Sotera Health Company (NASDAQ:SHC) Q2 2023 Earnings Call Transcript

Sotera Health Company (NASDAQ:SHC) Q2 2023 Earnings Call Transcript August 6, 2023

Operator: Good morning, and welcome to the Sotera Health Second Quarter 2023 Conference Call. All participants will be in listen-only mode. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Vice President and Treasurer, Jason Peterson. Please go ahead.

Jason Peterson: Good morning and thank you. Welcome to Sotera Health’s Second Quarter 2023 Results Call. You can find today’s press release and accompanying supplemental slides on the Investors section of our website at soterahealth.com. This webcast is being recorded, and a replay will be available in the Investors section of the Sotera Health website. On the call with me today are Chairman and Chief Executive Officer, Michael Petras and Chief Financial Officer, Jon Lyons. During the call, some of our comments may be considered forward-looking statements. The matters addressed in these statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied. Please refer to Sotera Health’s SEC filings and the forward-looking statement slide at the beginning of the presentation for a description of these risks and uncertainties.

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The company assumes no obligation to update any such forward-looking statements. Please note that during the discussion today, the company will present both GAAP and non-GAAP financial measures, including adjusted net income, adjusted EBITDA, adjusted EPS, net debt, adjusted EBITDA margin, segment income margin and net leverage ratio in addition to constant currency comparisons. A reconciliation of GAAP to non-GAAP measures for all relevant periods may be found in the schedules attached to the company’s press release and in the supplemental slides to this presentation. The operator will be assisting with the Q&A portion of the call today. Please limit yourself to one question and one follow-up so that we can give everyone an opportunity to ask questions.

As always, if you have any questions after the call, please feel free to reach out to me and the Investor Relations team. I’ll now turn the call over to Sotera Health Chairman and CEO, Michael Petras.

Michael Petras: Good morning, everyone, and thank you for joining Sotera Health’s Second Quarter 2023 Earnings Call. I would like to take a moment to introduce our newly appointed Chief Financial Officer, John Lyons. John comes to us from Owens Corning, a $10 billion Global Building and construction materials leader, where he served in various executive roles. Prior to John’s time with Owens Corning, he served in several senior leadership positions at Cardinal Health after beginning his career in public accounting. John brings a wealth of financial acumen as well as health care industry experience so Sotera Health and we’re excited to have him on board. I would also like to take a moment to thank Michael Biehl for his contributions as the interim CFO for Sotera Health.

Michael, thank you for your commitment and support over the past year and leading the company’s finance organization. As previously communicated on June 30, the settlement funds of approximately $408 million related to the Illinois ethylene oxide claims were released from escrow and on July 6, the claims against Sterigenics of the 879 claimants who opted into the settlement were dismissed with prejudice. Although we continue to believe these claims were without merit, we are pleased the settlement is finalized 1 month ahead of schedule, thanks to the efforts of our legal team, and with a 99.7% participation rate. In a moment, John will review our second quarter 2023 results in more detail. But first, I would like to review a few items from the quarter.

Total company revenues declined 4.3% and adjusted EBITDA declined 5.6% compared to the second quarter of 2022, driven primarily by the expected timing of Nordion’s Cobalt-60 harvest schedules. We delivered adjusted EPS of $0.21 for the quarter, which is a $0.06 decrease from the same period last year. Sterigenics, our largest reporting segment delivered 5.6% top-line growth for the second quarter of 2023. Sterigenics continues to service our customers even though the global economic outlook is challenging with lingering customer inventory and supply chain challenges and inflation. Although Sterigenics volumes are lighter than planned, the Sterigenics team is prudently managing costs, which has contributed to a 310 basis point segment income margin improvement compared to the first quarter of this year.

During the quarter, the team completed two expansion projects, and they continue to make progress on our EO facility enhancements in North America. These industry-leading enhancements demonstrate our commitment to ensure best-in-class emission controls for our employees, customers and the communities in which we operate. Nordion, our other reporting segment within the sterilization services business experienced a 37% year-over-year revenue decline due to the timing of Cobalt-60 harvest schedules. We have good visibility into the timing of Nordion’s revenue as it’s tied to the harvest schedules from our Cobalt-60 suppliers. As previously conveyed, Nordion’s 2023 revenue will be particularly lumpy as approximately 75% of the revenue is expected to occur in the second half of the year with approximately 50% of the year’s revenue occurring in the fourth quarter.

Nordion does continue to source a portion of its Cobalt-60 supply from Russia. At the start of the year, we stated that a total supply disruption from Russia could potentially result in a 0% to 3% impact on total 2023 Sotera Health revenues. At this juncture in the year, we are confident that there is zero risk to Russian supply impacting total Sotera Health full year 2023 revenues. The Cobalt-60 supply chain is a complex one, and I’m proud of the continued efforts by our Nordion team to ensure availability. Cobalt-60 is used to sterilize approximately 30% of the world’s single-use medical devices and is critical to the global health care community. This is a great example of how we play a critical role in safeguarding global health. Nelson Labs, our lab testing and advisory service business experienced sequential growth and expanded margins of approximately 680 basis points over the first quarter of this year.

Revenues in the second quarter of 2023 were 2.8% below the prior year quarter, which had experienced record revenues. However, volumes continue to be challenging in our lab business. In light of the softer-than-expected volumes, the Nelson Labs team is actively managing costs while keeping focus on quality and customer satisfaction. Due to the volume softness at Sterigenics and Nelson Labs that we expect to continue, we are adjusting our full year 2023 outlook. We now expect full year net revenue growth to be in the range of approximately 3% to 5% and full year adjusted EBITDA growth to be in the range of approximately 3% to 6%. We are confident that we have taken into account weaker volumes and other market dynamics reflected in this adjusted range.

We will continue to concentrate on executing our strategy to best serve our customers around the globe. Prior to John walking us through the financials in more detail, I’d like to take a minute to underscore our mission safeguarding Global Health, which is at the heart of our work. We performed government mandate sterilization and validation testing for medical and pharmaceutical products used each and every day. We supply Cobalt-60 for radiation oncology professionals to help treat brain cancer. In addition, we provide critical technical and regulatory expertise to solve our customers’ product development and sterility needs. Our indispensable services helped to protect millions of patients and health care providers around the world. One such example of how we shape our Global Health is via our team at Nelson Labs Europe, which performed extractable leachable studies for a single-use nasal spray using life-saving rescue treatment of patients experiencing an opioid overdose.

In the spring of 2023, the product received FDA approval for the U.S. market. The societal impact of this FDA approval is significant as overdoses caused by the use of synthetic opioid drugs, including fentanyl, unfortunately, remain a major and chronic problem in our society. Another example of our teams fulfilling our mission is highlighted through a video link located on the Safeguarding Global Health slide in our second quarter 2023 earnings presentation released this morning and available on our Investor Relations website. I encourage you to watch his video to learn about how Sterigenics and Nelson Labs work in conjunction to ensure critical sterilization and validation testing are performed for the successful delivery of vaccines around the world.

Now Jon will walk us through the financials.

Jonathan Lyons: Thank you, Michael. I want to begin by saying how excited I am to join Sotera Health, which holds such a unique position in the global health care supply chain. I look forward to working with our talented team and also look forward to meeting many of you in the near future. I will begin by covering the second quarter 2023 highlights on a consolidated basis and then provide some details on each of the business segments, along with updates on capital deployment and leverage. I will conclude with some additional comments on our updated 2023 outlook. On a consolidated total company basis, second quarter revenues declined by 4.3% as compared to the same period last year to $255 million. This equates to a 4.1% decline on a constant currency basis as foreign exchange headwinds are moderating for the company.

As mentioned on the first quarter call, we expect continued moderation of foreign exchange headwinds and expect foreign currency to become a tailwind during the back half of the year. Adjusted EBITDA declined by 5.6% compared to the second quarter of 2022 to $128 million. Adjusted EBITDA margins were 50.3%, representing a 73-basis point decline from second quarter 2022 levels. The decline in margins is driven by the lower volumes from Nordion and Nelson Labs experienced versus Q2 2022. Importantly, EBITDA margins were up sequentially in Q2 on the improvement in Sterigenics and Nelson that Michael referenced earlier as well as higher volumes from Nordion. Adjusted EPS was $0.21, a decrease of $0.06 from second quarter of 2022, the result of lower EBITDA and higher interest expense versus the prior year.

Net income for Q2 2023 was $24 million or $0.08 per diluted share compared to net income of $30 million or $0.11 per diluted share in Q2 2022. Our reported interest expense for the second quarter of 2023 was $31 million, which is an increase of approximately $17 million versus the same period last year. The increase is driven by higher rates on our variable rate debt as well as incremental interest on our $500 million term loan that closed in Q1 of this year. Now let’s take a look at our segment performance. For the quarter, Sterigenics delivered 5.6% revenue growth to $167 million as compared to the second quarter of last year. Revenue growth drivers for Q2 2023 included favorable pricing of 6.7% and favorable changes in foreign exchange rates of almost 1%, partially offset by unfavorable volume and mix of 1.7%.

Compared to the prior year quarter, segment income for Q2 2023 increased 7.5% to $91 million and segment income margins increased by 100 basis points to 54.9%, driven by favorable pricing, partially offset by unfavorable volume and mix and inflation. Nordion’s second quarter revenue declined by approximately 37% to $32 million compared to Q2 2022 which we expected based on the timing of Cobalt-60 harvest schedules. Nordion’s revenue decline was driven by unfavorable impact from buying a mix of nearly 39% and changes in foreign currency exchange rates of almost 4%, partially offset by a favorable impact from pricing of 5.7%. Segment income declined 40.7% to approximately $18 million and segment income margin decreased 380 basis points to 55.6% compared to the same period last year.

Segment income and segment margin changes versus second quarter 2022 were due to the unfavorable volume and mix offset by favorable pricing. For Nelson Labs, second quarter 2023 revenue declined by 2.8% to $57 million compared to the second quarter of 2022. Revenue was impacted by unfavorable volume and mix of 6.9%, partially offset by a 3.6% benefit from pricing and favorable changes in foreign currency of almost 1%. Nelson Labs second quarter 2023 segment income decreased by 8.6% to $19 million and segment income margins contracted by over 200 basis points to 33.9% versus second quarter 2022. This decline was due to unfavorable volume and mix as well as inflation partially offset by favorable pricing. I will now turn to cash generation, capital deployment and net leverage.

As Michael mentioned earlier, on June 30, 2023, the settlement funds of approximately $408 million related to the Illinois ethylene oxide claims were released from escrow. This resulted in net cash used in operating activities of approximately $303 million. When adjusting for the $408 million outflow, cash provided by operating activities was a source of over $100 million for the first 6 months of 2023, which was in line with the same period last year. As of June 30, 2023, we had approximately $635 million of available liquidity, which includes $263 million in unrestricted cash and $372 million of available capacity on our revolving line of credit. As expected, our net leverage ratio at the end of Q2 2023 was 4.2x. This was an increase from the year-end 2022 level of 3.2x due to the new $500 million term loan issued in connection with the ethylene oxide settlement and the associated $408 million payment.

Our capital expenditures for the second quarter 2023 totaled $53 million. Growth CapEx and facility enhancements drove the increased investment versus Q2 of last year. Now turning to guidance. We are adjusting the full year 2023 outlook we provided in February. We now expect total revenues to be in the range of $1.035 billion to $1.055 billion from our previous range of $1.055 billion to $1.09 billion, representing an annual growth rate of approximately 3% to 5%. From a quarterly shape perspective, as Michael mentioned, we anticipate that approximately half of Nordion’s full year revenue will occur in the fourth quarter. In addition, we expect Sterigenics volumes to slightly increase throughout the remainder of the year and Nelson Labs revenue to remain relatively flat sequentially.

For the full year, we expect adjusted EBITDA to be in the range of $520 million to $535 million from a range of $530 million to $550 million, representing an annual growth rate of approximately 3% to 6%. The tax rate is now expected to be in the range of 30% to 32% from our previous range of 30% to 33%. Weighted average diluted shares remain in the $283 million to $285 million range. Adjusted EPS remains in the range of $0.78 to $0.86. We now expect capital expenditures to be in the range of $200 million to $215 million, at the upper end of the previous range of $185 million to $215 million driven primarily by increased capitalized interest from higher borrowing costs. Lastly, we expect net leverage to finish the year at or below 4x. Now I’ll turn the call back to Michael.

Michael Petras: Thank you, John. As we move to Q&A, I want to reemphasize that Sotera Health is focusing on executing our strategy and is dedicated to our mission of Safeguarding Global Health. At this point, operator, let’s open the call for question and answer.

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Q&A Session

Operator: Thank you. We will now being the question-and-answer session. [Operator Instructions] And the first question will be from Patrick Donnelly with Citi. Please go ahead.

Unidentified Analyst: You have Brendan on for Patrick. Thank so much for all the clarity with the revised guidance. I actually wanted to ask on the EO settlement in Illinois, with the 3 claimants that decided to opt out, any idea what the timeline is moving forward?

Michael Petras: Good morning, Brendan. It’s Michael. No, we don’t. We’re waiting on the court to tell us the timelines and scheduling plans. Just so it’s clear for you and others, we had the option to walk away on the deal, but we went ahead and reviewed the claimants and all the fact sheet around that, and we feel very confident about moving forward with the settlement with those three opt-outs.

Unidentified Analyst: Great. Thank you. And then, second question is a follow-up on how should we think about pricing in the second half of the year given the reduced volumes?

Michael Petras: We’ve said along this business is about 3.5% to 5% price. I think you ought to feel confident that it will be in that range looking forward.

Operator: And the next question will be from Sean Dodge from RBC Capital. Please go ahead.

Sean Dodge: Thanks. Good morning and congratulations, Jon. Glad to have you here. Michael, the sequential improvement in Sterigenics margins, can you just walk us through in a little bit more detail what drove that? And then as we think about the expectation that volumes there will be a little bit softer than maybe initially contemplated, how much adjustment or maybe how much more adjustments than you make to that cost structure in the short-term to try and right-size for that?

Michael Petras: Good morning Sean. We’ll continue to be efficient as best we can in our operations as we look across all 3 businesses as the volume softening. We’ve had some challenges, as you’ve probably seen and heard in other areas that inventory destocking and inventory levels of some of our customers. But we feel pretty good about the margin levels and consistent performance we get out of Sterigenics. There isn’t huge flexibility on that cost structure. There is some labor aspect within those operations, but they’re not large operations. If you take a given facility, 30, 40 people in any given facility, it’s not like there’s 400, 500 per facility. So there is some limitations on that. But the team has done a really nice job on operating leverage, and we continue to get price in that business. So we feel good about the margin levels within Sterigenics.

Sean Dodge: Okay. Great. And then on the EO emissions, the regulations there, any more updates or thoughts on the proposed rule there from the EPA and what the final rule could look like? And I guess have you been in communication with the EPA as the proposed rules were released?

Michael Petras: Yes. So we submitted comments and I think there is probably, in total, something like 40,000 comments across the industry. Our expectation is the EPA, they’re working on their consent orders. So we expect them to have some type of adoption of a NESHAP by March 2024. That’s the current timeline that we’re expecting to see final rules. We’ve had conversations with the regulators through different trade groups. They’re aware of the inputs from us as well as many others.

Operator: And the next question is from Dave Windley from Jefferies.

David Windley: Michael, we’ve talked in the past about kind of the volumes that the industry, the kind of broader health care industry is seeing on the medtech side and amongst medtech hospitals, et cetera, there’s been talk about improvements in those volumes and you’ve commented about kind of the disconnect between that and what you are seeing. I wondered if you could comment on that, what indicators you’re seeing in kind of ahead of you that make you think that the softness that you’re experiencing is going to continue and perhaps is pricing — are customers showing any sensitivity to the price that you’re taking? And is that affecting volumes at all? Thanks.

Michael Petras: Thank you, David. Hospital volumes have been rebounding and returning to pre-pandemic levels and many facets around the world, we’re seeing that we do see inventory pressure at our customers. We see that, as I mentioned last quarter, we’re seeing to continue into this quarter. We’ll see that probably moving forward into the next quarter as well. So we’ve been thoughtful on how we look at our outlook on that side. That doesn’t mean we’re not seeing improvements in cardiac devices or orthopedic. It’s just when you look at it in totality, there’s categories that are down, particularly when you look at PPE, or you look at surgical kits and areas like that, where there’s lots of inventory buildup because people are scrambling to get it during the COVID time period.

So I don’t want you to walk away thinking that we’re seeing it across the board. We’ve got significant customer growth in many, many customers in the categories I just referenced. As far as price, listen, that’s always a conversation we have with customers or somebody on the other end of that conversation. We feel confident about our ability to continue to get price because of a great service we bring and the criticality of our services. But that’s always a delicate conversation. Sterigenics in the quarter continue to have a nice quarter and that side, the volume and mix was just a little softer. But we factored it into our thinking going forward. And we think, as I mentioned just previously, when asked, the company in total will get 3.5% to 5% price, depending on which business you’re talking about in our outlook.

David Windley: Right. Okay. Great. And then maybe relatedly, but bigger picture on your guidance. Your margin implication in the new guidance is not a lot but slightly higher, in fact, than where it was in the past. So you’re kind of taking cost out faster than the revenue decline. Could you talk in a little bit more detail about the areas where you’re able to do that without further implicating or further compromising revenue?