Sotera Health Company (NASDAQ:SHC) Q3 2023 Earnings Call Transcript

Sotera Health Company (NASDAQ:SHC) Q3 2023 Earnings Call Transcript November 4, 2023

Operator: Good morning and welcome to the Sotera Health Third Quarter 2023 Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [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 Third Quarter 2023 Earnings 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.

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 of 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 post-call, please feel free to reach out to me and the Investor Relations team. I will 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 Third Quarter 2023 Earnings Call. This morning, we reported year-over-year top and bottom line growth plus margin improvement. Consistent with our past commentary, macro environment headwinds still exist such as rising interest rates, inflation and customer supply chain challenges. The team has done a good job at offsetting these headwinds as we execute on delivering on our mission of Safeguarding Global Health. I want to highlight a few items from our third quarter and year-to-date results. Compared to the third quarter of 2022, total company revenues increased 5.8%, while adjusted EBITDA increased 7.3%. We delivered adjusted EPS of $0.21 for the quarter, which is a $0.02 decrease from the same period last year, driven by increased interest expense.

Sterigenics, our largest reporting segment, delivered 6.7% top-line growth for the third quarter of 2023 as compared to the third quarter of 2022 despite ongoing customer inventory and supply chain challenges and some market softness. The Sterigenics business has been and is a consistent growth business. Revenue has grown more than 30% since we became a public company from approximately $500 million in 2020 to $657 million over the last 12 months. And segment income has grown by $90 million during the same period. This consistent growth at Sterigenics is a testament to the great job that’s been done by our team and the critical nature of our business, even when our customers are fighting through significant macroeconomic challenges. Sterigenics is a strong business that plays a critical role in providing government-mandated sterilization services to over 2,000 customers across 48 facilities in 13 countries.

More than 90% of sterilization services revenue comes from customers on their multiyear contracts. We are very important to our customers in the commercialization of their health care products and ultimately, in the role we play getting safe products to patients. During the quarter, the team completed another facility expansion project for which the customer product validation phase is underway. We also continue to make good progress on our EO facility enhancements in the United States. 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, delivered a 14% year-over-year revenue increase in the third quarter versus last year.

As communicated previously, Nordion’s revenue is tied to the harvest schedules of our Cobalt-60 suppliers, which results in irregular revenue patterns on a quarter-to-quarter basis. The team has unique experience in navigating the complex Cobalt-60 supply chain, and the Nordion team remains on track to deliver a significant portion of its full year revenue in the fourth quarter as planned and previously communicated. 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 another great example of how we play a critical role in Safeguarding Global Health. Revenue in Nelson Labs, our lab testing and advisory service business, experienced a 2.1% decline versus the prior year quarter as testing volumes continue to be soft based on three primary drivers.

First, the extensions of the deadlines for compliance with the European Union Medical Devices regulations. Second, the decline to funding for start-ups in smaller companies and lastly, routine lot release testing tied to sterilization volume. A bright spot for the Nelson Labs business is the RCA performance. RCA plays a critical role in helping customers remediate FDA audit findings. As a consulting business, however, RCA margins dilute those with Nelson Labs more generally. In light of the softer-than-expected volumes, the Nelson Labs team is actively managing costs while remaining focused on quality. Our staffing levels have stabilized, turnaround times and utilization levels have improved and customer satisfaction scores are solid. Turning to the 2023 outlook.

Due to the volume softness at Sterigenics and Nelson Labs, we expect that 2023 revenue and adjusted EBITDA will finish at the lower end of the 2023 outlook range we provided during our second quarter earnings call. Now I would like to give a brief update on the ethylene oxide litigation in Georgia. In October, we announced that Sterigenics signed a binding term sheet to resolve 79 ethylene oxide claims against Sterigenics for $35 million, subject to the participation by all the plaintiffs. We expect to complete this settlement by year-end. The settlement in no way constitutes an admission of liability or admissions from our Atlanta facility have ever posed any safety hazard to the surrounding community. The settlement was driven by circumstances unique to one of the cases that was about to begin trial in the State Court of Gwinnett County.

We continue to vigorously defend the approximately 240 remaining personal injury claims pending in the State Court of Cobb County, where we are optimistic the court will apply the rules of evidence properly and afford Sterigenics the opportunity to fully and fairly defend itself based on valid science. The judge in Cobb County has already acknowledged the central importance of science to the EO cases by implementing a case management order that places science and causation front and center in the 10 personal injury cases that will be decided first. In contrast to the approach taken by the judges in Cook County, Illinois and Gwinnett County, Georgia, only cases in which the plaintiffs present sufficient scientific proof to the judge’s satisfaction that the plaintiffs alleged exposure to EO from the Atlanta facility could have caused and, in fact, did cause the illnesses they allege will be allowed to go to trial before a jury.

We are confident that when the rules of evidence are applied properly, the science and related evidence about EO refuse claims that emissions from Sterigenics facilities can or do cause cancer or the other harms alleged in the EO litigation. This was proven by the complete defense verdict returned in favor of Sterigenics almost a year ago in the foreign case in Cook County, Illinois. More detailed information about the settlement and the EO litigation is available in the 10-Q that will be filed today, and as always, on the ethylene oxide pages on our Investor Relations website. Prior to turning this call over to Jon to walk 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 tests for medical and pharmaceutical products used each and every day to make sure the products are safe and meet regulatory requirements. We sterilize millions of products each year that benefit millions of patients. We supply Cobalt-60 to enable gamma sterilization globally and for the treatment of early-stage breast cancer. In addition, we provide critical scientific and regulatory expertise to help solve our customers’ challenges. Our mission-critical services help protect millions of patients and health care providers around the world. An example of our team’s fulfilling our mission is highlighted in a video link, look in the Safeguarding Global Health slide and our third quarter 2023 earnings presentation released this morning and available on our Investor Relations website.

I encourage you to watch this video to learn how Nordion plays a vital role in the treatment of breast cancer. Now Jon will walk us through the financials.

Jonathan Lyons: Thank you, Michael. I will begin by covering the third 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. On a consolidated total company basis, third quarter revenues increased by 5.8% as compared to the same period last year to $263 million. This equates to a 4.3 increase on a constant currency basis as foreign exchange turned to a tailwind as expected for the quarter. Adjusted EBITDA increased by 7.3% to $134 million as compared to the third quarter of 2022. Adjusted EBITDA margins finished at 51%, which was an increase of more than 70 basis points versus both the third quarter of 2022 and the second quarter of 2023.

Adjusted EPS was $0.21, a decrease of $0.02 from the third quarter of 2022, driven by higher interest expense versus the prior year. The reported net loss for Q3 2023 was $14 million or $0.05 per diluted share, inclusive of the $35 million Georgia settlement, compared to net income of $25 million or $0.09 per diluted share in Q3 2022. Our reported interest expense for the third quarter of 2023 was $41 million, which is an increase of approximately $17 million versus the same period last year. The increase is driven primarily by the increase in interest rates and the $500 million term loan that closed in Q1. Now let’s take a closer look at our segment performance. For the quarter, Sterigenics delivered 6.7% revenue growth to $168 million as compared to the third quarter of last year.

Revenue growth drivers for Q3 2023 included favorable pricing of 6.3% and favorable changes in foreign currency exchange rates of 2.2%, partially offset by unfavorable volume and mix of 1.8%. Compared to the prior year quarter, segment income for Q3 2023 increased 8.9% to $93 million, and segment income margins increased by approximately 110 basis points to 55.3%, driven by favorable pricing, partially offset by unfavorable volume and mix as well as inflation. Nordion’s third quarter revenue increased by 14.3% to $40 million compared to Q3 2022. Nordion’s revenue increase was driven by favorable pricing of 9.4% and favorable volume and mix of 6.9%, partially offset by an unfavorable impact from changes in foreign currency exchange rates of 2%.

Nordion segment income increased 18.5% to approximately $24 million, and segment income margin increased more than 210 basis points to 60% compared to the same period last year. Segment income and margin changes versus third quarter 2022 were driven by favorability in pricing, volume and mix and partially offset by inflation. For Nelson Labs, third quarter 2023 revenue declined by 2.1% to approximately $55 million compared to the third quarter of 2022. Revenue was impacted by volume and mix declines of 8%, partially offset by a 4.1% benefit from pricing and favorable changes in foreign currency of approximately 1.8%. Nelson Labs’ third quarter 2023 segment income decreased by 11.2% to $17 million, and segment income margins contracted by approximately 320 basis points to 31.3% versus third quarter 2022.

This decline was due to the unfavorable volume and mix as well as inflation, partially offset by favorable pricing. I will now turn to liquidity, net leverage and capital deployment. The company is in a strong liquidity position. As of September 30, 2023, we had approximately $645 million of available liquidity, which includes $245 million in unrestricted cash and $400 million of available capacity on our revolving line of credit. Through the third quarter, after adjusting for the $408 million Illinois settlement, we generated over $145 million of operating cash. This is a testament to the tremendous cash generating capability of this business. Our net leverage ratio at the end of the third quarter was 4.2 times. This was an increase from the year-end 2022 level of 3.2 times and was driven by the new $500 million term loan issued in connection with the Illinois ethylene oxide settlement.

Our capital expenditures totaled $52 million for the third quarter of 2023 and $150 million on a year-to-date basis. Over the past couple of years, we have been operating in a period of elevated capital expenditures due to the US EO facility enhancements, Sterigenics’ capacity additions and the strategic cobalt development programs. Spending on the cobalt development and US EO facility enhancements programs totaled approximately $50 million in 2022, and we have spent nearly the same amount through Q3 of this year. Our cobalt development programs are required to support the long-term growth of gamma sterilization. Our last significant cobalt program was approximately 20 years ago. It is also important to note that current development programs will begin to yield revenue late in the decade.

Sterigenics has three active capacity expansion projects continuing. Capital spending will be largely complete on the first of this year. Capital spending for the other two, which are greenfields will be largely complete by the end of 2025. As previously communicated, we expect 2024 will be another year of heightened investment. Based on our current view, we expect a significant reduction in capital expenditures for the US EO facility enhancements and cobalt development programs in 2025 and Sterigenics’ growth investments in 2026. We have a great company and we will continue to invest in all three businesses to maintain and to grow Sotera Health for the long-term. As we complete the stage of elevated investment, we expect to substantially increase the conversion of our strong operating cash flow to free cash flow, which is a key priority.

Now I’d like to discuss our 2023 outlook. Based on ongoing market softness, we expect full year 2023 results to be at the lower end of our previous outlook, which is total revenues in the range of $1.035 billion to $1.055 billion, representing an annual growth rate of approximately 3% to 5%. Full year adjusted EBITDA in the range of $520 million to $535 million, representing an annual growth rate of approximately 3% to 6%. As mentioned earlier, we are on track to deliver approximately 50% of Nordion’s full year revenue in the fourth quarter. For Nordion, we expect 2023 full year adjusted EBITDA margins to be similar to 2022 full year margins. For the remainder of the business, we expect Q4 to be similar to Q3 for both top and bottom line. Tax rate is expected to be in the range of 30% to 32%.

Weighted average diluted shares are expected to be in the range of 283 million to 285 million. Adjusted EPS is expected to be in the range of $0.78 to $0.86. Capital expenditures are expected to be in the range of $200 million to $215 million. And lastly we expect net leverage to finish the year at or below four times. Now I’ll turn the call back over to Michael.

Michael Petras: Thank you, Jon. Before we move to Q&A, I would like to take a minute to express our condolences to the family, friends and work colleagues of Matt Mishan from KeyBanc. Matt had been following our company since 2020. In just one week prior to his passing, we are fortunate to spend time with him in Boston. Matt will truly be missed. At this point in time, let’s open the call for question and answer.

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Q&A Session

Operator: We’ll now begin the question-and-answer session. [Operator Instructions] The first question today comes from Sean Dodge with RBC Capital. Please go ahead.

Sean Dodge: Yes. Thanks. Good morning. I just want to start with a quick clarification, Michael, on your comments around the remaining Georgia cases. So 240 remain there. But in those counties, you said that the judge is going to require those who provide some type of evidence of exposure that caused their illness. So is that right that number could actually — the number that actually go to trial, could that be whittled down some? Or is that 240 number in many cases, is that the number sort of already cleared that initial hurdle that have provided their proof and will go to trial?

Michael Petras: Good morning, Sean. So here’s how it works. There’s 240 cases. There were 10 cases that the judge has pulled out to kind of go through Phase I and Phase II. Phase I is general causation, Phase II is specific causation. So the answer to your question is, yes, the cases could go down. So if a condition comes through — goes through Phase I, it has to pass through — if it’s leukemia or it’s breast cancer, lymphoma, it has to go through Phase I. So a given case has to go through Phase I, if it passes that, it goes to Phase II. If it passes that screen with the judge, then it goes to a trial jury, and you take it through the whole case. So there is a case scenario here where something gets knocked out in one of those first two cases.

Let’s say, ALL, for example. It could not — maybe not pass Phase I and Phase II, which means you will not go to a jury trial. So yes, it could reduce the number of cases. Is that — it’s a little complex. I want to make sure I’m being clear enough for you.

Sean Dodge: No, that’s great. That helps. And then maybe just on the EO emissions regulations, is there any more updates you can share there? You guys have been communicating with the EPA, and any ideas on changes we could see in the final rule? It looks like that’s expected now in Q1 of ’24.

Michael Petras: No. We continue to engage with our regulators like we always do, but we have no more visibility on exactly what’s going to be in the final rule. But we, again, are very confident of the improvements we’ve put in place and the timing we expect on the knee shaft is in the first quarter — late first quarter.

Sean Dodge: Okay. Great. Thanks again.

Michael Petras: Thank you, Sean.

Operator: The next question comes from Patrick Donnelly with Citi. Please go ahead.

Patrick Donnelly: Hey, guys. Thanks for taking the questions. Michael, just as we think about the go-forward, obviously, some of these headwinds are lingering. Is it still right — are you still confident, I should say, in the high-single-digit organic growth profile of the business here? A lot of companies have come out and discussed ’24 as relatively lower growth given some of the headwinds. Obviously, you guys moved to low end here. Just curious if we should be thinking about the near term a bit differently and your visibility into things improving as we work our way into ’24.

Michael Petras: Yes. Patrick, thank you. We are confident in the ability to continue to grow high single digits in the business. As you know, we felt some of the challenges from our customers and their supply chains and inventory challenges. But when you look at the mid to long-range, we expect this business to perform at high single-digits organically.

Patrick Donnelly: Okay. No, that’s helpful. And then just on the margin profile. I assume no real changes in terms of the cost controls, given the near-term headwinds. But can you just talk about the moving pieces on the margins? Obviously, pricing has been a nice tailwind for you guys for a long time. Any change to that algorithm as we work our way forward, just anything we should be thinking about in the near term in terms of the margin moving pieces? Thank you.

Michael Petras: Yes. Obviously, volume is the biggest lever we have on driving margin and margin expansion. We do get price. We’ve been able to prove that we’re able to offset price inflation because of our price actions. But again, it all comes back to the value that we create with our customers. And our customers pay for the service because it’s so critical and important to them. Yes, price has been running a little higher than we have guided towards. We’ve said it’s 3.5% to 5% over the long range. It’s been a little higher than that because inflation has been a little higher than that. We’ve been offsetting it. But we expect that price will continue in that range in the future. We also expect volumes to return to where they’ve been historically, which will continue to give us great operating leverage.

But the team is doing a good job in managing through that. The Sterigenics facilities don’t have a ton of labor, but Mike and the team have done a good job in managing around that. And the same with Joe on the Nelson side and working through the volume challenges there. They’ve been through a lot with the COVID, the job crisis that happened and then some of the regulation changes. But overall, we feel good about our ability and our margin rates continue to hold in there as we’ve proven out in our business model.

Patrick Donnelly: Appreciate it.

Operator: The next question comes from Luke Sergott with Barclays. Please go ahead.

Unidentified Analyst: Good morning. This is [Salem] (ph) on for Luke. Maybe just a follow-up on Sean’s question earlier about the cases outstanding. Is there a time line right now for when we might hear about whether some of these cases are exiting Phase I or Phase II or if they’re getting stopped? Just curious about the time line there.

Michael Petras: Yes. So good morning, Sam. Yes, there is a time line set up. Phase I, we’ll get through general causation through October ’24. Phase II would be August of 2025. And then ultimately, any surviving cases would go to a jury trial, they would start in September, October 2025 is the current time line that we expect.

Unidentified Analyst: Got you. That’s really helpful. Thank you. And then this — hearing a lot about biopharma kind of tightening their budgets. Just wondering about what the effects are there for you guys? What’s your exposure there? And if you’re hearing anything similar on that demand environment? And then just on GLP-1, it’s expected to hit devices, volumes kind of in the long run. What’s kind of your sense of or your plan for capacity? And is that kind of offset by any sterilization of some of the pens that will be used for GLP-1? Just curious about how you’re thinking about that as well.