SHC - Sotera Health: Retain Hold Rating As Weakness In Segments Persists

2023-08-16 10:52:10 ET

Summary

• SHC reported $255 million in revenue in 2Q23, a decline of 4.3% but beat on EPS.
• I reiterate a hold rating due to ongoing weaknesses in Nelson Labs and prolonged inventory destocking issues.
• Margins can be protected through cost management, but it must demonstrate sustainable growth at Sterigenics and recovery at Nelson Labs to drive the stock upwards in my view.

Investment action

I recommended a hold rating for Sotera Health (SHC) when I wrote about it the last time, as Nelson Labs weaknesses and litigation risks were still present. Based on my current outlook and analysis of SHC, I recommend a hold rating. While the litigation risk is gone, I think weakness can still be seen in Nelson, although margins can be protected via cost management. According to my latest model, updated with my new growth assumptions to reflect the inventory destocking situation and lower margins, the stock seems to be fair valued (no longer has potential upside). The catalyst for the stock to rerate upwards is for SHC to report results indicating a recovery in Nelson and that there are no lingering headwinds anymore (i.e., SHC shows the market that it has a clear path to growing as per historical levels).

Review

SHC reported $255 million in revenue in 2Q23, a decline of 4.3%; adjusted EBITDA of $128 (50% margin); adjusted EPS of $0.21 (above consensus of $0.16). Sterigenics grew by 6%, Nordion fell by 37% due largely to the lumpiness associated with the timing of nuclear reactor supply, and Nelson Labs continued to decline by 3%. Despite SHC beating estimates, I still don't think it's in the clear. Management has pointed out that it has seen more customer destocking than expected, which is a major headwind for the company in 2Q23.

Thank you, David. Hospital, volumes have been rebounding and returning to pre pandemic levels in 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 in how we look at our outlook on that side. That doesn't mean we're not seeing improvements in cardiac devices orthopedic. It's just when you look at it in totality. There's categories that are down, particularly when you look at PP&E and you look at surgical kits and areas like that where there lots of inventory build-up because people are scrambling to get it. 2Q23 call

Although these factors were highlighted in 1Q23, management now sees a more prolonged and severe headwind. It was also worrying to know that this might impact Sterigenics growth potential. In the call, management pointed out that while bioprocessing does not account for a sizable share of Sterigenics' revenue, volume was down 30% year over year in 2Q23. Investors were reassured, in my opinion, by management's comments that the inventory destocking dynamic is a temporary problem that shouldn't arise every year. This is mostly correct, as the COVID pandemic caused a glut of supplies, especially high-margin personal protective equipment and surgical kits. However, I believe that management must do more than merely make statements about the issue. In my opinion, the next few quarters will be very important for SHC to demonstrate that growth at Streigenics is sustainable and recovery at Nelson will begin.

SHC's continued pricing benefit is what's kept margins stable (and what allowed for the EPS beat). Sterigenics has seen pricing of 6.5% so far this year, and management has noted that they will see a benefit slightly above their usual, between the range of 3.5% to 5% in FY23. It is expected that Nelson's margin will return to its historical range of mid-30% in FY23 (as it did in 2Q at 34%), and that Sterigenics' margin will also continue to rise gradually from its first-quarter low. For the next two quarters, I anticipate stable margins as management implements cost-cutting measures, most likely led by Nelson, since there is wiggle room to lay off some of the extra workers who were brought on to meet anticipated demand. Keep in mind that Nelson Lab is a labor-intensive operation, which is why a larger-than-necessary staff is kept on hand to ensure consistent quality of service. If volumes were to come back online and SHC does not have the necessary headcount, growth could disappoint, again.

I just wanted to be clear with that David, we'll continue to drive efficiency. Mike and Joe. In particular, our working operating efficiencies in your team in. As you may recall, late last year, we built-up quite a bit of talent within Nelson side to address potential demand that would come because we're really focused on service since that demand has not come through as strongly as we'd like. We've appropriately let some of those head counts. If you will drill down a natural level, but. I don't want you to think that we're getting, super aggressive and just take a bunch of cost-out 2Q23 call

A positive conclusion that can be drawn from this quarter is that the IL settlement is now in the past. In June, SHC announced that the $408 million IL settlement had been released from escrow, and in July, 879 opt-in claims had been dismissed with prejudice. This has definitely removed one of the key overhangs on the stock.

Valuation

I shifted to downgrade my growth assumptions by half in FY23 to reflect management guidance. I have underestimated how severe the inventory destocking situation would impact the business. Giving management benefit of doubt (that the destocking issue will start to moderate in 2H23), I expect growth to accelerate in FY24 to high single digits (on easy FY23 comps) as the business recovers back to normalized mid-single digits growth rate. With the weaker outlook, I also reduced my margin expectation in FY23 to reflect guidance and FY24 as I steer towards a conservative outlook. There is no change to my valuation outlook as I think the market will not rerate the stock back to its average unless its reported results shows a recovery in Nelson.

Final thoughts

To summarize, I maintain my hold rating for SHC based on ongoing segment weaknesses, particularly Nelson Labs. While litigation risks have subsided and cost management can protect margins, Nelson's challenges persist. The main issued flagged in this quarter is the inventory destocking issue, which is now expected to be a more prolonged headwind, which affects the near-term sentiment and mid-term growth outlook of SHC. With my revised model, I now see SHC to be fair valued.

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