Firstlight Management Calls on the Board of Directors of Sotera Health Company to Launch Sale Process for Nelson Labs
PR Newswire
NEW YORK, Dec. 18, 2024
NEW YORK, Dec. 18, 2024 /PRNewswire/ -- On December 3, 2024, Firstlight Management LP sent a letter to the Board of Directors of Sotera Health Company (NASDAQ: SHC) calling for a sale of its Nelson Labs subsidiary. The full text of the letter is as follows:
Dear Members of the Board,
As you know, Firstlight Management is a Utah-based investment firm founded by an alumnus of Tiger Management and Leonard Green & Partners. We are shareholders of Sotera Health ("SHC") and believe so strongly in the potential at the Company that it is our only position.
We believe SHC has an opportunity to create an enormous amount of shareholder value by selling Nelson Labs and we call on the Board to initiate a sales process. Such a transaction would have the following benefits:
-- Consolidation of SHC's portfolio around its highest-quality and
highest-growth businesses. While Nelson Labs should be a good business,
it has struggled under SHC ownership. Nelson has grown EBITDA over
2018-2024E1 at a CAGR of just 2.7%, well south of Sterigenics (9.8%) and
Nordion (8.2%). Free cash flow tells a similar story with Nelson Labs'
free cash flow growth clocking in at a meager 1.2% annually over
2018-2023.2 These results even include the benefit of $108m of cumulative
M&A spend within Nelson Labs without which growth would have been even
more anemic. Viewed in this light, not only have SHC shareholders not
earned their cost of capital on their Nelson Labs investment, they've
actually lost money in real terms as inflation has outpaced EBITDA
growth. The future does not look much brighter with market expectations
for Nelson Labs EBITDA growth to continue lagging behind Sterigenics and
Nordion (4.3% versus 7.0% and 5.5%, respectively, over 2024E-2026E3). The
contrast in performance is unsurprising. Sterigenics and Nordion are
dominant businesses in consolidated markets with near prohibitive
barriers to entry. Nelson Labs is a small player in a fragmented market
and, understandably, not the primary focus of the SHC management team. We
believe the market would look very favorably on a SHC portfolio that is
both higher-quality and higher-growth following a divestiture of Nelson
Labs.
-- Highlight the discounted valuation of SHC as a whole. As of this writing,
SHC is trading at 9.6x 2025E EBITDA.4 We understand that private market
appetite for testing, inspection, certification, and compliance
businesses like Nelson Labs is robust and that multiples in precedent
deals have averaged 15.2x EBITDA.5 A sale of Nelson Labs- a good business
but the least attractive piece of the SHC portfolio- at a large premium
to the existing business would highlight to the market just how
undervalued the higher-growth and higher-quality remaining pieces of the
business are and leave SHC remainco trading at just 8.9x 2025 EBITDA,6 a
valuation level that we would not expect to persist for long.
-- Significant de-leveraging. At 15.2x EBITDA, consistent with precedent
transactions, a Nelson Labs sale would generate $1.1bn of gross proceeds.
Based on a reasonable range of cost basis estimates and assuming SHC's
federal net operating losses can be used to shield taxes on a sale,
Firstlight believes net proceeds to SHC would approximate $1bn. At that
level, SHC's net leverage ratio would fall from 3.7x to 2.2x on 2024E
EBITDA and set SHC remainco on a path to a very modest 1x of leverage as
soon as 2026. This would have a number of benefits: it would create an
ample cushion for investors fearful of potential future litigation
damages; it would result in SHC's leverage ratios falling in-line with or
even below peer levels; it would insulate SHC's balance sheet from future
inflation and interest rate volatility; and it would create capacity for
management to pursue accretive M&A in its attractive core business of
sterilization- an especially compelling opportunity at the moment as the
industry suffers distress following widespread ethylene oxide litigation
and demanding NESHAP capital spending requirements.
-- Significant earnings accretion. With SHC currently paying nearly 8% on
its term loan, any sale of Nelson Labs at a free cash flow yield less
than that (which translates to an EBITDA multiple of 12x on our figures)
with proceeds going to pay down debt would necessarily result in earnings
accretion. At a precedent multiple of 15.2x EBITDA, Firstlight believes a
transaction would be 4% accretive to 2025E EPS7 ceteris paribus. However,
there would be a substantial additional benefit of SHC's overall tax rate
falling from the low 30% area today to a more typical mid-20% tax rate as
SHC's leverage levels fall and the Company is no longer penalized for
running afoul of interest expense deductibility limits. Assuming SHC's
overall tax rate falls to 26%, a level that is consistent with our
understanding of the Company's geographic earnings mix and consistent
with SHC management intimations, a Nelson Labs sale at 15.2x EBITDA would
result in a 13% lift to 2025E EPS.8
-- Increased management focus and improved performance of SHC's core
sterilization businesses. Firstlight suspects that Nelson Labs has
consumed an inordinate amount of management time and attention as they
have attempted to right the ship. This is understandable, but after eight
years of effort, and with management even acknowledging at SHC's Investor
Day in November that Nelson Labs/Sterigenics cross-selling has not played
out as hoped, we believe it's time for SHC to recognize that it is not
the best owner of Nelson Labs and redouble its efforts in sterilization.
Indeed, SHC has a golden opportunity to aggressively take share in
contract sterilization today as stringent new NESHAP facility upgrade
requirements push independent players to the brink and medical device
OEMs potentially accelerate outsourcing to third-party specialists like
Sterigenics. We would look forward to what a leaner, more focused
organization could achieve in this regard.
We believe that any one of these benefits on its own would be enough to make a compelling argument to divest Nelson Labs, but when combined the case becomes overwhelming. A Nelson Labs sale would result in a higher-quality, higher-growth business with substantially less leverage, higher earnings, and a more focused management team. The logic is compelling.
We would welcome a conversation with management if we need to be disabused of any misconceptions and, as always, we are happy to restrict ourselves in the stock and wall-cross if invited. Otherwise, we hope to see a public announcement for the launch of a strategic alternatives process for Nelson Labs.
Respectfully,
AJ Secrist
Managing Partner
(1) Based on consensus expectations.
(2) Free cash flow defined as EBITDA less CapEx.
(3) Based on consensus expectations.
(4) Based on consensus expectations. Excludes future potential litigation liabilities.
(5) Source: Houlihan Lokey TICC Market Update, Summer 2024. Based on 46 deals over 2020-2024.
(6) Based on consensus expectations. Assumes a 15.2x EBITDA sale multiple for Nelson Labs.
(7) Based on consensus expectations.
(8) Based on consensus expectations.
CONTACTS
Media/Investors
ajs@firstlightlp.com
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SOURCE Firstlight Management LP
(END) Dow Jones Newswires
December 18, 2024 07:00 ET (12:00 GMT)
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