2023-06-06 06:22:14 ET
Summary
- Nelson Labs' weak 1Q23 performance and uncertain macroeconomic environment raise doubts about its ability to meet expectations and improve margins.
- Sotera Health's FY23 guidance puts significant pressure on 2H23 performance.
- The unresolved litigation risk surrounding SHC adds to the uncertainties.
Description
There are still too many unknowns for me to take a position in Sotera Health ( SHC ) stock. In particular, the Nelson Labs weakness and the litigation risks are still present. In spite of the fact that Sterigenics and Nordion are performing as expected, I have growing doubts about Nelson Labs' ability to meet guidance, given the implied acceleration in performance in the coming quarters. I note that 1Q23 performance was not great at all, especially when we consider that 1Q22 was an easy comp. As such, I reiterate my hold rating .
Weak Nelson Labs performance
As I mentioned before, I was particularly worried about Nelson Labs' ability to meet management's expectation of normal quarterly operations in 2H23 and how its margin would improve. The results of 1Q23 have given me more reason to doubt this. Nelson Labs' growth was stunted and their margins were squeezed because certain test volumes recovered more slowly than expected. Importantly, the margin shrank by -488 bps versus an easy 1Q22 comp. Despite management's assurances that the quarter will see an increase in validation testing orders, I remain concerned about the direct impact of the weak macroeconomic environment on SHC's R&D budgets from customers. I can't speak for other investors, but I've found it extremely challenging to predict the state of the macro environment this year. Who knows if that trend won't carry over into FY24? If this happens, I don't see how management can remain confident that business will pick up in the 2H23. If the worst case scenario for 3Q23 occurs, I expect the stock price to come under heavy selling pressure as investors lose faith in SHC's capacity for a volume recovery. If sales don't pick up, or even go down, Nelson Lab's profit margin will take a serious hit. 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. The mismatch in expected volume and increased headcount could really damage margins in the short-term.
Not sure if EPA proposal is a good or bad thing
2 months ago, the US Environmental Protection Agency [EPA] released proposal to strengthen standards for chemical and polymers plants, dramatically reduce cancer risks from air toxics, which I thought was positive for Sterigenics as it would force more consolidation in the market as the industry would need to cut down on chemical plants. The larger player in the industry would stand to benefit as they are in better position to optimize their plant capacity. With Sterigenics' market position and size, I believe it would benefit from this. However, the regulation would require SHC to invest more into CAPEX for site enhancements, which I worry would elevated the burden on SHC's balance sheet.
FY23 guidance reiterated
In normal circumstances, I would likely be positive about management reiterating guidance as it means nothing has changed since the last guide. However, this is not the case for SHC this time round as the guide puts a lot of pressure on 2H23 performance. I believe this has put SHC in the position that it must deliver as expectations are high. First, Nordion's management believes the second quarter of 2023 will bring in the bulk of the company's first-half revenue. Furthermore, they anticipate that the second half of the fiscal year 2023 will account for 75% of total revenue and 80% of adjusted EBITDA. Second, management think the first quarter was the low point for Sterigenics, and they expect the business to improve steadily and profitably throughout the rest of the year. As one can see, a lot of expectations are built up for 2H23, which is a rather risky move. For reference, consensus are expecting revenue in of ~$288 million and ~$300 million in 3Q/4Q23, levels which have not been surprised since the company got listed.
Risk
In my opinion, the cloud of litigation risk has yet to lift. Remember that a quorum for the settlement calls for a 98.7 percent opt-in rate, and that number is currently unknown to SHC. That is to say, the outcomes are about as reliable as a coin toss. If I were an investor, these would not be favorable odds. Therefore, I'd rather play it safe and wait until this risk is gone, even though management is optimistic because of their discussions with the plaintiff's counsel and anticipates a full resolution by the end of the summer.
Summary
There are still several concerns and uncertainties surrounding SHC. Firstly, the weak 1Q23 performance of Nelson Labs raises doubts about its ability to meet expectations and improve margins. Secondly, the unpredictable macroeconomic environment and potential impact on customers R&D budgets further add to the uncertainty. Finally, I believe management FY23 guidance puts significant pressure on 2H23 performance. Moreover, the litigation risk surrounding SHC remains unresolved. Given these factors, it is prudent to exercise caution and wait until some of these uncertainties are addressed before making any investment decisions regarding SHC.
For further details see:
Sotera Health: Still Many Uncertainties With The Stock