Sotera Health Company (SHC) Earnings Call Transcript & Summary

Good morning, everybody. Welcome to day 2 of the Healthcare Conference. Luke Sergott. I cover Life Sciences tools and diagnostics. Today, with me, I have Michael Petras, CEO of Sotera Health. Thank you for making it down.

Good morning, Luke.

And I guess we can get right into it. So let's talk about the demand trends and headwinds that you guys have been seeing across the business, but let's start on the Sterigenics versus the primary business. There's -- you guys service a lot of the industries including bioprocessing, you have PPE for the hospital supplies market, mostly in the device arena. So just talk about the different headwinds from a volume perspective that you guys have been seeing and any type of visibility on the recovery there?

Thanks for Barclays for holding the conference and inviting us down today. I'll make some forward-looking statements and also, you can refer to the SEC filings or our website as well for our risks and uncertainties as well as any non-GAAP financial measurements you can see those on our recent securities filings. So thanks for having us. Regarding volumes in the Sterigenics side is many folks know that's our largest business just over 60% of our total business. We're seeing volumes have kind of stabilized. They're not getting significantly worse nor better. As we stated in our last earnings call, we think the year will be relatively flat with the second half being slightly up on volumes. And we're seeing good procedural volume at the end markets. But ultimately, I think there's still a lot of inventory in the channel that they've had to work out across many, many of the medtech and pharma companies. You referenced bioprocessing. Bioprocessing is not a huge volume for us, but it is one that we play in. And that, in particular, if you've seen very clearly with some of the big processing folks. These taken significant volumes down and have had inventory challenges over the last several quarters. But we don't see getting a lot worse.

Yes. Just give us a sense on something I learned from a covered devices, but just how that channel works for you guys? I mean you have the GPOs, you have the actual OEMs, then you have the hospital inventories. Like, when do you see the destocking and the part of that value chain or supply chain?

So our engagement is with the manufacturers themselves. We don't engage directly to GPOs nor the health systems. From what I understand, not an expert on the entire supply chain, but the hospitals buy some products directly from mass distributors and then they also buy some products from the medtech companies physician preference items, for example. So they buy directly from them. So there's some inventory at the hospital systems but then there's inventory largely more at the medtech companies as well as their distributors. That's usually where the inventory is. When we get our orders from though, ultimately are from the medtech companies and the pharma companies.

Yes, the OEM guys. So right now, from a -- some of the destocking that you guys have been seeing the device volumes have been really strong the last few quarters. So is it safe to assume that the hospitals are essentially burning down their inventory and then maybe getting some of that flush out from the channel, the distributors and GPOs and like the sellout from them? And then maybe there's maybe a little bit more backlog from the OEMs and then you guys will see it. Is that kind of.

Yes, right. But I would say most of the inventory from our understanding is really at the medtech companies directly and the distributors. There isn't huge amounts in hospitals, but hospitals did -- they do take inventory on it in some cases, but they also took on a lot of PPE and some of the more consumables during COVID. I think one of the things that the medtech companies have been sorting through is during COVID, they weren't able to get all the componentry they wanted all, I say multiple orders or multiple places and they all came together over the last several quarters. So if you look at some of the public filings from the medtech companies, you see the leadership there talking about freeing up working capital in this area and it varies by company. You're talking finished goods, you're talking raw materials, you're talking in pharma, you're talking med device. It's not a real clear picture for anybody, but we get our orders from the OEMs.

That makes sense. And I just want to talk a little bit about capacity there from what you guys have from the device side. You continue to have to build out capacity and invest in CapEx. But as you're not seeing the big volume recovery that's hitting because obviously, the destocking. But when things get back to normal, give us a sense of your utilization and like how underserved that end market is or overserved, just give us a sense of that landscape.

Yes. Just proper context on the Sterigenics side. You're not talking about a business that does 10% buying and then down 20%. We're talking about up a couple percent down a couple percent. And last year was the first year since I've been since '16 that we saw a down year in volumes that I recall. When we look at our capacity, we're pretty well situated right now, obviously, because volumes are a little bit lower, but we try to target 80% capacity utilization. When we work on -- right now, we're in the midst system capacity expansion programs, when we work on that with our customers, we try to get commitment above 40% of the volume before we start to move forward on the new capacity.

Okay. Okay. Talk a little bit about Nelson Labs. Again, volumes, this is really kind of the ancillary to -- I always associate this with ancillary to stay, right? You do the actual sterilization in Sterigenics and then you have Nelson labs to do the testing to say, yes, this thing was actually sterilized properly. So the same headwinds hitting that segment as well or...

Yes, there will be three things that we've talked about with Nelson Labs as far as where the volumes have been impacted. The first one would be the sterilization volumes, right, and some of the lot release volumes that we get from the sterilization companies that we ultimately view the final testing in lot release. The second one would be the European medical device regulations that got deferred out a couple of years. And then the third one would be small to medium-sized customers, which we have quite a few venture-backed funding where we do a lot of work for them. But that business, it's been -- it's probably felt the most impact that a COVID over the last several years between shortages in testing volumes as well as the labor so that business is more labor-intensive. They had a good fourth quarter. But one of the things that we wanted to make sure people understood in the fourth quarter, in particular in that business, the volumes kind of were stable. They weren't terribly soft. But the real [indiscernible] was in our RCA business. That's the business where we're doing regulatory consulting and advisory, and that's where we're helping companies that getting the challenges with FDA inspections and things of that nature. So it's a little lower margin business. As we look in 2024, I'd say a couple of things with Nelson in particular. One, like all 3 of our businesses, the first quarter is typically softness. I would also tell you that the margin rates in the Nelson business is usually relatively low in the first quarter, low for us. We're a business that does 50% margin. So it's lower for us than the other 2 businesses. And that's driven by labor utilization and things of that nature. But I would just think of the business, we try to strive for mid-30s in margins. I don't think we'll ultimately get there in 2024 but that business -- when the volumes come back, and we do 900 tests in that business group, we're pretty critical for med device and pharma companies.

Okay. On the EU regulation, can you just give us the quick one on [indiscernible] what's changing the what are these -- do you view these as pushouts? Or as cancellation?

It could be a combination because what happens is the medical device regulation, those are new requirements that were being put on by EU. Last year, earlier in the year, they've been going on for '22 and '21 and then what happened in '23 -- early '23, I can't remember exactly when it was in the first quarter or early second quarter. They deferred those out to '26 to '28, depending on the kind of class of device you are. And how that impacts me on the OEM side is they will evaluate -- do they update their existing product to meet the medical device regulation or do they go ahead and come out with a whole new product launch that's ultimately going to replace it. Those are things that we're involved with customers as they start to come off these products, they come to us for testing. So over time, we'll see that volume come in.

All right. So it's more of another strategy on their part and then you guys find out later. So that's why it could be a cancellation or.

Exactly right.

Got you. And then kind of a little distant here, but the -- let's talk a little bit about pricing. You just mentioned margin, so it clicks pricing in my head. You guys continue to get decent pricing. I think that this is also partly due to how you guys run your capacity and overall, the demand of the industry. So talk about your pricing strategy and how that's changed and then what we should think about as a normalized pricing environment for you?

Yes. Over the last several years, our pricing run a little higher than our long-term projections, our long-term projections of 3.5% to 5% across the company. Nelson is usually on the low end of that, Nordion is on the high end of that. In the last several years, all 3 businesses did very well. Some inflation based and just contract renewals and some opportunities that we pursued. I would tell you, as we look at 2024, we'll be on the lower end of that range because of the fact that Nordion particular is going to have a little softer year and price still positive, price still well performing. It's just the timing of. Contract renewals that happened last year that gave them a little bit more momentum in '23 than they will in '24.

And on those contract renewals, is that more of just the pricing escalators weren't as big as they were in the past year?

Yes. Some of the contracts that came -- there were some large contracts. I think if I'm not mistaken, Nordion had like 11% price last year, which is outsized. And it was because of some large contracts that came from renewal last year. We're choosing people up to the market levels. But it will come back in the range of 3.5% to 5% across the companies, we look beyond '24.

And I think about your flat -- your margin guide for there, you typically end up -- you guys typically get some type of expansion this year, not but not this year, but typically you get expansion. But this year, you're guiding to flat margins year-over-year -- is that -- just walk us through the dynamics we just went through a little bit of pricing is not what you were getting last year. So volumes are coming back in the back half? Just walk us through the various dynamics.

Yes. The business in total does about 50% adjusted EBITDA margins. Nordion is our largest margin business over 60%. Nelson, these are our latest margins, as I mentioned, in typical year, we'd like to be targeting around 35%. And the mid-30s and then Sterigenics is in the low 50s. When we look at -- we're really focused on margin dollars and how do we drive growth in margin dollars over time, which we will see again in 2024. There won't be as much margin expansion with some of the investments and things that we're doing across the company. We get margin expansion from operating leverage as well as from price and mix health across many businesses. And I'd say just with the volumes away, we won't give as much operating leverage. But again, we're really focused on margin dollars than we are margin rate.

Got you. And you were talking about just the investments. I mean, when you guys IPO-ed, and we were talking about the margin opportunity, I mean it's typical investment you're getting 50% EBITDA margins, how could we get higher. So you always talked about improvement. It was likely going to come on the Nelson side. Talk about some of the plans or investments that you need to make, where you can improve that from the 30%, 35%.

On the Nelson side.

Yes.

I would say Nelson lab business in the past, during COVID when volumes are at really high levels. We're in the low 40s. That's higher than that business. We're talking about a lab here microbiology and chemistry lab.

Mid-30s.

Yes. Services, mid-30s is a pretty darn good business. And the Nelson team, again, I don't think we'll get there in '24 with some of the volume challenges in that business but it will be a very solid business. And what drives volume and margins in that business is volume, operating leverage, good productivity and then price overall. But we feel very good about where we are. Our customer satisfaction scores across our businesses are very high. We have strong relationships across the customer base.

Great. And then talk about the LRP, high single-digit top line growth. Can you just help us think about this like from a bottoms up and then we can do it from the pricing and volumes in the different businesses. But just overall market growth driving the three segments or how to think about that and then we can go into the...

Yes, if you get 2% to 4% market growth, you get 3.5% to 5% price, you get some mix across that starts to get you at mid-to-high single digits organic growth. But on top of that, we would put M&A.

Yes. So -- but like when you think about the Sterigenics, like the key driver there is obviously device volumes, right? I mean so how do you guys think about device volume from an LRP perspective in that roll up from the volume?

Yes. Again, should take -- in that business, we do quite a bit in med device and pharma. So if you think of low to mid-single digits in volume and mix and then you put price on top of that, that business does about 5% price per year or I'm sorry, about 4% price per year at 3.5% to 5% I mentioned earlier. So if you get that forward, then you get the volume, the mix on top of it, you start to get into the mid-to-high single digits in terms of...

It will be in the same thing. Okay. Then turn it back to, I guess, this guide from the 24% guide on Nordion. Last year, you had like a huge 3Q for Nordion just from the way that the shipments or the harvest scheduled. Anything outside of this year like any way to think about the revenue cadence for the Nordion business?

Yes. So some of the folks that may not be as familiar with the business, this business ships cobalt to their customers around the world. It's not a very transaction-intensive business. There's about 400, 500 shipments a year. When we look at it last, really heavily predicated on when the nuclear utilities are we to pull the cobalt out of the nuclear reactors. Last year, 75% of the volume went in the second half of the year, which we signaled 75% for the total year was in the second half, 50% was in the fourth quarter. We have good visibility in that business. It doesn't mean it won't move around, but the last year came through. When we look at 2024, the harvest schedule is a little bit more balanced. The first half will be a little lighter than the second half. So it's more balanced. The first quarter is always the softest quarter for all 3 of our businesses. And this year, in particular, Nordion with the harder schedule. I know lots of people have asked us, "Hey, how is this first quarter compared to last year as really light for Nordion because this I would just tell you, think about the first quarter and if you take the last couple of years, '22 and '23, we took an average of those, it would be slightly less than the average, if you think of it that way. Helpful -- for first quarter. Yes.

And then as the -- sticking with the Nordion business, I mean, you talked about the where you're the nuclear reactors. So you've avoided these sanctions from the Russia side, you're starting to -- you talk about getting contracts or supply from maybe some more Canadian reactors. Can you just give us a sense of the lay of the land, where the majority of the cobalt that you're getting is coming from and then plans as you avoid some of the more geopolitical issues.

Phenomenal business. Again, I'll kind of reiterate what we do in this business is we supply cobalt 60 that's used for medical device and pharma sterilization. It's also used for brain cancer treatment. The product that many have familiar with gamma knife. The gamma in that product is coming from the folks over at Nordion. Phenomenal business. This product is the only one of our 3 businesses as a product business. So we get that cobalt out of nuclear reactors. We process a new usable form in our nuclear site license facility and then we ship it to sterilizers or into the gamma knife application. We give cobalt from nuclear reactors all over the world. So Canada, has been and continues to be one of our largest sources. We work with the Ontario Power Group. We work with Bruce Power. We get cobalt from their nuclear reactors. Remember, these reactor's primary purpose of life is generating electricity. So we extract the cobalt in conjunction with the utility we harvested out of the -- we harvest it out of the nuclear reactor and then we take it and process it. So we could cobalt from Canada, Russia, India, China and Argentina. And we have these licensed vessels that are able to move as cobalt around the world. And then we take it, process it and ship it off the customers ultimately. We don't hold much inventory of this product because it's the case of 12% a year, which is one of the beauties as you sell to your customer and that has replenishment opportunity every year.

And then so from a geopolitical risk, like is it as a, what are you doing there to -- in case we get into in case the cobalt from Russia gets sanctioned or something happens with China in a trade war or anything like that?

Yes. So we work with the regulators and the government bodies around the world to make sure they understand the importance of cobalt to the global healthcare system. Obviously, we monitor the geopolitical challenges most recently, it's been in Russia. The team work with that. We make sure complying with all the rules and we continue to get cobalt as we have. We state every year to beginning of the year that there's a risk if we weren't able to get any cobalt this year from Russia. For example, I think this year, we said 0% to 3% is what we said total Sotera Health revenue risk would be if we weren't able to get cobalt from Russia. But we've been able to navigate that. And there's a lot of work that goes into it. Our teams do a phenomenal job working with our regulators and in Europe and the U.K. and U.S., Russia, making sure they understand the importance of what we do and making sure we get that cobalt. So we've been working at this for the last couple of years. And there's a lot of complexity in that wood freight lines and ocean carriers and oil insurance companies and what banks and how do you transact. So the team has done a really good job. We've actually gotten several inbounds from people asking us to help them, take on that effort, and that's not our business. We said no thank you. We're doing it because we have to do it, and the global healthcare industry is relying on us. That's what's most important.

Like a nightmare. Can we talk -- we're talking about the gamma and X-ray technologies. Just talk about the alternatives to the ethylene oxide. We get asked this a lot. And our simple answer is that there's no other modality out there that can do it at the capacity of ethylene oxide does. So what like how accurate is that statement? And can you help us like -- just give an anecdotal piece how many hips and knees or cardiac devices can fit in an ETO chamber versus like an x-ray or gamma changer?

According to the FDA, about 50% of medical devices or 20 billion devices a year are sterilized with ethylene oxide, okay? So 20 billion devices a year. EO is not going away. Ethylene oxide is not going away. We as a sterilizer do not determine the modality for sterilization as determined by the manufacturing, OEM in conjunction with the FDA. And then they come to us and say, "Hey, we need something sterilized with EO, something sterilized with gamma radiation. So when you look at ethylene oxide. It's a very effective sterilant. It's a dangerous material, just like a lot of the other materials we deal with. These are highly regulated industries. But you can have a one pallet chamber for ethylene oxide, you could have a 30 pallet chamber. There's 1, there's 12. There's 14, there's 20 pallet chamber. So you get a lot of product in a chamber in time to sterilize that what makes it so efficient, and it's also a very effective sterilant. It really helps penetrate and make sure the product has no microorganisms. Remember, that's the reason we're doing the sterilization is that when people are having surgical procedures, we want to make sure if it's a pacemaker, it's the PPE, the doctors where we want to make sure those products have no contaminants to harm the patient. That's ultimately what we're doing here.

How many devices can you fit on a pallet.

So you get cases of product on a given pallet and then you could have a mixed lot, which is multiple different devices or you could have one single pallet of one device. It really depends -- you got to be careful because the recipe for each product to be slightly different, so you got to be careful on what products you mix with. I don't know exactly how many products are in. It depends on how many in the Mastercard and how many master cartons are on a pallet -- but it's a lot. There's a lot -- it's a lot 30 pallets right.

Yes. And you can't do that -- why can't you do it with the x-ray or the gamma, is just not a material.

Because of the compatibility between the device and the type of sterilization. So some devices will not stand up the gamma radiation, some won't stand up ethylene oxide. It's dependent on the material composition. And then you see the product.

And then we heard about chlorine dioxide at a packaging conference. I didn't -- my guys did. Wow. I'm kind of we're going deep.

Yes, go ahead.

So just talk about this as a potential threat. It seemed pretty promising, but...

Our team invests in new technologies in exploration, matter of fact, I'm going over Europe and 2 weeks ago, look at some of the work that we're doing over in this area. We'll continue to evaluate that. We don't see anything listen, if there was some solution out there for ethylene oxide replacement, you'd be out there in scale today. We've been talking about this area for several, many years. And there isn't really any viable alternative in that kind of scale. But over the next 20 years, maybe there will be. And we continue to invest in exploration of those topics as well.

If you find when you just right on.

If we find one, we'll either buy it or build it.

Last minute here, let's talk about the update on the remaining litigation piece in Atlanta. Where are we with this? And is this going to look a lot like -- should we think about this as the Illinois where there was a majority of the cases with a few of the dockets? Or is this going to be a little bit more spread out?

Illinois was a different animal versus what you get in Georgia. Georgia, the court have decided instead of -- what happened in Illinois was you basically brought a group [indiscernible] and you had to teach them a securities law. You had to teach them about environmental law, you had to teach them about science and toxicology and everything else. In Georgia, the courts had decided, they're going to take 8 cases and they're going to go through Phase I general causation around the science. The judge is going to do this before the jury is brought in. And then if they get through general causation, could EO cause cancer and then they're going to go to a specific causation and did this -- could this facility at this level potentially cause cancer? If the 8 cases, any of those get through that first and second phase, they are going to trial, which won't happen until 2026.

Okay. That's helpful.

Right now, the current view is early 2026.

Okay. Awesome. And what are the updates on those on the -- will we get updates on what the phasing of that?

Yes, it's more information relevant that will do it. But right now, you've got a bunch of lawyers running up bills and got you running up [indiscernible] things like the nature we're working through.

[indiscernible] business. All right. Great. Thank you, Mike.

Thank you.

Good to see you.