2023-04-05 18:03:24 ET
Summary
- SHC reported strong results for 4Q and provided solid revenue growth guidance for FY23, with mid to high single-digit growth expected.
- There are several factors that could impact the company's performance in the coming year, including a slower ramp for Nelson Labs, labor inflation headwinds, and possible challenges from cobalt imports.
- Cash interest expense will likely increase to over $160 million in 2023 due to the increase in incremental debt, roughly doubling from 2022 levels.
Description
Sotera Health ( SHC ) reported strong results for 4Q and provided a solid 2023 revenue growth guidance of mid to high single digits, with flat EBITDA margins and a 14.5% decline in adj EPS. Interest costs on the additional debt brought on by the IL litigation settlement (more below) account for the difference between EBITDA and EPS. Despite positive comments about Sterigenics' performance and SHC's plan to reduce debt while investing in EO site improvements and capacity expansion, I anticipate lower margins in 2023 due to Nelson Labs' slower ramp and continuing labor inflation headwinds. Management has also raised the possibility of sanctions against Russian cobalt supply, which could have an effect on Nordion's guidance, which is heavily weighted toward the tail end. Despite acknowledging SHC's strong competitive advantage in the growing market for outsourced sterilization, I have lowered my rating for the company to "hold" due to several factors: (1) the uncertainty surrounding the margin progression of Nelson Labs; (2) possible challenges from cobalt imports from Russia, as identified by SHC; (3) the potential impact of ongoing litigation on GA trials in the second half of 2023; and (4) an above-target leverage ratio.
FY23 Growth and Margin Outlook
The timing of Nordion, the gradual recovery in Nelson, and the timing of pricing contracts in Sterigenics will all put the emphasis on growth and margins in the latter half of 2023. Management did not provide formal segment-level detail but did outline each company's expectations. First, nearly all of Nordion's 1H23 revenue to fall in 2Q23 due to the timing of the current cobalt harvest schedule, 75% of its FY23 revenue, and 80% of its FY23 adj. EBITDA to come in 2H23. I believe this poses a significant risk to FY23 guidance given the volatility in macro environment today. If, by 3Q23, we still do not hear any positive commentary regarding the feasibility of 4Q23 accelerating to meet guidance, I expect investors to significantly revise their expectations downwards as FY23 guidance might be seen as unlikely. Regarding Nelson, management anticipates a resumption of normal quarterly operations in the 2H23, with margins increasing from their low point in the 1Q23 to their normal run rate of 30%+ range by the end of the year. Lastly, for Sterigenics it will be one that produces stable growth sequentially with increased volumes at higher margin, despite seeing lower volumes and margins in 1Q due to typical seasonality. To sum up, adjusted EBITDA margin guidance for 2023 is due to a slower recovery process in Nelson and inflationary pressure baked into guidance. Further, I would warn that the guide places a disproportionate amount of weight on "returning to norm" and acceleration in the second half of the year. If you want to err on the side of caution, I suggest waiting until 2Q23, when management is likely to issue an update on the guidance (i.e., what is the progress).
Impact From Russia
Unfavorable developments for SHC include rising tensions in the Ukraine conflict and reports of possible EU sanctions against Rosatom, the Russian state-owned nuclear operator. While management is confident that they will be able to secure a sufficient supply of cobalt from Russia by 2023, I do not believe that investors have access to sufficient, credible information from the ground to agree with this assessment. The fact that 30% of all medical devices in the world are sterilized by gamma irradiation makes Russian cobalt a necessity in the medical device industry and is, in my opinion, a saving grace. However, management did hint that sanctions could have a flat to -3% impact on SHC's revenue for the year, depending on when they were implemented. However, the phrase "depending on timing" should be taken at face value, as it suggests that the impact may be significantly greater if it is for the entire fiscal year of FY24.
Balance Sheet
Earnings are anticipated to decrease while EBITDA is anticipated to remain flat in FY23, as was previously mentioned. To pay for the $408M IL litigation settlement, SHC drew down an additional $500 million on its Term Loan B. The debt raise puts the company ahead of its 2-4x net leverage ratio goal for the beginning of the year. However, I believe it can generate sufficient cash flow to make debt repayments and stay within its target range. Cash interest expense will increase to over $160 million in 2023 due to the increase in incremental debt, roughly doubling from 2022 levels.
Summary
In conclusion, SHC reported strong results for the 4Q and provided solid revenue growth guidance for FY23. However, there are several factors that could impact the company's performance in the coming year, including a slower ramp for Nelson Labs, labor inflation headwinds, and possible challenges from cobalt imports from Russia. Additionally, ongoing litigation and an above-target leverage ratio are cause for concern. Despite acknowledging the company's competitive advantage in the outsourced sterilization market, I have downgraded my rating for the company to "hold" due to these factors. Furthermore, the emphasis on growth and margins in the latter half of 2023, the impact of potential sanctions on Russian cobalt supply, and the company's balance sheet also warrant caution. Overall, while there are positive indicators, it may be prudent to wait for further updates before making any investment decisions.
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Sotera Health: Shifting To Hold As I Await Updates On Guidance