Sotera Health: Stable Long-Term Growth

Summary

• The industry is huge and has attractive unit economics.
• Sotera Health has comprehensive offerings and a global scale to meet demand.
• SHC has stable long-term growth underpinned by many secular trends.

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Description

I recommend buying Sotera Health (NASDAQ:SHC). SHC operates in a large TAM that has favourable secular trends supporting its long-term growth, and I believe SHC is well-positioned to ride on this wave. That aside, I also think that investors are ready to value SHC based on its business performance rather than the litigation that was ongoing previously. Which means, it would be easier to realize value when SHC is performing well moving forward.

Company overview

SHC combines the knowledge of Nelson Labs, Nordion, and Sterigenics to provide comprehensive health and sterilization services. As there are a lot of technicalities with these names, it is best to refer to SHC homepage for a better overview.

JPM Jan 2023 presentation

TAM is huge and attractive

Developing in-house sterilization and laboratory services capabilities can be a significant financial and time commitment for medical device and pharmaceutical manufacturers, so they often choose to outsource these services. The TAM for SHC's services is expected to be around $33 billion worldwide. estimated that terminal sterilization represents a $3.4 billion opportunity. Out of the remaining $29 billion, about $7.6 billion can be reached by SHC right away ($4.4 billion for pharmaceutical laboratory testing and $3.2 billion for medical device laboratory testing).

A number of long-term tendencies, in my opinion, are responsible for the expanding market for healthcare products like surgical tools and pharmaceuticals, which increases the demand for SHC targeted markets. For instance:

1. An aging population, which increases the overall number of patients and the consequent need for healthcare facilities and facilities' equipment. Equipment sterilization needs rise in tandem with the rate at which machines are used.
2. With more people having access to healthcare, more people are using tools that would otherwise sit idle due to a lack of need.
3. more stringent rules and an emphasis on safety for individuals. Because of how healthcare works, this is becoming increasingly vital.

JPM Jan 2023 presentation

Global scale with comprehensive offerings to meet end-to-end needs

SHC is a worldwide company that provides customers with a full range of sterilization, laboratory testing, and expert advisory services. As the healthcare industry's regulatory landscape becomes more complex and technical, having a global reach for these services is essential. Offering these services together is how I think SHC sets itself apart from the competition and provides the most value to its customers. Customers can rest easy knowing their products will reach their end users in sterile condition thanks to SHC's extensive sterilization capabilities.

And through its global network of facilities, SHC serves thousands of customers in dozens of countries and regions. This is supported by SHC's strategy to integrate its global network of facilities into a unified backend system. Customers who operate on a global scale require this level of integration because they seek out partners who can offer consistent service, knowledge, and expertise no matter where they are located. In my opinion, this gives SGC a significant edge over the competition. It is very challenging for new competitors to enter and replicate SHC's scale due to the high cost of entering the market, the complexity of the licensing processes involved in doing so up front, and the stringent regulations that must be adhered to.

That's why I think SHC will be able to keep growing its service offerings and customer base thanks to its global scale, which is backed by its integrated facility network and key competencies.

Attractive revenue model

Since it is a manufacturer's service provider, SHC is shielded from the uncertainties of dealing with payors. I anticipate that the development of new healthcare equipment and the increasing emphasis on sterilization will fuel the expansion in SHC business as the use of medical devices rises.

What's more, this sector's allure stems from its naturally appealing characteristics. Due to the fact that SHC's customers rely on the company's comprehensive services throughout the product's entire lifespan, SHC has an enviable track record of maintaining decades-long partnerships with its most valuable clients. Due to the essential nature of SHC services, a sizable percentage of income comes from long-term contracts. The consistently high customer renewal rates for SHC's top sterilization services are a testament to the reliability and consistency of SHC.

It's also important to remember that changing service providers can be time-consuming and costly. This is due to the fact that it is time-consuming and costly to re-validate and re-submit to the FDA after switching service providers. Depending on the type of product, all of these steps could take anywhere from months to years.

39th Annual JPM healthcare conference Jan 2021

Expertise in navigating the complex and strict regulatory environment

The markets in which SHC operates are extremely nuanced and intricate, necessitating a high level of technical know-how and specialized knowledge. Improved Ethylene Oxide [EO] cycle design and processes are something that SHC regularly discusses with customers, the FDA, and other interested parties in order to maintain compliance. The goal is to achieve a level of EO emission from the sterilization process that is as minimal as is practically possible. In my opinion, SHC is able to contribute to the development, interpretation, and advice on safety standards because of the relationships it has fostered and the thought leadership it has established among regulators and customers. As a result, SHC is able to better inform and counsel its clientele on the state of the industry and its ever-evolving standards and requirements.

FCF for M&A and debt paydown

Earlier, we discussed how SHC stands out thanks to the durability and stickiness of its revenue model. By increasing its market share and selling for higher prices, I anticipate that SHC will continue to produce massive amounts of EBITDA and free cash flow (EBITDA to FCF). This means I am not as concerned about the leverage on SHC's balance sheet. SHC's net debt to adjusted EBITDA ratio is about 3.3x as of 3Q22, and I anticipate it will continue to fall.

Furthermore, SHC has completed over ten deals since 2013, increasing adjusted EBITDA by over $150 million. To increase its global capabilities and footprint, as well as its addressable market, I anticipate SHC will maintain an active strategy of strategic acquisitions.

JPM Jan 2023 presentation

Valuation

In FY23, I believe SHC is worth USD20.38, representing a 17% increase. My model is based on management's FY22 reduced guidance as well as long-term growth projections. Given the nature of the business and its high visibility into future revenues, I believe SHC can meet management guidance.

For me, one key thing to watch is margin expansion, which SHC has been doing well. I don't see a problem with further margin expansion as long as they can continue to grow top-line and benefit from operating leverage.

Aside from that, the recent lawsuit settlement has resulted in a very strong share price reaction, which is good for the stock because investors are now more willing to value SHC based on its business performance.

Own estimates

JPM Jan 2023 presentation

Key risks

Regulatory risk

Though SHC is a recognized leader in the field, that does not make them completely safe. It is important for SHC to comply with all applicable laws and regulations, as the company is subject to stringent regulatory requirements and is audited on a regular basis to ensure compliance. The recent litigation is a prime example of what might happen to the stock if SHC does not manage this risk well.

Unable to increase price

SHC's overall sales growth is comprised of several factors, one of which is the annual increase in prices. In my opinion, SHC's price increases are sustainable because of the company's high barriers to entry and impressive record of customer retention. However, if additional price increases are not realized in the future, this could be a drag on the company's growth and profit margins in the medium to long term.

Summary

SHC operates in the healthcare industry, providing comprehensive health and sterilization services. The market for SHC's services is expected to be around $33 billion worldwide, with an estimated $3.4 billion opportunity for terminal sterilization alone. SHC is well-positioned to take advantage of this market due to its global reach and comprehensive offerings that meet end-to-end needs.

The company serves thousands of customers in dozens of countries and regions through its global network of facilities, which are integrated into a unified backend system. This gives SHC a significant edge over the competition, making it challenging for new competitors to enter the market.

Additionally, SHC has an attractive revenue model, as it is a manufacturer's service provider, which shields it from uncertainties of dealing with public or private payors. Overall, the company has favourable secular trends supporting its long-term growth, and investors are ready to value SHC based on its business performance rather than the previous ongoing litigation.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.