The next section was excerpted from this fund letter.
Sotera Well being Firm (SHC)
After I initially sat down to write down this letter, I deliberate to write down a bit on SHC that may have been considerably completely different than the one I’m writing now. Only some weeks in the past, my thesis was primarily centered on SHC’s litigation, and I believed that SHC’s fundamentals, whereas glorious, had been solely a minor driver of the inventory. Nevertheless, in mid-January, SHC settled considerably all its worrisome litigation, sending shares up ~110% in just a few days. Now, I imagine there may be little to speak about on the legal responsibility aspect, although I feel the market has not absolutely processed the extent to which the overhang has been eliminated. Regardless of this fast reversal in share worth and story, I proceed to imagine SHC is a superb funding. Whereas remaining bullish when a inventory is up over 100% appears past the partnership’s worth investing roots, I am not alone in my considering. The beneath excerpt from a current Wolfe word matches my ideas:
Occasionally, a inventory ~doubles and nonetheless might be undervalued by at the least ~half. Following scrub of mannequin, together with add-in of anticipated borrow to cowl proposed settlement, and recent evaluation of broader comp universe, we see a variety of room for this a number of to proceed recovering as proposed IL settlement progresses to closing and basic deserves return as focus (i.e., substantial moat, actual pricing energy, favorable business construction and development, long-duration contracts). Inventory appears higher arrange now than ever to be a ‘reverse LBO’ fairness story which, primarily based on our prior expertise, is a beautiful descriptor. We body new $25 year-end 2023 goal worth as 15 instances 2024 adjusted EBITDA. Versus our provisional vary, we rolled time horizon ahead and used excessive finish of quoted multiples. Even nonetheless, room for the uber-bulls to squint and see potential for extra.
To elucidate our SHC funding, I’m going to stroll by way of how I got here throughout SHC, the enterprise’ fundamentals, and my considering on the legal responsibility. I’ll then clarify why I feel it stays a robust funding going ahead. The fund additionally has a big presentation accessible upon request.
I initially got here throughout SHC within the fall of 2021 when it was written upon a preferred funding thought web site. I used to be instantly drawn to the concept for 2 causes: it gave the impression to be a superb enterprise and it had a authorized legal responsibility, which I think about be an space of experience. Concerning the enterprise, SHC offers outsourced sterilization companies for medical gadget producers, the place it shares a duopoly with Steris (STE). Med gadget volumes general develop within the 4-6% vary, with minimal cyclicality, and as a service supplier to med gadget producers, SHC doesn’t take product design or reimbursement danger (i.e. the danger Medicare decides to decrease the worth they’ll pay), the 2 largest points which have beforehand stopped me from investing within the med gadget area. Additional, SHC’s companies are mission-critical, as you can’t promote an unsterilized coronary heart stent, and altering sterilizers usually requires FDA approval, but sterilization makes up beneath 1% of med gadget producers’ whole prices. This low share of COGS mixed with excessive switching prices creates substantial buyer lock in, and SHC boasts a 100% renewal fee with high accounts whereas persistently pushing 3-5% annual worth will increase. The result’s a enterprise with 10% natural gross sales development, de minimis cyclicality, and 50% working margins.
Unsurprisingly, companies with such favorable traits are inclined to commerce at excessive valuations, and in fall 2021, SHC was buying and selling at 25x ahead P/E and 17x ahead EV/EBITDA, although shares had been at a reduction to see STE, which traded 30x ahead P/E and 21x ahead EV/EBITDA. Whereas I’ve no agency guidelines for what a number of I’ll pay for a inventory, SHC’s valuation was modestly larger than the place I’m usually comfy initiating a place, although I do acknowledge some actually nice companies compound for years with out ever getting less expensive.
Nevertheless, what actually gave me each pause and curiosity was the potential volatility surrounding SHC’s authorized liabilities. SHC makes use of two major strategies of sterilization, ethylene oxide ((ETO)) and gamma radiation, and SHC had been sued at three EtO amenities following an unfavorable EPA report. The authorized points included private damage lawsuits alleging SHC’s EtO precipitated cancers at two separate amenities in Illinois and Georgia, and the Illinois private damage instances had been scheduled to start first in mid-2022. Illinois is without doubt one of the most plaintiff friendly jurisdictions within the USA, and Prepare dinner County, the place the instances had been filed, has made the Institute for Authorized Reform’s record of the “Cities or Counties with the Least Honest and Affordable Litigation Setting.”
As I’ve written earlier than, I continuously take a look at securities with authorized liabilities as I’ve earlier expertise investing in them and lots of traders merely lump all authorized liabilities within the “too exhausting” bucket, no matter what the particular legal responsibility is. After analyzing SHC’s authorized scenario, I got here away largely agreeing with the bull case that the EtO litigation would in the end show manageable. Nevertheless, as I wrote in my put up on Sunday Idea’s Brunch I shared just a few months in the past, private damage litigation when it will get to a jury is the best danger second in litigation evaluation:
In my view, private damage litigation is by far the toughest authorized legal responsibility to estimate, and the best danger conditions are when litigation reaches jury trials within the USA. In US private damage litigation, juries can award each compensatory damages for emotional struggling and punitive damages, that are arbitrary ideas that may end up in staggering sums. You may debate the info of a case all you need, however the actuality is that after it goes to jury, if they arrive again with an enormous quantity, it’s an issue. Many of the authorized liabilities which have materially impacted firms had been private damage litigation, equivalent to asbestos and Spherical Up.
Whereas I agreed the legal responsibility could be manageable, I discovered many buyside and sellside traders had been a bit flippant of their dismal of the litigation, significantly given IL’s plaintiff pleasant courts. It’s one factor to take a look at the info and conclude the science is on SHC’s aspect, however it’s a completely completely different animal to grasp statutory limits on punitive damages, litigation technique, the place the legal responsibility sits in a chapter, and so on. For example, going through mass tort litigation, firms usually intentionally bankrupt a subsidiary, and I puzzled what number of development healthcare traders actually had the experience to grasp that shedding nine-figure verdicts after which submitting for chapter will be an fairness constructive occasion.
Given my considerations on valuation and the litigation path, the fund initiated solely a small SHC place in H1 2022 and I adopted the litigation, trying to construct a much bigger place if there was a settlement and/or if the inventory grew to become materially cheaper. As destiny would have it, SHC misplaced its first case in dramatic style, with a jury awarding the primary plaintiff ~$350MM in compensatory and punitive damages, and SHC shares fell 60% within the following two days. Whereas I cannot go into element right here on my buying and selling choices and legal responsibility evaluation, the fund constructed a considerable place throughout This fall. Once more, companions are welcome to take a look at our presentation laying out my technique and thesis.
Coming into 2023, whereas conscious a settlement may occur at any level, I had a method to trace the instances as they developed, together with counsel and “eyes and ears” within the courtroom, and I used to be considering understanding of Chicago part-time to be in courtroom on sure days. Nevertheless, SHC and the plaintiffs settled nearly all IL litigation in mid-January, sending shares sharply larger. Whereas the transfer is dramatic, I imagine the market remains to be underestimating the diploma to which the authorized overhang has been eliminated.
The IL private damage instances had been, by far, SHC’s largest authorized legal responsibility as a consequence of their measurement (~850 instances vs. ~300 instances in GA) and the character of IL courts. The settlement resolves over 90% of instances in IL, and extra importantly, the IL settlement was for roughly $400k/case, which was inline with my estimates. Whereas future IL litigation is probably going as some residents develop most cancers at later dates, I imagine there might be beneath 20 legitimate instances filed per 12 months, which at $400k/case is immaterial within the context of SHC’s earnings, which I forecast to achieve $700MM in 2025 EBITDA. Concerning GA, the state has a stricter normal of causation than IL, which the GA plaintiffs haven’t but met, and punitive damages are capped at $250k/case in GA. Past these two instances, SHC faces no additional private damage litigation, thus I imagine SHC’s authorized danger going ahead isn’t any completely different than most American firms.
Whereas SHC’s catalyst path has definitely modified, I imagine SHC stays a compelling funding. SHC shares are actually buying and selling 17x and 14x my 2023 and 2024 EPS forecasts, and 12x and 11x EBITDA. Whereas solely a modest low cost to the market, I imagine SHC is a compelling development story, and peer STE at present trades 23x 2023 EPS and 15x 2023 EBITDA. Additional, SHC is 60% owned by GTCR and Warburg Pincus, two effectively revered PE corporations who’re extremely incentivized to maximise worth. Because the authorized decision is healthier understood, I imagine SHC shares are more likely to reweight at the least in direction of STE’s a number of whereas rolling ahead onto 2024 estimates. If not, I imagine GTCR and Warburg Pincus will ultimately pursue a sale of the corporate, as non-public valuations for SHC have beforehand been considerably larger than SHC’s present a number of.
Editor’s Observe: The abstract bullets for this text had been chosen by Looking for Alpha editors.