Description

Intro:

                Sotera (ticker: SHC) is a leading provider of sterilization and lab testing services to medical device and pharma manufacturers, which checks all the boxes of a wonderful business. The Company provides mission critical services that are government mandated yet make up a small share of the total cost of its customers’ systems. It also operates in an effective duopoly (with Steris, ticker: STE). Combined these dynamics provide SHC substantial pricing power to raise prices year in and year out at a rate of 5-6%.

We believe that SHC should grow revenues at HSD rates (organic, constant currency) on the back of volume growth in the MSD and pricing power at similar clips. Combined with margin expansion of 100-150bps p.a we expect SHC to generate high teens EPS CAGR for the next 10 years.

The Company trades for 25x CY22 P/E and 16.8x CY22 EV/EBITDA. Even without multiples expansion we see the case as attractive. We expect the shares to outperform overtime, as a legal overhangs that are unduly pressuring the stock abate, and as PE ownership of the stock unwinds.

The business:

Sotera provides lab testing and advisory services to the medical device and pharmaceutical industries. These services include end-to-end sterilization as well as microbiological lab tests and advisory services. These services help ensure that medical, pharmaceutical and food products are safe for healthcare practitioners, patients and consumers globally.

The services that Sotera provides are essential to its customers’ manufacturing process and supply chains. Most of these services are mandated at the FDA level. Customers include more than 40 of the top 50 medical device companies and 8 of the top 10 global pharmaceutical companies (based on revenue). Sotera has 64 facilities worldwide, nearly 3,000 employees and more than 5,800 customers in over 50 countries.

Business Mix:

Sotera operate through 3 divisions: Sterigenics, Nordion and Nelson Labs:

Sterigenics (~60% of revenues, ~64% of Adj. EBITDA): Sterigenics is a global provider of outsourced terminal sterilization services in the medical device and pharmaceutical industries, with facilities strategically located next to customer’s manufacturing sites or distribution hubs. SHC’s makes ~5% of the bill-of-materials for a typical medical device or pharma product. Sterilization is also a fixed cost business, with very high incremental margins that benefits from mostly stable and growing demand.

Sterigenics operate three different modalities: Gamma (~45% of revenue, 23 facilities), Ethylene Oxide (“EO”) (42% of revenue, 17 facilities) and e-Beam & Xray (12% of revenue, 8 facilities). More than 80% of Sterigenics’ net revenues attribute to customers using more than one of their facilities and more than 50% of Sterigenics’ net revenues derive from customers using five or more facilities.

Sterigenics Long Term growth prospect is tied to medical devices volume which grows MSD and pricing power which SHC raises at the ~Low to Mid single digit per year. Combined, the business should grow topline by HSD organically with incremental margins that support 100bps of EBITDA margin expansion per year for the foreseeable future.

Nordion (~14% of revenues, ~16% of Adj. EBITDA): Nordion is the leading global provider of cobalt-60 (“Co-60”), which is the key component in gamma sterilization. Co-60 is a radioactive isotope that emits gamma radiation that sterilizes items by killing contaminating micro-organisms. It decays naturally at a rate of approximately 12% annually, creating natural demand for replenishment.

Nordion currently has access to Co-60 supply at nuclear reactors pursuant to multi-year contracts with three operators that cover 13 reactors at five generating stations. These contracts extend between 2024 and 2064, with the largest supplier under contract until 2064. Nordion supplies products and services to approximately 40 customers (Including Sterigenics and Steris) and it is estimated that Nordion has ~70% market share.

Nordion Long Term growth is LSD in terms of volume and MSD+ in price for combined MSD to HSD organic growth.

Nelson Labs (~26% of revenues, ~20% of Adj. EBITDA): Provides over 800 tests in microbiology and analytical chemistry around product safety. Nelson Labs serves over 3,800 customers. Demand benefits from a regulatory environment that is getting more complex.

Nelson Labs will grow at HSD in terms of volume and LSD in price for combined HSD to LDD organic growth.

Total business: will grow revenue at HSD. High incremental margins on a cost basis that is mostly fixed, supports EBITDA margins expansion of 100-150bps p.a. Including use of cash we believe that SHC should expand EPS at high teens for many years to come.

Balance sheet: levered at ~4x leveraged, scaling down to ~3x by EOY2023. Long term range goal of 2x-4x Net Debt / Adj. EBITDA. Debt is covenant light.

Cyclicality: Covid proved that even the medical devices market can be cyclical with volume declining in tandem with the elective procedures. Yet, Sotera benefited from PPE (Personal Protective Equipment) volume growth and performed well during the period. As electives ramp, the traditional volume of medical devices will rise again, supporting demand for Sotera’s services combined with secular tailwinds from outsourcing of sterilization. The shift to disposables vs. recurring use medical devices is an additional Long Term tailwind.

Valuation: SHC trades as of Oct. 19, 2021 for $26/Share, on ~280m diluted shares outstanding and MC of $7.2Bn. Debt of ~$1.86Bn and cash of ~$156m. Total EV of: ~$9Bn. In 2021 it will generate ~$930m of revenues and ~$483m of Adj. EBITDA (~52% margin). Adj. EPS in 2021 and 2022 is $0.89/1.05 respectively (+18% yoy). On 2022/2023 it trades for 16.8x/15x EV/EBITDA and 25x/21.2x P/E.

Risks:

Litigations -

                Ethylene Oxide Tort Litigation – Illinois - On September 2018, tort lawsuits on behalf of approximately 835 personal injury plaintiffs were filed in Illinois state courts against Sotera. Plaintiffs allege they suffered personal injuries including cancer and wrongful death, resulting from EO emissions at SHC’s Willowbrook facility.

Our View: The Tort case is fairly complex but the net takeaway is that Sotera was in compliance with all regulatory requirements. The tort lawsuits are based on new research (2014) which indicated that EO is cariogenic at levels that are much below the legislated threshold. However, plaintiffs need to prove causality, which appears to be a stretch as EO is evident in the air all around us and the fact that EO is scattered in the wind fairly quickly. Furthermore, EO levels fall below their cariogenic levels at very short radius from the exposure site. Wrongdoing is also an important element, but our research of the lawsuit indicates there are no glaring smoking guns. In a downside case, we believe the financial exposure is more than priced into the stock. We mapped all the residential houses surrounding the Willowbrook facilities in a 2.5 mi. radius, which should be the upper limit of EO exposure and estimate maximum total exposure at ~5% of the current market cap. Moreover, tort claims are capped at 2 years, meaning the 835 plaintiffs' number is unlikely to grow for past cases. All in we believe the probability of material impairment is low as evident by the fact that Sotera elected not to accrue legal exposure on its balance sheet.

                Timeline: Trials in three of the individual cases included in the Consolidated Case have been scheduled for July 18, 2022, September 12, 2022 and November 7, 2022. 

Ethylene Oxide Tort Litigation – Georgia - On May 19, 2020, a lawsuit against Sotera was filed by 53 employees of a contract sterilization customer of Sterigenics. Plaintiffs claim personal injuries resulting from alleged exposure to residual EO while working at the customer’s distribution center in Lithia Springs, Georgia. Employees allege they were unaware that they were being exposed to EO in their workplace and seek damages.

Since August 17, 2020, 15 lawsuits against Sotera Health LLC, Sterigenics U.S., LLC and other parties have been filed by 41 plaintiffs in the State Court of Cobb County, Georgia and the State Court of Gwinnett County, Georgia in which plaintiffs allege that they suffered personal injuries and loss of consortium resulting from emissions and releases of EO from Sterigenics’ Atlanta facility

                Timeline: Ten of the personal injury lawsuits pending in Cobb County have been consolidated for pretrial purposes, governed by a phased case management order pursuant to which general causation issues are scheduled to be determined by November 15, 2022. Specific causation issues are scheduled to be determined by March 2023, and one case is scheduled to be trial-ready by July 2023. The remaining personal injury and property devaluation cases are in various early stages of pleadings and motions practice and fact discovery.

Our View: Like the Illinois case reasoning, we believe the probability of material impairment is low as evident by the fact that Sotera elected not to accrue legal exposure on its balance sheet. The downside exposure from these cases is far lower than the Willowbrook case given the number of plaintiffs and nature of claims

                Ethylene Oxide Litigation – New Mexico - On December 22, 2020, the New Mexico Attorney General filed a lawsuit against the Company alleging that emissions of EO from Sterigenics’ sterilization facility in Santa Teresa, New Mexico constitute a public nuisance and have deteriorated the air quality in Santa Teresa and surrounding communities and materially contributed to increased health risks suffered by residents of those communities. On May 26, 2021 the Third Judicial District held a preliminary injunction hearing. On June 29, 2021, the Court entered an Order Granting Preliminary Injunction. The Order does not require the closure of the facility but prohibits Sterigenics from allowing any uncontrolled emission or release of EO from the facility, including prohibitions on leaving doors open when not in use and allowing EO to escape through point sources prior to filtration or processing through emission controls.

Before this lawsuit was filed, Sterigenics was working to implement additional emission control enhancements at the Santa Teresa facility to further reduce EO emissions beyond permitted levels. On June 11, 2021, Sterigenics received a permit from the New Mexico Environment Department, clearing the way for the next steps in Sterigenics’ implementation of these additional emission control enhancements.

Our View: Currently, ethylene oxide gas is used to sterilize 50% of all medical supplies that require a high level of disinfection. There is no alternative. We view it as highly unlikely that the EO facility will be shut down. Moreover, increased regulation should benefit Sotera as smaller companies will struggle to comply, and insourced sterilization procedures would likely shift towards outsourced.

                Timeline: hearing on October 28, 2021

                On final comment regarding legal exposure: our conversation with several customers of SHC indicate that they themselves have conducted inquires on SHC’s actions in each case. All these customers found that SHC acted ethically. To our knowledge SHC has not lost a single customer due to these lawsuits.

Insiders trading – Breaking the lock-up period – Sotera IPO’d on Nov. 20, 2020 with lock-up period of 180 days (May 18, 2021). Insiders (CEO and majority funds) sold on March 22, 2021. No other transactions took place by those involved since March. Per our conversations with management, we believe that the markets sent a clear message to management questioning their governance which was noted and well understood. Our impression was that this was an action driven by management’s lack of experience in the public markets.

Shareholders structure – Warburg Pincus and GTCR together hold ~62.1% of the Company. (In May 2015 those funds acquired a controlling interest in the Company).

Competition – Steris’ division AST (Applied Sterilization Technologies) has grown at a low teens rate vs. HSD for Sotera (2 year CAGR). As mentioned above, sterilization is a duopoly with demand based on modality and proximity to the manufacturer facility. We estimate the outperformance is related mostly to capacity investment cycles. There are no indications for long term market share shift between players (not currently and not in the past). Steris itself does not expect to grow faster than Sotera going forward. We also note that in order to change sterilization facility customers need to go through FDA reapproval, which makes switching very difficult. Historically the industry saw little share shifts for existing products. 

Catalyst

Legal overhangs that are unduly pressuring the stock abate and PE ownership of the stock unwinds