Sotera Health Stock: Catalyst Changes, Compelling Investment (NASDAQ:SHC)

The following segment was excerpted from this fund letter.

Sotera Health Company (SHC)

When I initially sat down to write this letter, I planned to write a section on SHC that would have been substantially different than the one I am writing now. Only a few weeks ago, my thesis was primarily centered on SHC’s litigation, and I believed that SHC’s fundamentals, while excellent, were only a minor driver of the stock. However, in mid-January, SHC settled substantially all its worrisome litigation, sending shares up ~110% in a few days. Now, I believe there is little to talk about on the liability side, though I think the market has not fully processed the extent to which the overhang has been removed. Despite this quick reversal in share price and story, I continue to believe SHC is an excellent investment. While remaining bullish when a stock is up over 100% seems beyond the partnership’s value investing roots, I am not alone in my thinking. The below excerpt from a recent Wolfe note matches my thoughts:

Infrequently, a stock ~doubles and still could be undervalued by at least ~half. Following scrub of model, including add-in of expected borrow to cover proposed settlement, and fresh review of broader comp universe, we see a lot of room for this multiple to continue recovering as proposed IL settlement progresses to final and fundamental merits return as focus (i.e., substantial moat, real pricing power, favorable industry structure and trend, long-duration contracts). Stock seems better set up now than ever to be a ‘reverse LBO’ equity story which, based on our prior experience, is an attractive descriptor. We frame new $25 year-end 2023 target price as 15 times 2024 adjusted EBITDA. Versus our provisional range, we rolled time horizon forward and used high end of quoted multiples. Even still, room for the uber-bulls to squint and see potential for more.

To explain our SHC investment, I am going to walk through how I came across SHC, the business’ fundamentals, and my thinking on the liability. I will then explain why I think it remains a strong investment going forward. The fund also has a large presentation available upon request.

I originally came across SHC in the fall of 2021 when it was written upon a popular investment idea website. I was immediately drawn to the idea for two reasons: it seemed to be an excellent business and it had a legal liability, which I consider be an area of expertise. Regarding the business, SHC provides outsourced sterilization services for medical device manufacturers, where it shares a duopoly with Steris (STE). Med device volumes overall grow in the 4-6% range, with minimal cyclicality, and as a service provider to med device manufacturers, SHC does not take product design or reimbursement risk (i.e. the risk Medicare decides to lower the price they will pay), the two biggest issues that have previously stopped me from investing in the med device space. Further, SHC’s services are mission-critical, as you cannot sell an unsterilized heart stent, and changing sterilizers often requires FDA approval, yet sterilization makes up under 1% of med device manufacturers’ total costs. This low share of COGS combined with high switching costs creates substantial customer lock in, and SHC boasts a 100% renewal rate with top accounts while consistently pushing 3-5% annual price increases. The result is a business with 10% organic sales growth, de minimis cyclicality, and 50% operating margins.

Unsurprisingly, businesses with such favorable characteristics tend to trade at high valuations, and in fall 2021, SHC was trading at 25x forward P/E and 17x forward EV/EBITDA, though shares were at a discount to peer STE, which traded 30x forward P/E and 21x forward EV/EBITDA. While I have no firm rules for what multiple I will pay for a stock, SHC’s valuation was modestly higher than where I am typically comfortable initiating a position, though I do acknowledge some truly great businesses compound for years without ever getting much cheaper.

However, what truly gave me both pause and interest was the potential volatility surrounding SHC’s legal liabilities. SHC uses two primary methods of sterilization, ethylene oxide ((ETO)) and gamma radiation, and SHC had been sued at three EtO facilities following an unfavorable EPA report. The legal issues included personal injury lawsuits alleging SHC’s EtO caused cancers at two separate facilities in Illinois and Georgia, and the Illinois personal injury cases were scheduled to begin first in mid-2022. Illinois is one of the most plaintiff friendly jurisdictions in the USA, and Cook County, where the cases were filed, has made the Institute for Legal Reform’s list of the “Cities or Counties with the Least Fair and Reasonable Litigation Environment.”

As I have written before, I frequently look at securities with legal liabilities as I have previous experience investing in them and many investors simply lump all legal liabilities in the “too hard” bucket, regardless of what the specific liability is. After analyzing SHC’s legal situation, I came away largely agreeing with the bull case that the EtO litigation would ultimately prove manageable. However, as I wrote in my post on Sunday Idea’s Brunch I shared a few months ago, personal injury litigation when it gets to a jury is the highest risk moment in litigation analysis:

In my opinion, personal injury litigation is by far the hardest legal liability to estimate, and the highest risk situations are when litigation reaches jury trials in the USA. In US personal injury litigation, juries can award both compensatory damages for emotional suffering and punitive damages, which are arbitrary concepts that can result in staggering sums. You can debate the facts of a case all you want, but the reality is that once it goes to jury, if they come back with a big number, it’s a problem. Most of the legal liabilities that have materially impacted companies were personal injury litigation, such as asbestos and Round Up.

While I agreed the liability would be manageable, I found many buyside and sellside investors were a bit flippant in their dismal of the litigation, particularly given IL’s plaintiff friendly courts. It is one thing to look at the facts and conclude the science is on SHC’s side, but it’s an entirely different animal to understand statutory limits on punitive damages, litigation strategy, where the liability sits in a bankruptcy, etc. For instance, facing mass tort litigation, companies often intentionally bankrupt a subsidiary, and I wondered how many growth healthcare investors truly had the expertise to understand that losing nine-figure verdicts and then filing for bankruptcy can be an equity positive event.

Given my concerns on valuation and the litigation path, the fund initiated only a small SHC position in H1 2022 and I followed the litigation, looking to build a bigger position if there was a settlement and/or if the stock became materially cheaper. As fate would have it, SHC lost its first case in dramatic fashion, with a jury awarding the first plaintiff ~$350MM in compensatory and punitive damages, and SHC shares fell 60% in the following two days. While I will not go into detail here on my trading decisions and liability analysis, the fund built a substantial position during Q4. Again, partners are welcome to look at our presentation laying out my strategy and thesis.

Entering 2023, while aware a settlement could happen at any point, I had a strategy to track the cases as they developed, including counsel and “eyes and ears” in the courtroom, and I was contemplating working out of Chicago part-time to be in court on certain days. However, SHC and the plaintiffs settled virtually all IL litigation in mid-January, sending shares sharply higher. While the move is dramatic, I believe the market is still underestimating the degree to which the legal overhang has been removed.

The IL personal injury cases were, by far, SHC’s largest legal liability due to their size (~850 cases vs. ~300 cases in GA) and the nature of IL courts. The settlement resolves over 90% of cases in IL, and more importantly, the IL settlement was for roughly $400k/case, which was inline with my estimates. While future IL litigation is likely as some residents develop cancer at later dates, I believe there will be under 20 valid cases filed per year, which at $400k/case is immaterial in the context of SHC’s earnings, which I forecast to reach $700MM in 2025 EBITDA. Regarding GA, the state has a stricter standard of causation than IL, which the GA plaintiffs have not yet met, and punitive damages are capped at $250k/case in GA. Beyond these two cases, SHC faces no further personal injury litigation, thus I believe SHC’s legal risk going forward is no different than most American companies.

While SHC’s catalyst path has certainly changed, I believe SHC remains a compelling investment. SHC shares are now trading 17x and 14x my 2023 and 2024 EPS forecasts, and 12x and 11x EBITDA. While only a modest discount to the market, I believe SHC is a compelling growth story, and peer STE currently trades 23x 2023 EPS and 15x 2023 EBITDA. Further, SHC is 60% owned by GTCR and Warburg Pincus, two well respected PE firms who are highly incentivized to maximize value. As the legal resolution is better understood, I believe SHC shares are likely to reweight at least towards STE’s multiple while rolling forward onto 2024 estimates. If not, I believe GTCR and Warburg Pincus will eventually pursue a sale of the company, as private valuations for SHC have previously been substantially higher than SHC’s current multiple.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.