Description

Sotera Health Company (SHC) common equity presents the opportunity to buy a business with one of the strongest economic moats imaginable trading at a meaningful discount to  intrinsic value. Our thesis is that Sotera could be one of those rare businesses which one can buy and hold for a very long period of time, given the sustainability of its growth and durability of its competitive moat. 

This report will focus on the underlying economic and competitive dynamics of the business and make the case for its unusual business quality.  We will then discuss the recent legal settlement surrounding ethylene oxide (EO) and highlight how existential risk has been removed from the story. Finally we’ll conclude with a discussion of valuation and an explanation of how we arrive at a price target between $26-29/share relative to today's price of $18/share.

Background on Recent Price Action in SHC

Sotera ,through its predecessor companies, was founded in the 1930s. GTCR and Warburg Pincus acquired controlling interest in 2015 and still own 62% of the common stock. In November of 2020, Sotera IPOed at  $23/share and raised $1.2 billion. Post IPO, the stock traded lower given the expiration of the post IPO lock up, overhang from the pandemic, and most importantly, fear over a mass tort lawsuit that was originally filed in 2018 and scheduled to go to trial in 2022. After receiving an adverse verdict in its first trial in September of 2022, Sotera’s stock collapsed to under $6/share. A positive verdict in November of 2022 and  a settlement of all the Illinois cases in January of 2023 have helped to bring the stock back to $18.

Background on Business/Competitive Moat

Sotera provides  mission-critical sterilization solutions and lab testing for the healthcare industry. Their customers include 40 of the top 50 medical- device companies and nine of the top ten global pharmaceutical companies. Sotera’s sterilization services are an essential part of the manufacturing process, and many of their services are necessary to satisfy government regulations.  For many products, their customers are required to include the specific facility used to validate a product's listing in the FDA’s product registration and re-register if they switch facilities. This dynamic contributes to low customer churn and long-term relationships. Sotera has a  100% renewal rate among its top ten customers over the last five years and an average tenure of over a decade with minimal customer concentration.

Sotera conducts its business in three divisions which will be discussed below - Sterigenics, Nordion, and Nelson Labs:

• Sterigenics - Gamma Irradiation, Ethylene Oxide (EO), and E-Beam Sterilization  

Sterigenics has provided outsourced terminal sterilization and irradiation services for over 90 years. Terminal sterilization is the process of sterilizing a product in its final packaging before it is shipped to end-users. The target products include kits and trays, implants, syringes, catheters, wound care products, medical protective barriers (including “PPE”), and pharmaceuticals:

https://investors.soterahealth.com/static-files/e0723ed9-ff11-408f-8846-3ef1ff587112

Sterigenics uses three major commercial terminal sterilization technologies: gamma irradiation, EO processing, and E-beam irradiation. 

Sotera Health  10K- 2022

The key takeaway from the above slide is that certain products require the use of gamma irradiation whereas other products require Ethylene Oxide (the main difference relates to the thickness of the material and the ability to withstand radiation) . Importantly, most customers utilize multiple technologies across different locations which are strategically located closeby to customers’ manufacturing sites and distribution hubs. With 48 facilities in 13 countries, Sterigenics’ global network of sterilization facilities represents a significant competitive advantage: more than 80% of Sterigenics’ net revenues are attributable to customers using more than one facility and more than 50% of Sterigenics’ net revenues are attributable to customers using five or more facilities.

Sterigenics’ Competition

Sterigenics primarily operates in a duopoly and  competes with Applied Sterilization Technologies (AST), a segment of STERIS (STE), as well as other smaller or regional outsourced sterilization companies. In addition, some manufacturers (think large global MedTech and Pharma companies like Medtronic, etc.)  perform their own in-house sterilization but the market is moving increasingly to out-sourced sterilization.

• Nordion-Cobalt-60 Supply and Associated Services

Nordion is the leading global provider of Cobalt-60 used in the sterilization and irradiation process (Sterigenics buys Cobalt-60 from Nordion for Gamma Irradiation). Co-60 is a radioactive isotope that emits gamma radiation which sterilizes items by killing contaminating microorganisms. Gamma sterilization represents approximately 30% of single-use medical device sterilization worldwide. Nordion’s customers include both outsourced contract sterilizers, including Sterigenics, as well as medical device manufacturers that sterilize their products in-house.

The Co-60 supply chain is incredibly complex. First, the Co-60 production process requires high purity Co-59 which is produced globally, primarily as a byproduct of nickel and copper mining. Then Co-59 is compressed into “targets,” which are pellets and slugs suitable to be activated into Co-60. These targets are then encapsulated and delivered to be installed in nuclear reactors around the world. Depending on the type of reactor and the location of the Co-59 in the reactor, the conversion process can take between 18 months and five years. Once the conversion to Co-60 is complete, the targets are extracted from the nuclear reactor while the reactor is shut down, and the targets are shipped to Nordion to be processed into Co-60 usable for the customers. The final product is placed in proprietary lead and steel containers, which Nordion uses to transport Co-60 to its customers. As one might imagine, there is a significant regulatory burden in the production, management and transportation of Co-60 given the inherent danger of transporting radioactive material.

Nordion has multi-year contracts for  Co-60 supply at  13 reactors that extend to dates between 2024 and 2064, with their largest supplier under contract until 2064. The majority of their Co-60 is produced under multi-year contracts with nuclear reactor operators in Canada and Russia. There is a symbiotic relationship between Nordion and the electric utilities that run the reactors because Nordion provides the Co-59 targets which are manufactured to proprietary specifications customized for each supplier. That is to say, it’s not easy to disintermediate Nordion given the multiple steps before and after the Co-60 is ready to be harvested.  In addition, Nordion acquires a portion of their Co-60 supply from reactors that produce Co-60 in Argentina, China and India. Currently, approximately 9% of nuclear reactors worldwide are the type of reactors that can produce commercial quantities of Co-60. In 2022 there was no disruption in supply from Russia, but management has warned that Nordion’s supply could be lumpy given the multiple steps in the supply chain. 

Nordion’s customer base is relatively concentrated with approximately 40 customers (Sterigenics being one of them). Demand is relatively constant given that Co-60 decays at 12% per year, which creates stable, recurring demand as customers must purchase incremental supply to satisfy ongoing needs. Customer relationships are typically governed by multi-year supply agreements.

Nordion Competition

Nordion’s two main competitors include a Russian Co-60 supplier which currently supplies certain regions in Europe and Asia, and a China-based producer, which currently supplies the domestic Chinese market. In addition, certain regional competitors have the capability to produce Co-60. 

• Nelson Labs

Nelson Labs (acquired in 2016)  provides microbiological and analytical chemistry laboratory tests across the medical device and pharmaceutical industries.Nelson only represents ~20% of TTM EBITDA, but there is substantial customer overlap with the sterilization business and similar underlying growth drivers.

 Mass Tort Settlement relating to Ethylene Oxide (EO)

EO exists naturally in the air and comes from a variety of sources, including the human body, among other natural and everyday sources. Over 20 billion medical products in the United States are sterilized using EO every year. 

In 2018, EO sterilization became the subject of regulatory and media scrutiny due to the release of a controversial and highly conservative EPA risk assessment. As a result, Sterigenics and other medical supply sterilization companies were subjected to hundreds of personal injury claims (870 in the state of Illinois) citing alleged injury due to long term environmental exposure from emissions from sterilization facilities.  

Below is a brief timeline of what has transpired since September of last year:

On September 19, 2022, in the first bellwether plaintiff case, a jury in Cook County, Illinois found Sterigenics liable for $363mm in damages:

https://www.chicagotribune.com/news/environment/ct-sterigenics-verdict-20220919-hlu7zoytabcdhe2nvuze7spmny-story.html

Then on November 18, 2022,  with a different judge in the second plaintiff trial, Sterigenics was found not guilty:

https://investors.soterahealth.com/news-releases/news-release-details/sterigenics-issues-statement-favorable-verdict-fornek-trial

Finally on January 9, 2023, two subsidiaries of Sotera entered into binding term sheets with a committee representing the 870 claimants who have filed lawsuits:

https://investors.soterahealth.com/node/8661/html

The Term Sheets provide a path to final settlement without Sotera admitting guilt. If the conditions to the Term Sheets are satisfied by May 1, 2023, Sterigenics will contribute $408 million to a settlement fund that will be used to pay all settlement fees, including the $363mm from the first case. Final settlement of the claims is conditioned on opt-in consent from the plaintiffs at a 98.6% rate. The company is confident that the conditions of the settlement will be met:

https://jpmorgan.metameetings.net/events/healthcare23/general_signin?gpu_only=true

Assuming there is an equal split among all of the plaintiffs, each case is being settled for ~$468,000 before subtracting for contingency fees. Going forward, assuming 10-20 cases per year would cost Sotera between $5mm-$10mm per year. Currently Sotera has been  spending  >$60mm on ongoing litigation.  Historically Sotera has supported Debt/EBITDA as high as 7x and now sits at 3- 4x Therefore, they have the wherewithal to take on more debt should the need arise. Bottom line: Sotera has the financial strength to handle much worse outcomes should they get another adverse ruling.  

It’s important to note that the Term Sheets do not cover (i) future lawsuits in Illinois (ii) lawsuits in Georgia and New Mexico. As relates to the 300 cases in Georgia, management has highlighted that Georgia has different standards than IL as relates to causation (the judge in the first trial in Illinois did not admit evidence from Sotera’s causation expert!). Also, Georgia has a $250,000/case cap on punitive damages. 

We expect there to be more litigation, but we see it as a cost of doing business which Sotera can ultimately pass on to its customers through its steady pricing power. As can be seen from the video below, Sterigencis is at the forefront of ensuring safety and the regulatory barriers are likely to increase with time which will solidify the competitive moat around the business:

Building a World-Class Sterilization Facility

Valuation 

Sotera is cheap based upon 1) its relative trading multiples with its one publicly traded competitor, 2) its relative valuation to its historical trading multiple, and 3)based upon its absolute discount to intrinsic value derived through a DCF.  

Current Trading Multiples Valuation

Sotera has 280mm shares outstanding and at the current stock price has a $5 billion market cap. Net debt, adjusting for $500mm in additional borrowing to fund the litigation settlement, equals $2.1billion – for a Total Enterprise Value of $7.1 billion. Currently SHC is trading at 12.5x EV/’23 EBITDA versus Steris (STE) which trades at 17x EV/’23 EBITDA. Valued at Steris’ multiple of 17x, SHC would be worth ~$26/share. Steris only derives 40% of its operating income from sterilization so it’s not a perfect comp. However, Sotera traded at >17x EV/EBITDA before the lawsuit so the peer multiple has historical basis. It’s also important to note that Sotera generates 51% EBITDA margins versus 48% EBITDA margins for Steris so it could be argued that Sotera deserves an even higher multiple than Steris.

DCF Valuation and Growth Prospects

A pillar of our conviction relates to Sotera’s long-term reinvestment prospects: Sotera can reinvest capital in its business at a predictable, high rate of return (15-20% IRRs) by building new facilities. There are currently seven active capacity expansions underway (including two greenfield). 40% of the sterilization market is still in-sourced and up for grabs which will drive top-line growth in addition to secular growth in their end markets.  As time goes by, legal risk, media scrutiny, and expensive EPA regulations will likely make out-sourcing even more attractive. Best of all,  Sterigenics is able to build new facilities after they get capacity commitments and/or take-or-pay contracts. Sotera has laid out long-term guidance for high single digit organic growth from a combination of price (3.5%-5%/year) and high single-digit volume & mix growth:

https://investors.soterahealth.com/static-files/e0723ed9-ff11-408f-8846-3ef1ff587112

Given the current tightness in the outsourced market (both Sterigenics and Steris are operating at >90% capacity) and the shift away from in-sourcing, we are inclined to model steadily increasing cash flows. Putting everything together, we’re confident that Sotera can grow operating income long into the future and generate stable cash flows to more than justify the current valuation:

In conclusion, given its high quality and predictable growth prospects, Sotera would make the perfect candidate for a growth-at-a-reasonable-price investment. But the noise  and uncertainty surrounding its recent ethylene oxide settlement has left it trading at a substantial discount to fair value. With >50% EBITDA margins, plenty of room to raise prices, and wide open growth potential, we think Sotera represents a truly unique opportunity to buy one of the world’s great businesses at a compelling price. 

Catalyst

-Final Settlement for EO in May 2023

-Earnings Growth