Description

Trader Talk: great business worth 2x current price due to a few medium-term issues that will fade in the next year or two, plus a particularly timely entry point due to a busted block trade

Introduction

SHC has been written up twice on VIC before and has a good amount of sellside coverage. As such, I will only provide a modest summary of the business. Instead, I am focused on what makes SHC a timely investment now.

Thesis

In a vacuum, SHC screens as my ideal type of business: one half of a duopoly market with good long-term growth where the product sold is mission critical to customers, with high switching costs, yet the product’s cost is immaterial to their customers. In the case of SHC, the company is one of two scaled outsourced providers of medical device and pharmaceutical sterilization services. SHC is diversified across almost all major medical device and pharmaceutical manufacturers, boasts a 100% retention rate with top customers, and has consistently grown sales at close to 10%. Further, sterilization represents ~1-2% of their customers’ cost of goods sold, and SHC has over ~50% EBITDA margins. Normally, a consistent 10% growth story with >50% margins would trade at a significant multiple. For instance, MSFT and V, two “compounder bro” favorites, have similar projected growth and margin profiles and trade 32x and 28x forward earnings, respectively.  Indeed, from when SHC IPOed in late 2020 until legal fears derailed the stock in fall 2022, shares consistently traded over 18x EV/EBITDA and 25x P/E, yet shares currently trade less than 11x my 2024 EV/EBITDA and 14x my 2024 EPS. Further, STE, the other side of the sterilization duopoly, currently trades 17x forward EV/EBITDA and 25x forward EPS.

I believe a trifecta of headwinds has held SHC back since the settlement. Importantly, I believe those headwinds will largely abate in the next year or two, and that SHC’s multiple can normalize while the business continues to grow. First, SHC slightly missed expectations due to destocking at medical device manufacturers as global supply chains normalized, a phenomenon seen in many industries. I believe this is the largest issue holding SHC back and I expect it to be resolved this year. Second, SHC is currently investing aggressively in capacity ahead of an EPA rules change that will likely result in capacity leaving the industry. As volumes are weak from the destock and capex is high for the capacity expansion, SHC is being penalized as their investments are not yielding their prior EBITDA growth. As volume headwinds abate and the regulatory update is completed, I believe SHC is well positioned to capture volume share above their prior few years' run-rate. Inorganic growth through acquiring some facilities that would otherwise close is also possible. Third, I believe many investors are still hesitant to invest in SHC in case the legal liabilities resurface. As my prior VIC posts show, I have invested in numerous companies with legal overhangs, but it is difficult for investors without relevant experience to believe the coast is clear, so to speak, even after the bulk of the storm has passed. This represents an opportunity to purchase shares in SHC at a discount despite its current litigation outlook being manageable and not too different from most companies’ legal risks. A similar phenomenon has played out with our CC investment over the last five years. In 2019, a short seller simply pointing out that there was legal risk caused a 70% drop in the stock. In 2023, CC announced a massive settlement, followed by legal risks putting that settlement at risk, yet the stock did relatively little on the news in both directions. It takes time for people to digest litigation risk, and it is difficult to know precisely when they will. But eventually, they do, and I believe the normalization of SHC’s multiple to levels seen before its collapse in fall 2022 represents a significant catalyst.

Finally, and arguably most timely, SHC is majority owned by two private equity firms, Warburg Pinuc and GTCR, who priced a block trade after Q4 results. After the Q, SHC shares finished over $17. Two days later the sellers priced a block at $14.75, which quickly broke the block price, pushing shares under $14 in short order. With the stock down almost 20% on zero incremental fundamental news – they literally had just given numbers and guidance a day before the block trade was announced – I believe it is a timely entry point.

Valuation

I estimate SHC will earn $560MM in 2024 EBITDA, slightly above SHC’s guidance and Street consensus, driven by my belief the volumes will turn in the second half. I estimate SHC will grow EBITDA ~10% a year from there to reach ~$700MM in 2026 EBITDA and $1.50 in 2026 EPS. 18x EV/EBITDA and 25x P/E yields $37 versus the current share price of $14.

Risks

·       Regulatory – SHC operates in heavily regulated industries. While this provides barriers to entry, regulatory risk is always present, such as the ~$80-$100MM in capex SHC has spent in the last two years to comply with increasing ethylene oxide (EO) regulations.

·       Continued Med Stock Inventory Destock – If SHC’s customers are not finished rationalizing inventories this year, it is likely shares remain range bound.

·       Legal – SHC has faced lawsuits over its EO facilities in the USA, and further litigation is always possible

Catalysts

·       Busted block trade – market absorbs liquidity within a few months

·       Numbers finally at a bottom and guidance beatable

·       NESHAP rule change for EO facilities drives closures and M&A

·       Gradual fade of legal risk and earnings growth

Model

Reasons to Own SHC

1.      Fantastic business that is highly likely to grow sales and EBITDA 10% a year for the next decade or more

2.      Numbers are finally at a bottom

a.  Channel destocking ending

b.  NESHAP rules will drive capacity closures and M&A

3.      Legal risks abating

4.      Busted block trade

Fantastic Business – Durable Healthcare Compounder

Simply put, I believe SHC is a rare business given its high barriers to entry, high switching costs, mission-critical services, and de minimus cost to customers. It is rare to find a business with >50% margins, and rarer still to find one without significant competition waiting in the wings. Combined with the predictable nature of its growth, I think SHC is an ideal compounder. To that point, for instance, when GS initiated, they used a 20x EV/EBITDA bear case multiple when stock was $26, and a 23x bull case. Since then, estimates are slightly lower – GS projected $539MM in 2022 EBITDA but SHC only hit $528MM in 2023 – but the business has still grown ~8% a year. In fact, SHC has grown every year since 2005. Despite this, the stock now trades at half its previous multiple.

I think SHC is somewhat of an orphaned security, where the quality is there for those who look for it but the trailing volatility and legal risk has scared away the “steady eddy” compounder bros. As those things abate, I think the stock can reweight. Alternatively, I am comfortable holding SHC indefinitely where I can clip 10% organic growth at a valuation that implies ~8-10% share repurchase per year as SHC capital intensity falls over the next two years and leverage falls towards the bottom of their targeted 2-4x debt/EBITDA range.

Sterigenics

§  SHC’s largest segment, Sterigenics, is an outsourced provider of med device and pharma sterilization, a duopoly industry which typically grows volumes 5-8% per year with minimal cyclicality

§  Med device and pharma volumes grow ~4-6% a year

§  Sterilization is about 60% outsourced and 40% insourced, up from 50% outsourced ten years ago. As the trend towards outsourcing continues, this adds 100-200bps a year to SHC volumes.

§  Med device sterilization is both mission-critical to customers and a negligible ~1-2% of total device COGS

§  Sterilization is part of the FDA approval process and customers must refile with the FDA in order to switch sterilizers, which creates significant customer lock-in

§  Sterigenics has a 100% renewal rate with top ten customers over the last five years

§  80% of their customers use more than one facility, and 50% use five or more

§  The ability to offer redundancy is a clear competitive edge versus smaller regional players, and only STE and SHC can offer it

§  For instance, ABT is not going to single point of failure their supply chain for a $500MM annual heart stent business to save $50k…

§  With customer lock-in and only one competitor, Sterigenics can push ~4% price annually, which along with industry growth of 5-8% yields ~9-12% topline growth at >50% margins

§  Unless med devices and pharma innovation stops, people stop seeking medical care, and/or the trend towards outsourcing ends, I believe Sterigenics can grow 10% a year for decades

Nordion

·       Nordion produces cobalt 60 (C0-60), the radioactive isotope of naturally occurring cobalt (CO-59), which is primarily used in sterilization (>90% of all CO-60 demand)

·       The process of making CO-60 is to take CO-59, stick it into a nuclear reactor, wait a few years, then remove the CO-60, reprocess it, and ship it to sterilization customers, primarily SHC, STE, and the med device and pharma manufacturers

·       Nordion is effectively a monopoly, with 70-80% global share, and competes primarily against smaller Russian and Chinese competitors who their serve local markets

·       CO-60 is effectively sold out globally, as capacity has not kept up with growing med device and pharma volumes

·       Segment has been growing 10% a year primarily on price, though volumes should pick up over the next few years

·       Nordion is very lumpy from Q to Q, as it can only be harvested from the reactors at specific times

o   However, as demand is far above supply, the business is very predictable over time unless an alternative sterilization modality replaces gamma rays from CO-60

·       I project 10% a year EBITDA growth

Nelson

·       Nelson provides sterilization, validation, and other testing services to med device and pharma companies

·       Roughly half its volumes are tied to sterilization – Nelson validates that the sterilization that SHC, STE, etc. provide is meeting the FDA’s requirements

·       As a result, the segment has faced the same volume headwinds as Sterigenics

·       Once volumes turn, I believe Nelson can grow sales 7-10% a year and reach mid-30s EBITDA margins

Growth Algorithm

·       Combined, I believe SHC can produce 7-10% EBITDA growth for a decade plus, with minimal cyclicality

·       SHC is currently in a capital reinvestment cycle – capital is running at 20% of sales in 2024 vs. 5-7% from 2018-2020 – but once the reinvestment cycle completes, I believe share repurchases and M&A will become a large part of the story

·       SHC targets a 2-4x net debt/EBITDA leverage target, which on both Street and my numbers implies SHC will be at or below its lower leverage bound by 2026

Numbers at a Bottom

Estimates vs. Street

·       I know my Street estimates are not exactly lined up with Bloomberg consensus, but I just use Barclays numbers for simplicity

·       The general gist – that I model H1 similarly and then model and inflection above Street in back half and into 2025/2026 holds

·       An EBITDA inflection combined with debt paydown, normalizing tax rate, falling interest rates, and $700MM in share repurchase in next three years drives my EPS well above Street

o   I think M&A might be more likely than buyback, but it is more difficult to model

I believe SHC is set to beat estimates for two key reasons: an end to destocking and NESHAP regulations driving closures/consolidation in the EO sterilization market

Destocking

·       During COVID supply chain disruptions, med device companies, like many other industries, stocked up on inventories to provide a larger buffer and ensure customers’ orders could be fulfilled

·       As the supply chain pressures have normalized, med device manufacturers are reducing their working capital, which is resulting in lower volumes for SHC and STE’s AST segment (the other side of the duopoly)

·       It is hard to know exactly when this will end, but SHC and STE both say that things are not getting any worse and we are already seeing green shoots in certain markets

·       Importantly, procedures, the ultimate end market for all med devices, are still growing nicely at mid-single digits

·       SHC is already one year into flat volume growth, and I do not believe the industry has enough inventory to go two years without continuing to expand volumes to match procedure growth

·       Bioprocessing, which was roughly 8% of SHC’s volumes pre-destocking, has seen an even sharper 30% decline in volumes due to the falloff in biotech funding

o   Key bioprocessing tool manufacturers Sartorius and Repligen have returned to book-to-bill ratios >1x since the fall

NESHAP Regulations

·       There is a long, convoluted story on the EPA’s EO regulations, but a short summary is that they updated a few critical rules in the 2010s which resulted in the litigation at three SHC plants discussed below. EPA is now finalizing an their updated NESHAP rules which will further restrict how much EO sterilizers are allowed to release from their plants. The rule is due this month, March 2024, though the EPA has a way of missing deadlines.

·       I believe these updated new rules will cause capacity closures as they are expensive and many EO sterilizers have barely updated their safety measures since the 1990s

o   SHC has already spent ~$80-$100MM updating their existing seven EO facilities in the USA and was a leader on safety previously

·       As many of these legacy sterilizers, both regional players with one to three facilities and in-house facilities at manufacturers, will be facing significant costs to upgrade, I believe it is likely some will chose to exit, either by an outright closure or looking to sell to STE or SHC

·       SHC is well-positioned to benefit from this

o   SHC has significantly expanded capacity in the last few years with four facility upgrades in 2023 and three more due in 2024 and 2025, including two greenfields

o   As SHC’s capacity enters the market and others leave, I believe SHC is well positioned to achieve their historical >20% ROICs

o   SHC also has ample buying power to purchase and upgrade certain EO facilities

Legal Risks Abating

·       SHC has eight EO facilities in the USA, three of which have seen litigation stemming from EPA and CDC reports issued in 2016 and 2018 – Illinois (IL), Georgia (GA), and Nevada (NV)

·       The key thing to understand is that EO is a naturally occurring substance – you are literally breathing in and exhaling EO at trace levels as you read this. The EO sterilization process uses a lot more EO than you and I are breathing (hopefully!) and the EO facilities historically simply released the EO through vents in the back of the building that resulted in higher levels of EO in the surrounding areas relative to the background EO levels found everywhere.

·       The critical detail is that once you turn off a facility and/or reduce the emissions, the EO levels around the facility fall within a matter of minutes to levels indistinguishable from the background levels we experience every day. Further, even when the facility was pumping out the EO without scrubbing, the natural dispersion of the gas made the level indistinguishable from background levels within a few miles of the facilities. This limits the scope of those who could be impacted to a few miles from the facility and limits the potential for future litigation as, once the EO emissions are heavily scrubbed, levels are indistinguishable from background within a few hundred feet of the facility.

o   This is not a case like Monsanto’s RoundUp, JNJ’s talc, or asbestos where it was sold directly to consumers via an end-market product, so a lot of people can claim to have come in contact with it

o   Nor is it a case like DD/MMM’s PFAS, where you can say “you guys specifically caused this pollution” because the chemical does not breakdown into naturally occuring compounds

·       IL is where the large personal injury lawsuit that spooked investors occurred, but that is now settled and SHC paid $408MM last year, or ~$400k/case

o   There are remaining twenty some lawsuits here and people will continue to develop cancer, probably about 10 per year given the 2.5 limit around facility, but once a settlement precedent is established, very, very few opt to go to court and most simply accept the precedent settlement, plus or minus a few thousand for whether it’s a strong case or a weak one

·       GA is a much tougher state for this type of personal injury litigation as it has a stricter science standard (Dalton vs. Frye) and there is also a $250k cap on punitive damages

o   There’s about 220 cases outstanding there which have not gotten through a judge determining if they have enough science to go to court

o   If they do, $400k/case is likely what the 220 will settle for, or a sub $100MM pre-tax loss

·       NV is a much more limited case as the facility is in the middle of the desert with no homes within 2.5 miles

o   The State AG sued, which is mainly a publicity stunt, and the court dismissed most of the State’s claims

o   This will most likely settle for at most a token fine and another good press conference for the politicians

·       There are five other facilities, two of which are in plaintiff-friendly California (CA)

o   While the two CA facilities are worth keeping an eye on, if there were an issue here, it would take at least five years to reach court

o   The EPA has said all of SHC’s other facilities are fine and presently pose no risk to their communities, which is why there has not been any additional litigation so far

o   This is the type of legal risk that can have an occasional headline, but there will be no material financial damages here for the foreseeable future, and most likely none ever paid

·       Taking a step back, broadly speaking, investors sometimes go “legal risk = too hard bucket” on legal risk stocks, and the stock falls out of the sky. Over time, the legal risk either manifests into something material (Monsanto, asbestos) or after some time appears more bark than bite (Vioxx)

·       If I am correct that over the next two years SHC will experience minimal disruption from legal risks, I think it is likely investors grow comfortable with the risk, and we can benefit from significant multiple expansion

Block Trade

Two weeks ago, SHC’s large PE owners (GTCR, Warbug) priced a block trade for 25MM shares at $14.75, compared to a float of ~100MM shares and a closing price of $17.34. It did not go well, and SHC broke the block trade price two days later. Shares are now trading sub-$14. This has resulted in what I think is a favorable entry price on purely technical factors. I expect the impact of the busted block trade to fade within the next few weeks to at most two months.

Catalyst

·       Busted block trade – market absorbs liquidity within a few months

·       Numbers finally at a bottom and guidance beatable

·       NESHAP rule change for EO facilities drives closures and M&A

·       Gradual fade of legal risk and earnings growth