhancements, because this is a not normalized spend, $100 million plus that we've spent on it. We want to make sure that people understand that's not the normal CapEx.