Carcinogens saving lives? The great business of Sterigenics
Research & Valuation: Sotera Health Corp (NASDAQ: SHC)
Industrial-grade sterilization is a highly-regulated niche industry but it contains some of the most durable businesses in the world.
Prior to the 1960’s, medical product sterilization generally took place using hot steam. The high temperature killed bacteria living on objects such as scalpels, which significantly decreased the risk of an infection occurring post-operation. In many such cases, it was not the surgery itself but the exposure of your inner body to external bacteria that presented the danger.
Steam was a great method for its time but it was eventually supplanted by radioactive and/or gaseous sterilization, reason being that high temperature steam damages products and/or packaging, whereas radioactive or gaseous methods did not. Scientists and engineers in the early 1900’s had been experimenting with various sterilization methods that would kill bacteria without damaging the product itself and eventually discovered three superior methods that make up the majority of the sterilization industry today:
Gamma irradiation: Products are exposed to gamma rays emitted by Cobalt (Co-60), which penetrate dense materials to kill microbes. Gamma is particularly effective at sterilizing high-density medical products such as sutures, surgical tools and stents.
Ethylene Oxide (EO) processing: A gas sterilization process where packaged goods are loaded into a secure chamber that is then injected with ethylene oxide gas to penetrate the packaging. EO sterilization is particularly useful for materials that are degraded by radiation or heat. For this reason, it is typically the only method available to effectively sterilize items such as procedure kits, PPE and many devices used in cardiac procedures.
E-beam irradiation: Products are exposed to machine-generated radiation in the form of a stream of electrons. E-beam is particularly effective for low density products such as glass labware.
Millions of medical products are sterilized each day, but many still don’t understand how vital the process is to the healthcare system. In my opinion, there are multiple factors that make this industry quite attractive to investors.
The sterilization process itself handles radioactive product, as well as carcinogenic gas. At face value, this means that the industry is heavily regulated and requires complex operating and health & safety procedures to ensure continuing compliance with authorities. This is particularly troublesome when sterilization customers have production facilities located in multiple countries and must coordinate the regulations in tandem. Once one considers the NIMBY (not in my back yard) concerns, it’s no surprise that it’s incredibly difficult to build a greenfield sterilization facility today without years of approvals and regulatory proceedings.
As part of the safety and approval process, many governments throughout the world mandate the sterilization of medical products and codify this step into the drug/medical approval process. For example, the FDA in the US specifically requests the location of the primary sterilization facility (as well as its backup) to be listed on the FDA application. If a medical device or pharmaceutical company wanted to switch sterilization providers/locations after going through the FDA process, they would have to submit a request to the FDA that would require a material change in the approval. This is costly and time consuming, and likely not worth the added headache.
The cost of sterilizing medical products is low and is estimated to be close to 1% of the sales price. For example, a $5,000 hip implant in the US would cost as little as $50 to sterilize. In the grand scheme of things, this provides the sterilization provider with the ability to exert pricing power. For example, if they were to increase the cost of sterilization by 10% the following year, the cost of sterilization relative to the sales price would rise to 1.1%, a still negligible amount.
It’s not uncommon for medical device and pharmaceutical companies to have operating margins near 20%. Therefore, a small increase in their cost of goods sold is immaterial to their bottom line. Bottom line: medical device and pharmaceutical companies aren’t incentivized to save money on sterilization. Even if the medical or pharmaceutical product is free of manufacturing defects, not sterilizing it properly is the difference between life and death (and lawsuits).
The sterilization industry typically operates under multi-year contracts that are 3-5 years in length, and typically have both price and cost escalators built-into the contracts. These highly-predictable contract structures provide customer lock-in but also provide them with certainty of execution and dedicated supply-chain space. These structures heavily favour the incumbent sterilization providers and suggests that large market share changes between providers is almost non-existent.
Outsourcing has been a trend in the sterilization space as medical device and pharmaceutical companies have continued to focus on what they know best: product development. A decade ago, outsourced sterilization was estimated to be ~40% of the addressable market, and today it nears 50%. Sterilization is a small portion of the overall cost of goods and is fraught with risk. Bringing the process in-house won’t materially decrease a customers costs, and if anything, will likely increase their legal liability exposure. Not a great risk/reward tradeoff.
Facilities, whether in-house or outsourced, are highly-dependent on throughput volume. This is an industry with very high fixed costs; thus, operating at near capacity is very important to decreasing your cost per product. Outsourced providers are able to aggregate customer demand in their facilities to ensure that they always operate near capacity. This does wonders for incremental margins.
Many in-house sterilization processes continue to be used to this day. However, new incremental supply has leaned towards sterilization outsourcing, given the increasingly strict regulatory environment and potential liability. Some players in the industry have been the target of lawsuits over their handling of carcinogenic material, which will likely continue the outsourcing trend in the long run. Medical product and pharmaceutical companies don’t want to take on additional liability that isn’t directly related to the product they are manufacturing.
The global sterilization industry is controlled by two players with ~70% combined market share, with the remaining ~30% split among sub-scale operators. I don’t typically think that high market share is particularly important, but in this case, it helps to better serve the large multinational medical and pharmaceutical customers. Most of the large customers in the industry have production facilities in multiple countries, all needing to be serviced by a sterilizer. Instead of having ten contracts with ten separate sterilization companies, a multinational customer can engage with one or two sterilization providers. Similar to the aluminium can production industry, it’s not uncommon for sterilizers to locate their sterilization facilities near their customers to limit transportation and handling costs.
Lastly, the large sterilizers provide critical redundancy and peace of mind for their customers. In many countries, companies need to list a backup sterilization facility on their regulatory application. Should a facility experience downtime, the large providers can quickly shift product to the backup facility to ensure no product delays. Given that sterilization is the last step before the product is eventually delivered to hospitals and other locations, any delay in the process means that customers must tie up capital in inventory for that much longer.
Enter Sotera Health Corporation (NASDAQ: SHC), a ~$1bn revenue sterilization and testing company that owns 65 facilities throughout the world. Sotera’s resume speaks for itself. It counts 9 of the top 10 largest pharmaceutical companies and 40 of the top 50 medical device companies as its customers.
Sotera’s three main businesses operate under the trade names of Sterigenics, Nordion and Nelson Labs. A summary of Sotera’s business segments are provided below:
Sterigenics
Sterigenics has been in business for over 90 years and provides sterilization services throughout the world. Sterigenics uses many different forms of sterilization at its facilities including gamma irradiation, ethylene oxide gas, and e-beam irradiation. It’s important to note that Sterigenics is indifferent to the type of sterilization process used at its facilities, and generally explores new types as they are commercialized. X-ray irradiation and Nitrogen Dioxide (NO2) are new commercial applications that the company has been testing in select locations. This segment is Sotera’s crown jewel and generates $667MM (~63.5%) and $362MM (~68.5%) of the company’s revenue and EBITDA, respectively.
Sterigenics operates 48 facilities located in 13 countries, with gamma irradiation and ethylene oxide (EO) comprising the majority of the sterilization technologies used. Each facility is estimated to cost $40-50MM to build, and Sterigenics estimates that the cost to replace their entire network would be as much as $1.9bn. In my opinion, the real difficulty in replicating their network is overcoming the regulatory and NIMBY issues when building each individual facility, let alone an entire network that spans 13 different countries.
Approximately 80% of their revenue is attributable to customers using more than one facility; and more than 50% of revenue is attributable to customers using five or more facilities. This is a perfect example of how difficult it would be to compete in this industry. A new entrant would have to simultaneously build multiple greenfield facilities in different countries, while also encountering enormous amounts of concern and red tape as it relates to the danger of the radiation and carcinogenic material nearby local residents. Existing facilities are incredibly valuable and entrenched, and it is generally much easier to increase capacity at existing locations, instead of greenfielding a new facility. In addition to these barriers, the large sterilization companies generally pre-sell ~40% of a new facility’s capacity to new and existing customers, before they even break ground. This again, favours the incumbents.
Sterigenics has an average tenure of over a decade for its top 25 customers, and has a near 100% renewal rate for its top 10 customers in the past 5 years. More than 90% of its revenue is derived from customers under multi-year contracts. The company generally pushes through 3-5% price increases per year on customers, in addition to the GDP-like increases in underlying volume. Sterigenics has been following this playbook since inception and customers are generally used to paying a little bit more for their services each year.
Sterigenics’ main competitor is Applied Sterilization Technologies (AST), a segment of Steris PLC (NYSE: STE). Sterigenics and AST have ~70% combined market share in the sterilization industry, with AST being larger than Sterigenics. In 2023, the AST segment in Steris generated $914MM and $429MM of revenue and operating income, respectively. AST has 60 facilities globally that use similar technologies to Sterigenics, and ~80% of customers are on 3-5 year contracts. The AST segment in Steris comprises ~20% of total revenue and ~36% of total operating income, which is a much smaller proportion relative to Sterigenics in Sotera. Steris has generally harvested cash flow from its AST segment throughout the years and used it to acquire businesses in other fields such as healthcare, life sciences and dental.
It is estimated that both Sterigenics and AST operate near maximum capacity utilization, and have been doing so for many many years. The industry is generally short of capacity given the regulatory hurdles and liability concerns, with no expected reprieves coming in the foreseeable future. Both companies undertake facility expansion projects every now and then, which helps meet increasing customer demand.
Nordion
Nordion is one of the leading providers of Cobalt-60 (Co-60) used in the sterilization and irradiation processes throughout the world. The company provides a supply of Co-60 to customers, the processing of Co-60, the recycling of depleted sources, and the overall logistics associated with the material. Some may also be familiar with the Gamma Knife, which is a radioactive surgery performed with a specific type of Co-60 supplied by Nordion. It is estimated that Nordion has ~70% market share, with near zero competition.
Co-60 is a radioactive isotope that is used by companies to emit gamma irradiation and sterilize medical products. It is estimated that ~30% of single-use medical devices are sterilized with gamma irradiation. To create Co-60, one must place mined Cobalt-59 (Co-59) into a nuclear reactor and wait 1-5 years until it is activated into radioactive Co-60. The difficulty in the industry is in opening up the nuclear reactor and retrieving the newly-minted Co-60. Typically the Co-60 harvest is timed during planned reactor shutdowns, which requires close coordination with operators and regulatory authorities. Activated Co-60 generally has a 20 year useful life and a natural decay rate of ~12% per year. This decay ensures a constant Co-60 demand as it decreases in radioactivity over time and needs to be replenished.
Unfortunately, only 9% of active nuclear reactors in the world are capable of creating Co-60. Nordion’s two largest nuclear suppliers are Canada and Russia, and it is estimated that ~50% of Co-60 is produced in Ontario, Canada. These supply agreements total 5 generating stations, with Nordion’s largest supplier under contract until 2064. Nordion’s competition is extremely limited, and other sterilization providers must rely solely on Co-60 sourced from troublesome jurisdictions, such as Russia, and to a lesser extent China. It is for this reason that Nordion has been patenting many technologies to produce Co-60 in reactors that are water-coolant based, the most common type of nuclear reactor in the world.
In 2023, more than 90% of Nordion’s revenues were from customers under multi-year contracts. Nordion’s customers include Sterigenics, as well as providers that sterilize their products in-house. Nordion’s competence isn’t just limited to sourcing Co-60; it also has extensive expertise in installing the conveyor and control systems in large-scale gamma irradiation facilities. Its resume counts building 100 of the estimated 290 active gamma systems in the world.
Nordion was a dual-listed (TSX/NYSE) publicly-traded stock when it was acquired by Sotera in mid-2014 for an aggregate purchase price of ~$800MM. This acquisition provided vertical integration up into the Sterigenics supply chain and helped secure the majority of its supply of Co-60 going forward.
Nelson Labs
Nelson Labs is Sotera’s testing and advisory service and serves as the catch-all in its push to vertically-integrate down into the sterilization supply chain. It mainly provides microbiological and chemistry testing for customers throughout the early development and quality-control stages of the production life cycle.
Nelson is used by its customers in an advisory capacity and in a continuous testing capacity. It will generally advise customers at the product development stage how they should plan to sterilize their products. This includes choosing certain packaging materials, product design choices and packaging barriers. Nelson has embedded itself in this part of the supply chain to set the table for the product to eventually become a Sterigenics customer. This portion of the business is more dependent on new product development, which can be somewhat cyclical.
Nelson also provides sterility and quality-control testing once a product has received regulatory approval and is being put into production. This includes batch verification testing and environmental testing of the production line. Per Sotera, Nelson “often” provides quality control testing for the products for which it performed the initial validation testing. In addition, these products are also “often” sterilized by Sterigenics. As exemplified, Nelson is a strategic asset for Sterigenics and provides significant cross-sell opportunities.
It is estimated that as much as 40% of Nelson’s business is in simply validating that sterilization plants are working properly, which is a nice source of recurring revenue.
Sotera acquired Nelson Labs for an undisclosed amount in 2016 and today it counts 570 employees, 85 laboratories and more than 3,000 clients in 57 countries. Since the Nelson acquisition, Sotera has engaged in a few bolt-on acquisitions which have increased its testing count expertise.
In my opinion, Nelson is Sotera’s least competitively-entrenched business, but is still a great complement to the Sterigenics business. Nelson provides them an opportunity to get a foot in the door when discussions are occurring about choosing sterilization providers.
Sotera Corporate History
1999 - Acquired by Ion Beam Applications, valuing the equity at $235MM.
2004 - Acquired by Silverfleet Capital for $333MM
2011 - Acquired by GTCR for $675MM
2015 - Recapitalized by Warburg Pincus by purchasing a majority stake in the business valued as much as $2bn (including debt). GTCR continues as a minority owner.
2017 - Sotera pays out ~$190MM in distributions to shareholders
2018 (August) - Sotera explores a sale worth as much as $5bn (including debt).
2018 (September) - Sotera is the target of tort litigation
2018 - Sotera pays out ~$170MM in distributions to shareholders
2019 - Sotera pays out ~$660MM in distributions to shareholders
2020 (November) - Sotera IPO’s
2021 (March) - Warburg Pincus, GTCR and members of management sell 25MM shares in a secondary offering at $27 per share
2024 (February) - Warburg Pincus, GTCR and members of management sell 28.75MM shares in a secondary offering at $14.75 per share
Given the high-quality nature of the business and its ability to withstand large amounts of leverage, it surprised me that Sotera came public via IPO. In my opinion, the business model is perfectly suited for private equity buyers and would’ve likely remained in private hands.
When Sotera explored a sale in August 2018, it was rumoured that no buyers were willing to meet the price because of the outstanding litigation and potential associated liabilities. The decision to IPO in 2020 was likely a strategic decision, given that the Covid pandemic had increased demand for healthcare companies, in addition to public-company investors being generally less scrutinizing of legal liabilities.
Litigation
In my opinion, Sotera is in the top 5% of businesses I’ve ever studied. Unfortunately, the story doesn’t end there.
In 2016, the environmental protection agency’s (EPA) risk program published a study which moved Ethylene Oxide (EO) from “probably carcinogenic” to “carcinogenic”, and decreased the countrywide safe inhalation guidelines. Later in 2018, the EPA used this study to evaluate nationwide cancer risks and determined that 106 census tracts in the US had elevated cancer risks due to EO exposure. Three of Sterigenics’ facilities were located in problematic census tracts: Illinois, Georgia and New Mexico. Sterigenics vigorously defended itself against these cases and claimed that these studies were flawed because it assumed a 24/7 exposure to EO emissions for 70 consecutive years. This supposedly flawed study showed that these high-risk jurisdictions contributed to 100 additional cancer cases per 1 million people (0.01%).
As a result of this risk assessment and later nationwide study, sterilizers became the subject of hundreds of personal injury claims and tort lawsuits alleging illness due to long-term EO exposure.
As the lawsuits progressed, Sotera lost a preliminary jury verdict in Illinois in September 2022 which caused its stock to drop nearly 60%, implying a high chance of bankruptcy due to future legal liabilities. It’s important to note that Sotera was defending itself in a jurisdiction of Illinois that is known to have the most plaintiff-friendly laws in the entire country. Many insurance companies won’t even write liability insurance in this jurisdiction because of the plaintiff-friendly nature of the legal system. As the court cases continued in Illinois, Sterigenics decided to settle 879 cases for a total of $408MM. There remain ~25 personal injury claims in Illinois court today.
Sotera was also the subject of mass tort litigation at its facility in Georgia, although the number of claims were fewer than Illinois. In October 2023, Sotera settled 79 of the Georgia cases for $35MM. Sotera claims that it only settled 79 of the cases because it was in “the best interests of Sterigenics and all stakeholders”. There remain 245 personal injury claims in Georgia court today.
At this point, the majority of the company's highly-profile legal liabilities have been settled. Yet, it’s important to note that trials are still set for the remaining cases that haven’t yet been settled. Presumably, those cases are much more likely to be dismissed by the courts, which is why Sotera didn’t want to settle them in the first place.
The remaining litigation outlined in Sotera disclosures are for its New Mexico facility, and a recent lawsuit in Vernon, California. The New Mexico facility is located in the middle of the desert and is not subject to personal injury claims, which makes the risk of any large personal injury payouts immaterial. New Mexico’s auditor general is simply suing for damages for uncontrolled emissions from the facility.
The Vernon litigation is a mass tort lawsuit, but this situation is different that Illinois and Georgia because the EPA did not designate this facility as being in a “high risk” jurisdiction. Therefore the company believes that this case is entirely without merit. Of course, future claims could occur in other jurisdictions but I suspect that the severity of the settlements will be much less going forward.
It’s important to remember that EO sterilization is used for over 20bn medical products annually, and accounts for ~50% of medical product sterilization in the US. While EO is cancer-causing in large quantities, Sotera has always disclosed its facilities emissions with all regulators to ensure continuing compliance. Unfortunately, EO sterilization is still a necessity because it is particularly well-suited for sterilizing products that use resins and/or multiple layers of plastic packaging. For sterilizing these types of packaging, EO has no known substitutes.
Lastly, I think it’s important to put the safe inhalation guidelines in perspective. The EPA study used a threshold EO exposure of 0.0002 ug/m³. For example, an 2003 SUV and gas grill will emit 198 ug/m³ and 252 ug/m³ of EO, respectively. At the end of the day though, it’s too late to debate the EPA standards.
The difficulty in dealing with legal liabilities is deciding how to handicap the valuation and the risk of the investment. As of 2023, Sotera disclosed that it spent ~$72MM in EO legal fees, and in previous years it spent anywhere from $35-70MM per year.
These lawsuits and claims have unintended consequences on the sterilization industry, which may help Sotera and AST in the long run. These consequences likely mean that in-house sterilizers are second-guessing their potential legal exposure. In addition, building new EO sterilization facilities is likely going to be much more difficult going forward from a public policy standpoint.
Since the onset of the lawsuits and in anticipation of even stricter guidelines from the EPA, Sterigenics has modified all of its EO facilities to include three additional safety measures: double scrub processes, negative pressure systems, and optimized discharge points. None of these stricter measures were ever required by the EPA, but Sotera spent an additional ~$30-40MM to enhance all of its EO facilities. These enhancements now hold each facility to such a high emissions standard, that any changes in future EPA guidelines won’t require much additional work.
It’s important to note that Sterigenics has been disclosing their EO emissions to state and federal regulators for nearly 20 years, even during times when it wasn’t required. I don’t believe that Sterigenics was trying to be a bad actor; they were simply following environmental rules and happened to get caught in personal injury litigation when the rule-changes tilted the legal landscape.
Management Follow-Through
It is incredibly difficult to assess company culture as an outsider without interacting and meeting with management and current/former employees. However, one can assess what management has said about the business in the past and look to see if they followed through on their commitments.
Post IPO, management laid out a three-prong plan: organic growth, debt pay down, and small bolt-on acquisitions. In the last three and a half years since the IPO, Sotera management hasn’t shied away from increasing CapEx through either capacity expansions or building new greenfield facilities. Prior to its IPO, Sotera spent ~$50-70MM per year on CapEx, whereas it spent a total of ~$500MM in CapEx in just the last three years. The greenfield facilities typically take 1-2 years to build, and another handful of years to stabilize. Therefore, the financial impact from most of the new developments haven’t yet flowed through the income statement. One could argue that its private equity owners minimized growth CapEx during the years leading up to the IPO to payout a large stream of distributions to limited partners.
The majority of the incremental increase in CapEx for the past few years was directed towards Sterigenics capacity expansions. Management noted in previous calls that their maximum utilization is in the low 80%'s, and that facility expansions would allow them to better serve their customers. I view these investments positively since it continues to strengthen the company's moat and provides incremental volume to an existing facility, which increases overall contribution margins. It’s difficult to be certain, but I estimate that the average Sterigenics facility does ~$7.5MM in stabilized EBITDA and costs $40-50MM to build. This would imply an estimated after-tax return on a new greenfield facility of 10-12%. Comparing this to Sotera’s normalized return on invested capital (ROIC) over the past five years implies a similar return metric. As Sotera’s growth CapEx further normalizes, I expect their ROIC to strengthen over time.
The remainder of the increase in CapEx was directed towards Nordion. Pre IPO, Nordion generally spent ~$2-4MM on CapEx per year, whereas it spent a total of ~$86MM in the past three years. When the pandemic and the Russian war occurred, Nordion saw an increase in demand for Co-60, but it also recognized that it needed to diversify its exposure away from Russian nuclear reactors (estimated to be 20% of Nordion’s supply). Nordion’s product and customers were never impacted by sanctions or supply-curtailments but management saw the increased risk and decided to invest today to further diversify its supplier base.
Management has admitted that these are very long term investments given the logistical challenges of building new radiation space in a nuclear reactor, and that many of these investments will only start to pay off near the end of the decade. I commend the management team for making these investments today even though the benefits are so far into the future that most investors wouldn’t want them to be making them.
In terms of debt paydown, management has been consistent with their previous comments. If it hadn’t been for the EO settlements in 2023, Sotera was well on its way to materially decreasing its debt load in the their targeted range of 2-4x net debt/EBITDA. As the business continues to move forward and grow, Sotera will naturally deleverage. The company’s current debt is structured with two separate facilities both maturing near the end of 2026 and paying interest rates of 8-9% (floating based on SOFR). Both debt facilities have been partially hedged with interest rate caps/swaps to mitigate the risk of rising rates. In addition, the company also has an unutilized $423MM revolving credit facility, which can help to mitigate any cash-flow timing issues.
Based on the company’s expected growth and a step-down in growth CapEx, I estimate that Sotera could repay its entire debt in 6-7 years. The more realistic scenario is that new capacity expansions, new greenfield facilities, and regular price increases contribute to significant EBITDA growth, which naturally deleverages the balance sheet. At that time, Sotera will look to refinance and term-out its debt at much cheaper rates.
The last item that management highlighted at the IPO was the opportunity for bolt-on acquisitions in the Nelson Labs segment. Sotera has completed a few acquisitions in this segment since going public, adding BioSciences Laboratories and Regulatory Compliance Associates (RCA). These acquisitions amounted to less than $50MM in purchase price; therefore, revenue disclosures are limited and hard to estimate. The RCA acquisition is quite fascinating as they provide highly-technical advisory and consulting services to medical device and pharmaceutical companies. Sotera’s CEO specifically called out the RCA acquisition as being margin dilutive, which is an acquisition strategy that a public company would typically avoid doing. RCA is a very strategic asset in that it provides highly-technical regulatory advice, which is a major value-add to its customers.
Board of Directors and Management Compensation
Even though Sotera IPO’d in late 2020, it’s important to note that it is still majority-owned by two private equity firms, Warburg Pincus (31.38%) and GTCR (20.92%). Warburg and GTCR have been involved in the ownership of Sotera since 2015 and 2011, respectively.
Sotera’s board comprises eleven board members that are staggered for three-year terms, ensuring that only a handful of directors are exposed to yearly elections. Of the eleven members: three are GTCR nominees, three are Warburg nominees, one is the current CEO, and the other four are considered “independent”. The compensation committee, generally thought of as the most powerful committee, only comprises two members, of which both are affiliated with GTCR and Warburg.
From a governance perspective, Sotera leaves something to be desired. Two-person compensation committees are irresponsible and are far too small and nimble. Staggered boards are also not ideal from a governance standpoint, as they cut two ways. They provide the framework for a board to make good long-term decisions, but also limit the ability for investors to take action should they be making poor decisions. The company also has policies that the CEO and Chairperson roles cannot be separated, in addition to electing not to have a lead director. These policies were most likely instituted during the IPO.
Sotera, Warburg and GTCR are parties to a stockholder agreement which provides certain board election rights. Warburg can elect up to four directors, so long as it holds 60% of the shares it held at the IPO. GTCR can elect up to three directors, so long as it holds 70% of the shares it held at the IPO. As both firms sell down their ownership, their director nomination rights decrease accordingly. As long as Warburg’s overall ownership stays above 2.8% of shares outstanding, it will have the right to nominate one director. Similarly, GTCR has a 2.8% total ownership threshold to be able to nominate one director to the board.
Mr. Michael Petras has been Sotera’s CEO since June 2016, and has held the Chairman role since 2019. His current ownership comprises ~8.1MM shares in Sotera that are valued at ~$90MM. Mr. Petras’ base salary is ~$1MM, with typically another $9MM in bonuses and equity compensation. I believe that his ownership stake in the business is significant enough relative to his yearly pay to ensure decent shareholder alignment. Mr. Petra is very experienced in running multinational organizations and previously held CEO roles at various segments of Cardinal Health (NYSE: CAH), as well as GE Lighting.
Executive compensation at Sotera comprises a base salary, short-term bonus based on EBITDA targets, and long-term equity awards of 50% RSU’s and 50% stock options. In my opinion, the performance hurdles for the bonus calculations are low and too easily achievable for a business with such high predictability. The RSU’s and options are awarded yearly and don’t have any type of performance hurdles, which isn’t ideal.
Related to executive compensation, there were governance “dark arts'' that occurred at Sotera during their litigation crisis in September/October 2022. An excellent write up of the situation can be found here. I won’t rehash the situation, but in my opinion it provided very good insight into the power dynamics of Sotera’s board, as well as the ability to bend the rules when one is majority-owned by private equity. It is quite obvious that Mr. Petras (CEO), Mr. Constantine Mihas (GTCR board member) and Mr. James Neary (Warburg board member) are the most powerful individuals at Sotera. Unfortunately, these are marks against the board's resume and shows that, although small, they are willing to reallocate funds to management by taking from shareholders.
Other Risks
Insiders and certain members of management have recently sold shares in a secondary offering at a price of $13.75 during February 2024. This is a significant decrease in price relative to the last time they undertook a secondary offering at $27 per share. As always, insider sales can be made based on a multitude of factors, including one which paints a less rosy view of Sotera’s future.
I also happened to notice in the Stockholder Agreement that so long as Warburg and GTCR have one director on the board, that Sotera must provide both private equity sponsors with monthly operating reports, budgets, notice of material events, such as civil actions, and/or other information that a sponsor would reasonably request. While I don’t think that either firm would engage in a secondary share sale while in possession of material public information, it is a possibility.
Valuation
Sterigenics and Nordion are extremely high-quality businesses with 3-5 year contracts, built-in price increases and cost escalators. Organic revenue growth (including price increases) for both is somewhere in the 5-8% range, with essentially no cyclicality or volume loss experienced during economic downturns. I’m going to stick to napkin math since I don’t think it needs to be complicated. Using NTM combined EBITDA for Sterigenics and Nordion (adding back all the unfavourable things the company removes) of $375MM, and estimated maintenance CapEx of $72MM, I believe these two businesses have a run-rate EBIT of $303MM. This amount does not include planned growth via greenfield facilities, and it also includes ~$75MM of yearly EO legal expenses.
If Sotera didn’t have the legal overhang above its head, I think a business of this quality could easily be valued at 20-25x EV/EBIT, not dissimilar to Steris’ valuation. That would peg the enterprise value of these two segments at $6.0-7.5bn. Of course, adding back the $75MM in EO legal expenses would move EBIT to $378MM and increase the value to ~$7.5-9.4bn.
Nelson Labs is a decent little business, but in my opinion, isn’t as insulated from competition compared to Sterigenics and Nordion. Nelson has generated 3-year average revenue of ~$220MM and I estimate normalized NTM EBIT of ~$59MM. Placing a 15x EV/EBIT multiple values Nelson at $0.88bn. I am likely underestimating Nelson’s value because of its strategic value to Sotera as a whole, but I would rather be conservative.
Adding these together yields a total enterprise value of ~$6.9-8.4bn; and after subtracting net debt and dividing by shares outstanding, I estimate an equity value of $17.14-22.49 per share. Sotera’s current share price is $11.40. If one were to add back the EO legal expenses of $75MM, the estimated equity value would rise to $22.44-29.11 per share. Of course, the latter valuation range assumes that Sotera is completely free of legal liability risk for the foreseeable future, which is improbable.
That undervaluation is all good and well, but the legal issues are an integral part of the Sotera story. In the spirit of creating a draconian scenario, I decided to penalize Sotera with a $750MM legal liability tomorrow, which would be funded via interest-only debt at 8%. The $750MM liability would hypothetically settle any current legal liabilities, as well as for the foreseeable future. I chose this amount completely out of thin air, and I do realize that this amount is large relative to Sotera’s current market cap, and large relative to previous settlements.
It’s likely too punitive of a scenario, but investors should nonetheless attempt to stress-test the balance sheet and valuation to get comfortable with various scenarios. This incremental debt would increase leverage to ~5.1x Net Debt/EBITDA and decrease EBITDA interest coverage to ~2.41x. I also estimate that Net Debt/EBIT would rise to ~7.8x, and EBIT interest coverage would decrease to 1.55x.
Those pro-forma debt metrics are very high, but Sotera is quite a cash-generative business and their S-1 filing shows that they were levered at ~7.6x Net Debt/EBITDA pre-IPO. There are also indications that Sotera had been levered at this level during the majority of its private equity history.
I’d argue that Sotera would likely live to see another day even in this scenario, which is ideal for mitigating downside. I concede that the market would punish Sotera in this highly-levered scenario, but the implied valuation is still undemanding. The incremental $750MM of debt would increase Sotera’s NTM EV/EBIT to ~16.8x, or ~13.9x if the $75MM in yearly legal spend is eliminated. Still a very reasonable multiple for a business of this quality, in my opinion.
Based on my estimate of normalized operating earnings, I believe that Sotera currently trades at ~14.7x NTM EV/EBIT. This is a significant bargain for a company that can grow high single digits in perpetuity, while being insulated from competitive threats. The legal liabilities still pose a risk to the thesis, but these have largely been concluded. I believe that there is a very high probability that Sotera’s services will increase in demand over the next 10-20 years, for which they will encounter little incremental competition. Sterilization methods and lab testing procedures may change over time, but with 3-5 year customer lock-ins, Sotera can monitor these changes and pivot as necessary.
Businesses of this quality are rarely available at reasonable multiples, and I believe that the remaining legal overhang provides an opportunity to buy Sotera at a great price.
As always, feel free to browse my other write ups here (link to Substack).
