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The following segment was excerpted from this fund letter.
Sotera Health Company (NASDAQ:SHC)
In a vacuum, SHC screens as my ideal type of business: one half of a duopoly market with good long-term growth where the product sold is mission critical to customers, with high switching costs, yet the product’s cost is immaterial to their customers.
In the case of SHC, the company is one of two scaled outsourced providers of medical device and pharmaceutical sterilization services. SHC is diversified across almost all major medical device and pharmaceutical manufacturers, boasts a 100% retention rate with top customers, and has consistently grown sales at close to 10%. Further, sterilization represents ~1% of their customers’ cost of goods sold, and SHC has an ~55% EBITDA margin.
Normally, a consistent 10% growth story with 55% margins would trade at a significant multiple. Indeed, from when SHC IPOed in late 2020 until legal fears derailed the stock in fall 2022, shares consistently traded over 18x EV/EBITDA and 25x P/E, yet shares currently trade less than 12x my 2024 EV/EBITDA and 15x my 2024 EPS.
I believe a trifecta of headwinds has held SHC back since the settlement. Importantly, I believe those headwinds will largely abate in the next year or two, and that SHC’s multiple can normalize while the business continues to grow.
First, SHC slightly missed expectations due to destocking at medical device manufacturers as global supply chains normalized, a phenomenon seen in many industries. I believe this is the largest issue holding SHC back and I expect it to be resolved this year.
Second, med device stocks broadly fell last year due to fears surrounding GLP-1s’ impact on obesity-related medical procedures. While SHC is correlated with med device stocks, I do not believe GLP-1s will materially impact SHC’s volumes, as the risk is speculative, long-term in nature, and the “at risk” obesity-related portion of medical devices is under 5% of SHC’s overall mix.
Third, I believe many investors are still hesitant to invest in SHC in case the legal liabilities resurface. As partners know, I have invested in numerous companies with legal overhangs, but it is difficult for investors without relevant experience to believe the coast is clear, so to speak, even after the bulk of the storm has passed. This represents an opportunity to purchase shares in SHC at a discount despite its current litigation outlook being manageable and not too different from most companies’ legal risks.
A similar phenomenon has played out with our CC investment over the last five years. In 2019, a short seller simply pointing out that there was legal risk caused a 70% drop in the stock. In 2023, CC announced a massive settlement, followed by legal risks putting that settlement at risk, yet the stock did relatively little on the news in both directions. It takes time for people to digest litigation risk, and it is difficult to know precisely when they will. But eventually, they do, and I believe the normalization of SHC’s multiple to levels seen before its collapse in fall 2022 represents a significant catalyst.
I estimate SHC will earn $700MM in 2026 EBITDA and $1.50 in 2026 EPS. 18x EV/EBITDA and 25x P/E yields $37 versus the current share price of $15.
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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
