Sotera Health (SHC) has received a welcome on the financial markets with shares up 10% on their first day of trading. Sotera offers a long-term reliable growth story, although that comes at a price in terms of elevated sales and earnings multiples.
The company’s core expertise, that of sterilization of everything related to medical products, is a service which is crucial and very much needed, and at the same time is a market which is hard to enter. Despite this “de-risked” business model, I believe that valuations are a bit too rich to create a compelling risk-reward here.
A 10 times sales multiple, but moreover realistic 40-50 times adjusted earnings multiple seems a bit rich, even after accounting for the low interest rate environment in which we find ourselves, as well as the single-digit comparable sales growth rates reported.
Safeguarding Global Health
The header of this paragraph is the mission of Sotera which is a leader in sterilization services, as well as lab testing and advisory services. The company provides these mission-critical sterilization services to both pharmaceutical and medical device companies, including leading names in their respective fields.
With an employee count of nearly 3,000 workers active across more than 60 facilities around the world, the company provides services to nearly 6,000 customers. With its Sterigenics brand, the company provides terminal sterilization services for its clients, as this act is the process of sterilizing the product in its final packaging. This function is very crucial and therefore often not just mandated but regulated as well
Sterilization services include procedure kits and trays, implants, catheters, wound care products and many other applications. The company provides a complete range: the three primary sterilization technologies which include gamma irradiation, ethylene oxide and electron beam irradiation, thereby offering services and methodologies across the board. These services are complemented by the Nelson brand through which the company provides lab services to its customers.
IPO & Valuation Thoughts
Sotera and its underwriters aimed to sell 46 million shares between $20 and $23 per share with the final price set at the high end of the preliminary offering range. At this level of $23 per share, Sotera raised $1.06 billion in gross proceeds with the offering.
With a share count of 277 million shares, the company supports an equity value of $6.4 billion at $23 per share. This underestimates the valuation of the company as the company operates with a pro-forma net debt load of $1.9 billion, and that is after incorporating the offering proceeds already.
This gives the company an enterprise value of $8.3 billion at the offer price. That is before considering the gains seen on the first day of trading as shares rose to $25 and change, boosting the enterprise valuation to roughly $8.9 billion.
Sotera generated $746 million in sales in 2018 on which the company reported an operating profit of $80 million, albeit pressured in a big way by a large impairment charge. Revenues rose a modest 4% in 2019 to $778 million, as operating earnings came in at $184 million last year, revealing a very profitable operation. This number even includes a $59 million amortization charge, as based on the 2019 performance adjusted EBITDA totaled $380 million.
It appears that COVID-19 does not have a big impact on the business, with revenues up around 4% so far this year, suggesting that sales might come in around $770 million this year. The company has further improved operating profits this year, running at a run rate of around $200 million, with EBITDA probably seen around $400 million.
Based on a net debt load of $1.9 billion, leverage ratios remain elevated at nearly 5 times, and that is after the gross proceed are used and earmarked to reduce debt. At these valuations, shares are valued at just over 10 times sales which is high given the mid-single-digit growth rates. These growth rates are not very convincing in my eyes, although solid for an established business.
The $200 million operating profit number will to a major extent be used to pay interest expenses, although lower relative leverage ratios and interest rates allow for a great reduction in this expense account. A 4% cost of debt, given the near 5 times leverage ratio, translates into a net interest expense of around $80 million, for a $120 million pre-tax earnings number.
If we account for some taxes, earnings might come in at $0.30-$0.40 per share, or about $0.20 per share higher if we adjust for amortization charges. If we add back the amortization charge and peg adjusted earnings at $0.50-$0.60 per share, multiples are elevated around 45 times earnings.
Other than a premium valuation and elevated leverage position, there are some specific risks tied to this business. One is that the company required Co-60 supply for many of its products, which it sources from nuclear reactor operators in Canada and Russia, as the nature of such operators and their facilities and political risks tied to Russia create some potential supply risks here. The nature of these solutions furthermore includes operational risks as well as stringent regulatory requirements, among others. While this creates risks, regulated industries create a barrier to entry as well.
On the other hand, sterilization is right within the focus not just because of COVID-19, yet the relative limited costs of such applications to the total costs of the products being sterilized, and significant improvement to the risk profile (hence, the reason why it is adopted in a big way, and often mandated) makes the underlying growth of the business look very promising in the long run.
Nonetheless, I think that the public offering is opportunistically timed. Given the pace of growth and leverage scenario, I think that the valuation is a bit rich in terms of revenue multiples and realistic earnings numbers as I fail to see a compelling risk-reward here.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
This content was originally published here.