Chris McIntyre thinks Sotera is an incredible business at a good valuation $SHC (Episode #154)

Chris McIntyre returns to the podcast to discuss Sotera Healthcare (SHC; note that this episode is sponsored by Daloopa and they have a very in depth SHC model available), why he thinks it's such a good business, and why he thinks the stock is still undervalued even after a big run in the wake of putting their legal liabilities (largely) behind them.

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Transcript begins below

Andrew Walker: Alright, hello and welcome to Yet Another Value podcast. I'm your host, Andrew Walker. If you like this podcast, it would mean a lot if you could rate, follow, subscribe, review wherever you're watching or listening to it. With me today, I'm happy to have on I believe for the 3rd time, my friend, Chris McIntyre. Chris, how's it going?

Chris McIntyre: Good, good. How are you?

Andrew: Doing good, man. Excited to have you back. Let me start this podcast the way I do every podcast. First, a quick disclaimer to remind everyone that nothing on this podcast is investing advice. We're not financial advisors. Please do your own due diligence, consult a financial advisor, whatever you have to do. Let's jump right into the stockroom and talk about on for the 3rd time. We started talking about doing a podcast on this in December, which might have been slightly more timely. But I still think - I mean, I know you would agree - it's still a super interesting company. I think there are some headwinds to maybe like the trading price, they get resolved over time. I think there's a really interesting opportunity. But I'm putting words in your mouth. I'll just turn it over to you. The stock we're going to talk about today is Sotara Healthcare. The ticker there is SHC, and flip it over to you. What's so interesting about it?

Chris: So I think the high-level trader talk pitch for it is Sotera Healthcare is a high quality business that had a legal liability to draw the stock down tremendously. So it was something like $30 a share almost in early 2021. I guess it is more like late 2020s, whatever exactly. It was $30 a share somewhere in this period. They had a legal liability to draw the stock all the way down to like 7 to 8 dollars at the start of the year. It's now a hundred percent year-to-date. You and I were both involved before the hundred percent move so just pointing that out.

Andrew: You might have been involved a little bit heavier than I was. I was involved, but you were involved and I'm thinking to myself not yet.

Chris: Yeah, the kind of [inaudible] So it's had this big re-weighting, but behind it, as much as we can say that the legal liability probably was exaggerated in the first place, it's very much a clearing event. And it's a much cleaner, easier to understand story, but it still is not re-traced all the way back to where it was. And underneath, what you're getting is a super high quality compounding asset. It's a healthcare and market-exposed stock without the risks that are I think higher on most healthcare investors lists, like payor risk and product cycle, and things like that. And so it's really like a stable 10 to 12% top-line grower, 50% margins, no real economic cycle, and currently trading. We could talk exactly about what the right way to think about those earnings versus EBITDA, something like 12 times EBITDA. I would say something like 16 times real owners' earnings for an asset that a comp group is more. As far as I'm thinking about, most people that listen to this podcast all the time like some sketchy special situation, off the beaten, that kind of stuff. But a comp group for an asset like this is really the stable [inaudible] and IRA typically trades 25, 30 times earning stocks, but they don't really ever stop growing because there's no real reason they're expected to stop. And so I think it's a really interesting opportunity to get long, sort of a funky security that is actually just not that funky at this point. And it's just a really high quality business. And so what you do is you get to clip this sort of like 10 or 12% top-line growth. Theoretically, its current price would be [inaudible] kind of set up with those strong, I think re-way catalyst in the next 6 to 18 months, something like that, where I can get in line with the peer group. And so this is like an example, when all the post IPO, like price targets came out and what people were using, people were slapping like 25 times EBITDA bull targets of like $50 a share, exiting like 2023. We're at 16, 17 so we're nowhere near like what the bull of bulls would have thought about this asset before the legal liability started. And I think when you think about the pitch, I think there really is like 2 different size of the pitch. Like one of the pitches is understanding the legal liabilities, whereas the simple pitches, they're kind of wrapped up in much easier to understand now. And then the second pitch is like, this is actually a really good business and here's how it's going to grow and compound, and why it's going to grow and compound.

Andrew: Perfect. So I think that we'll visit the legal in a little bit, I mean, if you and I, again, if we had been doing this podcast 2 months ago, the legal would have been front and center, and then we would have talked business. At this point, the legal is about to wrap up, as you said, the stocks up, it's more about understanding the business. I don't know if this is the best business in the history of the world. But when I wrap up the combination of the pricing power, the stickiness, the economic insensitivity, the moderate growth, it actually kind of is hard for me to imagine that there's a better business than this, once you wrap all those characteristics. So I want to ask you, what is the business and why do and I both think this is such a good business?

Chris: So Soltera Healthcare is 3 separate kind of divisions that are somewhat related but not totally related. But the main division, which is roughly, say, 70% of profits - and I think is the reason to be the most excited about the company - started with a revenue at 70% of profits. Right around there, that kind of general mix, maybe a little bit. The margins are slightly higher in the center. But what it does is - you know Sterigenics? Sterigenics is an outsourced sterilizer of mainly med devices, but also some pharma and a little bit of others and stuff. And so, the simple, high-level pitch is what you get is med device growth, which is say like units, 5, 6. So it's like a GDP 1.5 to kind of 2x growth start. So when people say biomedical revolution, we're all going to have artificial limbs and live to be 300, I hope. That sort of like, you know, above-market secular growth story is med devices, right?

The typical problem you have in med devices, though, are two-fold. So there's some really interesting good things in med devices, but it becomes a much harder business to wrap your head around for two reasons. One, there's like payer risk. So the government is a huge supplier of insurance through Medicare and Medicaid, and sometimes they change the price. And so, like overnight, sometimes you have these things where it comes in and it's like, "By the way, we're paying 20% less." This is a difficult market. You also have product risk, meaning what is the next gen heart center going to be and is this company going to execute or are they going to lose market share? And so these two things make this kind of space a little bit more challenging to invest in.

Andrew: Just throw one more liability risk too, right? You mentioned heart centers, it can turn out 2 years later, you find out, hey, every heart center you did, you thought the battery lasted 5 years, it lasted, 2 years, and you're massively liable for all these heart attacks. Like, you can invent a lot of different things, and you might laugh but I can point you to several examples where companies have come and said, "Hey, it turns out every installed product we've ever shipped is effective and we are going bankrupt because
we have to pay all of these [inaudible] liability claims.

Chris: Yup. Okay, so that's the difficulty in that space, right? But everyone's attracted to the space because the above market growth and also, because there's no real cycle, right? Like need a heart center or you need a emergency, surgery or whatever. It needs to happen and there's no economic cycle and so you get the growth without any real with, you know.

Andrew: Yep.

Chris: If interest rates move 2% heart centers volumes will not matter, it doesn't matter.

Andrew: [inaudible] You might give a couple people heart attacks and maybe
[inaudible]. increased. Yeah.

Chris: Yeah, yeah. But so because that's like the challenge in the medical space but what these guys do is they just sterilize the devices and so I'll get into the algorithm a second but I'll explain what the sterilization is...

Andrew: Perfect.

Chris:.. for the process and what happens is this medical device company, Johnson and Johnson, let's just say, Striker, whoever exactly makes these products and then they need to get them to market. So they got to ship it to a doctor's office or a distributor, or a hospital reverence going, right? But before they do that, they have to prove to the FDA how they actually made sure that there's not bugs all over this stuff, bacteria, viruses, mold, whatever exactly, right? So what they did, was they physically make the device, they loaded on a truck and then they drive it. They neither [inaudible] source, sterilize it themselves or the industries roughly a little over 50% outsource and what they do is they drive it to one of either Staris, which is the other side of the [inaudible] also sterilize facilities. And in that facility, they sterilize it using either gamma rays or something called ethylene oxide- which we'll talk about later when we talk to legal liabilities - and the device gets clean there and basically gets put back onto the truck and then the med device company actually delivers it to the thing. So, Tara takes no or Sterigenics specifically, takes no delivery risk. They take no product like, is this a good product or a bad product? Or is it going to lead market share vote, it takes none of that actual risk. And so, as a duopoly setup market, they also don't have a real competition angle. We can talk about why there's not competition in space, but there's really only 2 players.

And so what you get is, you get Med device growth, you get a little bit more trend towards outsourcing because the industry is say, 55% outsourced, which is 7% now. And a decade ago let's say 40%, I forget exactly the numbers but that's roughly the ballpark. And so you get like a little bit extra unit growth from the outsourcing trend and then they take 3 to 5% price and it's just really one of these like clean businesses where it's very hard to see how that end market doesn't keep growing. And it's also very hard to see how competition would actually come in to serve these products. So, just the high level stats that I was going through before this. They have a 100% renewal rate with their top 10 customers or 25 or whichever one that is disclosed. Contract length is something like 3 to 5 years. Eighty percent of their clients use more than one facility and over 50% use 5 or more. So, you're really built into these guys' networks. And the other thing also think about is that heart center, I [inaudible] out the average price of a heart center, something like $13,000 across some agency that's trying to complain that hospitals jack up rates but the statistic out there, right?

You might be paying $1.70 to sterilize it and so there's no real financial incentive for someone to switch sterilizers. Your build into their network and so it's difficult and on top of it, you need to get FDA approval for how you're going to do it. And so one of the biggest problems is, I forget which water is it, a class 1, 2 and 3 like med devices I forgot which one is the complicated one and which side is the less complicated like gauze or syringe or something. But for all them, you're written into it and the complicated ones you written into it. And it takes 6 months minimum if not a year plus to actually switched fires which has a two-fold. We get into some details here but like a two-fold like benefit to the business which is one, no one ever switches and two, you need to offer redundancy if you want to bid for larger contracts. If I'm the CFO or head of sterilization or whatever, for Johnson & Johnson, I don't want to have 70 different contact people. Having one or two is ideal for me to simplify my world, right? And so there's really only 2 people, I mean not really. There are only 2 people who can offer redundant things. Is the point being that like if there's an earthquake or a storm or a fire or something happens in one of the facilities that we are using to sterilize our heart centers written into the FDA approval, will be the elder backup alternative facilities that we can then ship product to so we don't have to pull the product from market.

And so if you're looking about from the competition angle, if we get together and we raised a hundred million dollars to open one of these facilities, right? [inaudible] is like, we're not fit for one contract, may be to start it, but we can't offer redundancy and it just becomes this very complicated thing and then also just to round out a little more on the contract side or the business side, they actually run [inaudible], Sterigenetics runs the facilities basically 24/7. So they take deliveries at 3:00 in the morning like literally on Sundays and the in-house provider, if you wanted in size or Johnson Johnson, we have staff at our facility, we are not going to be able to run those because [inaudible] volumes to run them 24/7. So like not only is it more redundancy built into the network, it also is actually cheaper because they're going to have the same basic machinery running 24/7 instead of running 40% of the time and so you basically like have a huge customer lock-in and it's also cheaper literally. We'll see where pricing goes over a period in time whatever. But like it's just this whole, it hasn't just a great momentum around it and a lot of like barriers and moats and so this business is one of the more bankable. It's hard to know what will happen in 10 years but the med devices are up, I think it's highly probable. [crosstalk]

Andrew: ...sterilizing med devices is also highly probable.

Chris: It's hard to imagine that we're not doing some version of all this and nothing happening that would delay the trajectory really of like this 10% top-line growth, if anything it's accelerating because their current growth investments but yeah.

Andrew: That was an absolutely great overview. You hit on many of the angles that I wanted to in the MOD section. I mean, hopefully people, if they're listening, they can understand why we think it's such a good business, right? Because of everything you said, but I just wanted to pull a little bit more on the why so hard for a new build competitor to come in because I think this will also help us transition into a little bit of the growth and the growth capex angle and if you build a facility it's all about utilization, right? So if you and I went and built a facility or these guys are out there building new facilities right now, it's not just that you can't go to Johnson & Johnson and say, "Hey, all the gauze that you're giving, or all the hips that you're getting sterilized at one of the Sterigenics facilities, switch them over to us." They can't do that because they have to interrupt their supply lines, get an FDA approval. It's not just that, you have to go get new product so you have to build out these things. So if we want to build something, we'd have 0 capacity. So do you want to talk about, when they're doing their growth cutbacks, how they get the facilities with build and how they know that both capex is going to have things to sterilize there? I think I kind of jumped into a few places but I think you see where I'm going.

Chris: It's a little bit odd to me. To me, they basically are built out of soda because they have all the relationships and all the network and everyone sort of knows them and they're just like, " This industry is [inaudible] sold out right now." And so they need to brought that back.

Andrew: I guess where we're trying to go is when they say, "Hey, we're going to build a new facility." What they've done is they've pre-sold and you can correct me if I'm wrong or feel free to jump in at any time from, they basically pre-sold, I think it's 50% of the capacity before they even put roots in the ground, right? They've got Johnson & Johnson and they say, "Hey, it's 2023. We're going to start building a facility. It is going to come online in 2025. We think we can do a 100,000 units per day in this facility. Will you take 10,000?" Johnson & Johnson says yes and before they even start building, they've got 50,000 units of the 100,000 sold and I was saying, if you and I went and did that, we wouldn't have the relationship so we basically have to spec build a sterile facility because Johnson & Johnson is not going to come and do it and agree to future products with us. So that's kind of where I was driving at, maybe I was just being a little bit too cavalier on it.

Chris: No, no, it's true. I feel like I'm over selling my talking about from the competition, which is like a weird way to phrase it but you're like dealing
with a very small amounts, right? So, there are some startup x-ray facilities, which is like, 1% of the market. So it's like a really tiny part of this market, right? The [inaudible] tried to find a guide, I have one contract to take 25% of volumes but the reality is like, it's hard. It's got to be super, not that critical, and on top of it, when these guys do their growth cutback they absolutely are like, "It's booked." They are booked with enough room. They have a plan for like how we're going to grow and expand our footprint over 5 plus years, 10 years, whatever. But, we're not executing on all the 10-year plan at the same time, so they actually are sold out just starting, the industry is actually really quite tight right here which is why [inaudible] at some point in this. But like it does sound like if anything the 10% I think, constant currency sales are going like 10 point forward something that. It could maybe get up towards like 13, 14 in like a couple years, just price plus volume growth. But yeah, they're deeply sold out. The other thing to think about too, because I think a lot about like it's like that buffeting. Like if you had a billion dollars, could you get in there whatever size dollar amount saying, right? But in this industry too, if you think about it, it's extremely niche.

And so there's not that many people that actually are employed in and have the knowledge to literally help you build it out. So even if we raised a billion dollars and we were going to build 10 plants on spec or 12 or whatever that math comes out to, I know that Cetera says, I can build 1.40 million but we might not be as good at it and what ever you want to talk about, but if you knew you could do it, which is like a long shot, moonshot pitch you know what I mean, it's hard to see how it happened. I don't know that you could literally staff the facilities to create the 3rd competitor, you know what I mean? It feels like an impossible task, and it might literally be an impossible task to actually do it.

Andrew: And as you said, like, Johnson & Johnson, the cost of this thing is a dollar, right? How are we going to get them to commit to us where we're going to go, "Hey you're sterilizing stuff for a dollar per unit, we'll do it for 95 cents!" and Johnson & Johnson, it's that famous thing. "Oh yeah, we're saving money on safety, saving 5 cents per unit on a thousand dollar unit is
absolutely nothing." But the downside is, we ship it to Chris and Andrews bootleg sterilization and they can't get it done. So, we're not selling these thousand dollar units or even worse, they forget to sterilize it. And there's like, a hip implant into somebody that's got bacteria on it. It's just one of those things, the down side versus the up side versus the cost. It's going to be really hard and Chris and Andrew have a lot of background and a lot of money. It's just going to be really hard to get somebody to agree to go to a new startup competitor.

Chris: Yeah, which is why it seems like a pretty cushy duopoly.

Andrew: Yep. I'm trying to remember the quote from the queue for call but I think the CEO said, since I got here in 2006, we've got like 15 years track record of made single digit plus organic growth, I think they're long-term algorithm if you will, is about 10% growth coming from some pricing in some volume. Do you want to talk about just that 10% growth, the pricing, the volume? Particularly, I think the pricing because that's the most interesting part of the story.

Chris: Yeah. So, they give blended guidance across the 3 segments when they say pricing, right? Because they got to like 3 to 5% pricing with like one of the segments being at the high end, one of the other segments is in low end and Sterigenics being in the middle. We should talk about the other segments at some point, but they're good, but not nearly as easy. But I think that the argument around pricing which ties into the legal liability is there's a capacity shortage because of some of the legal liability stuff and ethylene oxide which is half from the industry about [inaudible] because of that legal liability, there's just going to be a real hesitancy to see any more in sourcing and if anything, an acceleration towards outsourcing. So, capacity constrain are more demand than ever, 2 players regulatory burden going up equals better pricing over time. It's not much more sophisticated a thought than that.
We'll see exactly how it rolls through. I think to them, they want to keep their relationships on the right pace. So I don't anticipate them jacking prices 10% and inviting turmoil, they might be able to but to me, I think of anything like you could definitely see it over time. I mean, if you do the consultant calls, right? People are like yeah, no one wants to do this anymore and they're happy to pay the 2 cents extra to not run the legal liabilities because anything about it like the quote, "Does it make your beer better?" Like the Anheuser-Busch, which Amazon loves but sterilizing a hard stand in-house by Johnson & Johnson is not their core competency they don't know about it. There's these lawsuits, that [inaudible] just had to pay 400 million dollars. There's not a whole lot of reason to push back on price and there's not any real competition. And so I'd absolutely think over time pricing going up, is part of the story.

Andrew: Yep.

Chris: At this price, you don't have to believe that to [inaudible] it's definitely a part of the story.

Andrew: A year ago the pushback would have been, "Hey, they lost it legal case." and we'll get to the legal case in a second because it is important to go forward story, but some of the push back a year ago when they lost legal case and bankruptcy turmoil, all the sort of stuff, I think the first push back a lot of people would have when they look at this idea is they're going to say is, "All right, Andrew-Chris, great." I'm convinced this is a really good story. It's a really good business, but it's treating low teens EBITDA. I'm kind of looking at my 2020 numbers about 20 times unlevered free cash flow. There is some growth capex there we can talk about. But people might say, "Hey Andrew, Chris, this isn't early 2021 anymore right? 20 times unlevered free cash flow for a great company like that about fairish." And so people would probably say more, what's the opportunity cost of me buying this versus something else? Am I really going to generate a lot of alpha at kind of that valuation? How would you talk to people about that?

Chris: I point people towards 2 directions. One of which is like, okay so we're walking through that math, this is roughly speaking like trading in a market multiple, [inaudible] right? The stock market does not have a 50% operating margin with 10% top-line growth and no discernible learning cycle, that is not what the US stock market looks like. [inaudible], pure long, short paired off market neutral beta whatever you want to call a book, right? Like long $100 it [inaudible] short $100 of SPY, I think as an absolute alpha value add trade just let alone that. The second thing I point people towards 10% top-line growth and 50+% operating margins is Visa, and let's call Visa, Mastercard, where everyone agrees are great businesses that grow forever, and we all understand why because we're going from cash to not, right? With no competition of those two. But I think Visa trades right now is something I haven't written down over here. The trades I believe it's like 28 times forward and like 20 plus times EITDA. The margins are slightly higher though it's like 65% or something but like that's kind of thing. And so, I think a lot of guys who spend some time looking at off the run sort of value stuff end up looking at companies that aren't nearly as high quality as this, right?

And so it is the clouds like a lens because you're like, well, why I couldn't buy this offshore oil servicer for 3 times EBITDA on you...

Andrew: Hey, hey Chris, come on. Don't call anybody out on the potty.

Chris: [inaudible] point but like this is not a business that's going to see like down 50 EBITDA every now and then you know what I mean? That's not part of this business. And so, the peer group for this to me is like, Moody, Cintas, Echo Labs, Rollins like these, Eurofins, which is a different, it was a very comparable story actually trades in Europe, but Europeans has a margin insurance, but there's a company called Stericycle. Stericycle, ran out of growth [inaudible], but like these things can pound at a high rate for a long period of time because they're growing revenues 10 plus percent. And they're also not the hyper-growth ones where there's gonna be a rapid competition out of nowhere, right? You're not going to have a tick tock show up out of nowhere and just blow up potentially the market. And we're like, "Oh, I thought there were 3 players now." That's not like what's going to happen here. This is a slower but still well above GDP growth, kind of company. And so to me, the right peer group is there and I think it's very, very likely it will ultimately re-way towards like 24 plus times earnings. I think it's a very high probability and so part of my thesis is making that bet, but even if it weren't, we can talk about when I go to sleep at night, feeling safe about or whatever, however I'm supposed to be phrasing that. But this is definitely not a business that anything happening in the world is gonna like freak you out about "What is actually happening here? Is this business going to implode or anything like that?" It's not one of those businesses and so I am absolutely just happy to sit here and clip my 6% let's say, levered free cash flow return plus, my 11% top-line growth EBITDA whatever.

Andrew: And one of the things you said in there, like look, this is trading at about average market multiple, as you said, like a Visa or Mastercard trade for 5x returns of the multiple-ish that these guys trade for. Marriott and Hilton, probably the same thing and like Marriott and Hilton had economic sensitivity and there's the risk 2 years ago, everybody was "Airbnb, was going to take him down." They are competing in a oligopoly not a duopoly. Visa and MasterCard,18 months ago, I've already said, "Bitcoin and all these crypto players are going to take over." There is some technological risk with SHC, with serialization as you laid out duopoly, these things are locked in. It's really hard to say that there's any technological risk. I know some people have talked about some things but there's a reason we use ethylene oxide, it's very difficult to sterilize a lot of these things in mass as cheaply as we do. It's just hard to see anyway this business goes away. As you said, if all that takes through the downside and the upside is you've got a 5 or 6% bond, that's growing 10% plus some of that I said, "Another free cash flow. That's all the capex are going to do this year. They're investing capital. We can talk about how good the returns on capital they think when they build a new facility, how that drives growth" The downsides taken care of so there should be pretty good upside down over there.

Chris: Yeah, that's right. Someone is commenting on Twitter, but obviously had done work I have like a nice little word about it. But it talks about if ethylene oxide gets replaced [inaudible] but even though it's like all the scenarios, the minimum is a decade. There's no rapid change happening here unless a miracle curse. Whatever you think about like Visa and Mastercard, there are tons of players in payments and tons of turnover and tons of little parts that are changing at any given time and lots of growth capex going into it or venture capital dog or however you want to phrase it, those markets are inherently much more competitive than what you're looking at here. There's not a lot of demand for a third player and there's almost no scenario that a third player comes along. It took a long time to wait for this industry to evolve in this way and it's kind of like one of those things where, like, it's sort of like Moody's, right? Where it's like, I don't know. This is actually worse because I actually don't think there's any real argument that Cetera and Stericycle battering and heavily Moody's people are like, maybe it could be a better system but like it's hard to imagine anything replacing it now and so that's what we're going for. And so it's hard to really imagine how something comes in, which is a very valuable commodity in my opinion. And so, I understand people not willing to bank on 25X plus earnings multiples, right?

And frankly, if this thing reweights to 30X tomorrow like McIntyre Partnerships has someone shares for sale for anyone looking to purchase that price. But it's just a rare commodity and it's very rare I think to get a shot at these sort of type businesses, like at anything resembling a reasonable multiple. You almost always have to pay up for it and so what you end up injecting when you have that strategy, is you end up injecting one at lowers the return to the capital returns are inherently lower by being at higher multiple and then two, if you get it wrong you lose a lot more money. That's the problem. We find something 35x and it turns out that there's actually a pricing problem and suddenly, it's like 14x, that's like a down 60 on a downer, that's a huge blow up.

[inaudible] going to trade like commodity chemical multiples, like 12x. So I just think it's a as much as its up and I appreciate that people don't like to buy things up, that's like the opportunities that people don't like to buy things up and that's why it's still attractive.

Andrew: I agree and I think there's also when the legal liability was out there,
it was very difficult for anybody who wanted to buy a great business to be here. We should start shifting and talking about legal liabilities. Yeah. A couple months ago you had to be a legal analyst to be involved here. Now even though it's 2 months after the decision, the settlement got made, I do think there's still a, if you're looking to invest in a great company, you probably want the settlement to could be completely done, not 99% done and we'll talk about completely done the second, but be there so probably a flip of the people who bought the shares like at the height of the crisis. There's still probably some shares to get sold this stock. We probably should talk about ownership, is it only 33% or so, but float? So maybe the largest fundamental guys this isn't the top of their list, they'll get around to it eventually. So I still think you've got a tail wind as the hands transition to where they should go but let's switch over to the legal liabilities. We've alluded to them on. Why don't you give a brief background of what these are? What happened? How this resolved earlier this year? And what this looks like going forward.

Chris: Sure. So you think I should do like the historical perspective on how I got here or I should I do like an asset by asset?

Andrew: We probably don't need to start in the 80s asset by asset but probably just focus on what the government said few years ago, how that impacted Illinois and what happened last year and this year?

Chris: Sure. So ethylene oxide is one of the ways that they sterilize stuff. The other ways are gamma rays, which they make pencils, you take the tip off in a blast radiation at and they like run with conveyor belt under them, literally kind of what you're doing. And then you have ethylene oxide knows how to e-beam, which is kind of same thing as gamma ray. And then of ethylene oxide, which is a gas basically what you do is you take a pallet of whatever med device, you stick it in a chamber, you close the doors, you fill it with, I believe I actually filled it with nitrogen and then they insert a little ethylene oxide gas into the chamber and so ethylene oxide is like a pesticide. It's a toxic gas that kills things, right? So you stick it in the chamber and its really useful because it goes through plastic packaging. You fill the chamber with it and then you let the gas burn off and then you take the proper stuff out and it's clean. What happens is, ethylene oxide is a known carcinogen. It's a dangerous substance. You use it to kill stuff, right? And so people study this stuff all the time, so there's all kinds of [inaudible] guidelines around like what are the hours? How much exposure do you have? How do you clean it? And it's mainly that study for the whole history of the industry has been focused on, the safety for workers. It is also explosive too. So there's a lot of rules and regulations trying to protect people from using stuff.

Andrew: And just going back, when we talked about what a good business it is, we didn't talk about, "Hey, they're dealing with the carcinogen explosive poison" that adds a lot of regulatory burden that increased, the moat where Chris and Andrew, you probably aren't going to be able to start up a business and compete with these guys.

Chris: Yeah, exactly. What also happens though, is in the background of that is some of the ethylene oxide ends up emitted into the air around the facilities, right? And ethylene oxide is naturally occurring actually, so it's in particularly, exhaust fumes. So I'll put a pin it right here in this moment. You're in Manhattan, right?

Andrew: Yep.

Chris: So we're actually being exposed to more ethylene oxide than people
on this lawsuit were supposed, just as a side note. I'll take the pin out right there. So it's naturally occurring, it's all around. So there's always a background level of on ethylene oxide. But over time, the EPA was very concerned with all carcinogens, this is obviously something you'd be looking at. Thankfully, we live in a country that has good safety ratings like no one wants poisoned water, and all that kind of stuff, but what they did is in 2016, they did a study and they basically tried to conduct an estimate of expected cancer cases due to ethylene oxide in the environment around certain facilities, right? And we can talk about the study in a second, but what it did is it effectively kind of like put notice that like, "Hey, maybe we need some stricter safety ratings around emissions from these plants and I think it took, the I forget the exact number of plants that it said had an issue, but [inaudible] at the time, 8 ethylene oxide plants, 3 of them were on the list that said it had an issue. Subsequently they put out further notice and all that kind of stuff in the other 5 facilities of Sterigenics that use ethylene oxide have remained not on the list of problems but it hit these three facilities, right? One of which is an Illinois, one of which was in Georgia and one of which is in New Mexico. And so because of that and there was a CDC study on top of it, ignoring, whatever that is because of that, it started litigation at those 3 facilities and in particular what you ran into to is personal injury litigation, a mass tort personal injury litigation and I do a good amount of legal liability work as the fun, right?

And so, of all of the legal liabilities out there, personal injury mass tort litigation is by far the most potentially explosive litigation because once you get in front of a jury and you have someone who seems very sympathetic or something bad happened to and then you have the big main company and has the emails that are bad, it starts off a whole thing. So, what ended up happening though is they have a personal injury litigation advance in Illinois. They personal injury litigation that will advance in the future in Georgia. And then in New Mexico, the plan is in the middle of the desert so there's no one to see them. So there's regulatory actions run in the New Mexico plan, but don't for now it's not going to surprise to some and enormous thing. So for now, just leave New Mexico law.

So what the main issues were was the plant in Illinois and the plant in Georgia, and the difference between the 2 plants has everything to do with Illinois, being the most basically punitive, the most plaintiff friendly jurisdiction in America. So the issues is really not the science behind what actually it said hence like going back to the pin that you and I are being exposed to more ethylene oxide right at this moment than this plant was actually spewing into the environment around there. So it's really not a matter of like science and all this kind of stuff and if you want to go for people are like, "Hey that doesn't sound right." The EPA has like webinars where they put this stuff out and they know that their freak neighborhood down so you can go watch people from the EPA we're making these rules be like 40% of people get cancer lifetime exposure if 1 in 100,000 people gets cancer. In addition, you're really talking about an extremely low threshold that were at, right? Like, they're not like that concern about it like, don't eat red meat, that's like way higher on the list in this facility.

Andrew: If I remember correctly, the EPA what they said was, the people around Willow brook, it might have caused like one extra cancer case, every 3 years all around Willow brook if I'm remembering correctly...

Chris: Yeah, sort of.

Andrew: And it was like within the realm of rounding error, so it was like very shoddy science on that. But yeah.

Chris: So let's talk about the science for a second. The EPA is not going like, "Hey, is this, like 50% safer or 70%? They're going is this 99.9999% safe or is this 99.999999% safe, right? We're not interested in the 40, 60, 80% those are non-starters." So because of that, they conduct theoretical experiments that are obviously in intentionally completely unrealistic because we're trying to be extra, extra safe. So what they did is they collected 35 air samples to measure how much ethylene oxide is coming out of the plant and then they only use the 2 highest concentrations. The 2 highest concentrations occurred on days when the wind wasn't blowing because it's a gas. So it blows off immediately, right? And so they use the [inaudible] samples and then they conducted a study thinking what would happen to someone who lived for 70 years, from birth till 70, 24/7/365? No one has ever lived in a single place for 365 days a year 24/7 for 70 years and the wind never blow. It's an obviously, an intentionally ridiculous kind of threshold to make sure we're extra, extra safe and what they're looking for is, "Hey maybe this is on the border. Hey can you guys like spend like 10 million dollars extra and just make this extra safer." That's like the regulatory bird. They're not like, "Oh my God. This is asbestos and like we're actually killing people." That is not what we're talking about but what happens is, this gets in the hands of personal injury litigation and we can talk about what [inaudible] personal injury litigation looks like in US but it's this whole big industry, the highest paid lawyers and no other country really has a lawyer that makes a $100,000,000 a year. But in America, being a lawyer at point is an entrepreneurial endeavor, not a civil servant endeavor and so it is what it is. And Illinois is basically one of the most plaintiff friendly jurisdictions. And so, what ended up happening is these cases despite the sort of weak science, in Illinois, it's allowed to assert a single molecule could have caused your cancer, which, of course, is single molecule could never have cause you cancer, that's not at all how that works. But you are allowed to say to a jury, it is what it is right?

Andrew: When I was doing the research here and I think it's not just Illinois, but this particular jurisdiction within Illinois, is the most plaintiff friendly in the nation, I think. And if I remember correctly, one of the quotes I heard, when I was doing research, was somebody said, "Look, I've worked with insurance brokers and there's only one rule they have, we will not write insurance within - it was Cook County if I remember correctly- we will not write it within Cook County, Illinois because the jurisdiction is just too plaintiff friendly, we just can't write it there", so, they're willing to underwrite like water parks for drunk people. They underwrite that just fine. They just won't underwrite Cook County, Illinois because the rules are so bad there. So just to put in perspective, like kind of what jurisdiction you're dealing with I guess.

Chris: Yeah, exactly. And it's why the easy way to deal with it is just to zoom out and be like, it is [inaudible]. The specific thing is causality which we'll talk about, which I thought of, but if you get it to a jury in a jurisdiction it is a problem. It's just what it is. It has nothing to do with science. It has nothing to do with truth. It has everything to do with how it works in Illinois. And so specifically, though, there are 2 plants left, right? And so the Illinois plant, the simple way to wrap it up there is they settled. And so the settlement came in and this is like, I think people weren't as familiar with this kind of liabilities before. We're very worried about these explosive outcomes, kind of scenarios and the reality is like there are reasonably well-settled ranges for where these things kind of come out.

Andrew: Did you settle back? They lose their first case, right? The ruling is about 350 million and that's when the stock falls off of clip because they lose one case, they've got call it a thousand cases to round up outstanding left and people quickly start doing the math and say, if every case they're going to lose for 100 million, 200 million, 300 million times a 1,000 cases, not only would this company be bankrupt, but every company in America would basically be bankrupt facing that liability. So they lose that case, they win their second case, they take the first loss of second win in earlier this year, they announced the settlement for 400 plus million and then I'll flip it over to kind of start talking about the settlement.

Chris: Yeah, so they announced the settlement very specifically. I think it's worth it mentioning that the appeal, might as well since I'm talking about already. They had an appeal bond, it is very much the timing of it is. They had to post 150% of the judgment which would be roughly 500 million dollars say like 10% interest, whatever just to make simple math. So we're going to do this for 2 years so suddenly we're like, we're gonna have to pay like 50 to 100 million dollars in interest to settle this case. Your overall settlements 400 million dollars, you start kind of staring at the numbers, like how much is this worth really to fight, right? And so one of the things that the plaintiffs attorneys says, "If you ever involved in litigation, figure out how much money and applause the other side to fight you is like a huge part of the battle" and so, it just made sense and they were like, "Hey do you really want to go down this path or can we just admit that like we're not going to get out of Cetera this point, we're not getting out of this for less than 200 million bucks. It is what it is. Let's just get it done and maybe we pay Cetera the high end of like typical settlement." Not the high, high end, but the high end of let's say not specifically asbestos cancer settlements, right? But whatever, it's not that much money. We're talking about 40 million dollars is a lot of money, but we're talking about like one year's free cash flow. And so ultimately, if we're squabbling over like a quarter is free cash flow is a bit ass between the plaintiffs and defendants it was like, "Let's just get this done and get to story back on the road", right? So they hit the bed and that's where we're at, right? And so talking about Illinois, the steps left are actually settling the case.
I think there's actually a chance that you get paid on the settlement finalizing. The settlement finalizing is an interesting catalyst, I think, because people like, "Oh my God, they have to get 99% approval because that's our code."

Andrew: Let me just pause you there because we haven't said what that 99% of people are. So they announced the settlement in January and they say hey we're paying it's a little over 400 million dollars to settle the cases and one of the clauses in that settlement is hey, in order for this settlement to be in play, we have to settle as you said, 99% of the plaintiffs have to opt into this thing. I think there can only be 12 cases that don't opt into the settlement, if more than 12 cases don't opt in, Cetera has the right to break the settlement, not the plaintiff. So Cetera can look and say, "Oh, it was 13. Okay, we'll take that." Or, they can look and say, "It was 13. It was 20. It was 100. We're out. Not enough of these cases have settled", so please continue.

Chris: Yeah, exactly. So it's a weird Catalyst. The reason you settled is because of the one case that had the 51 million dollar appeal bond. And so, the way it also works, in these cases is the plaintiffs picked the order, right? So from a factual standpoint, the plaintiffs won their first case for a massive number and lost their second best case, right? So with that kind of hit ratio, the bottom 50% of cases, they're not going to be what you want to take to court, right? And so the point is that in an unlikely scenario that the settlement breaks, they've already settled the top cases. So what will be left is actually a much weaker batch of cases which is why I'm sure the plaintiffs attorneys are informing the clients. You're probably going to get much less than this if you actually go to court and it will take long time, which is why ultimately, they are pretty good at getting people. So, I think the most likely scenario is that it settles.

If it were not to settle, it is the funniest thing out of my sight. It's a funny catalyst because the stock is likely down and it is almost unquestionably an EV positive announcement. It has this little duality. So I think it's worth like paying attention to see if the settlement doesn't get to these things. I mean, obviously, we're paying attention to it but it is very likely to work out with the settlement and the reality is if they don't get 99%, it's likely that the settlement will still occur at a lower number relatively quickly after it breaks.

Andrew: But it will be a headache. It will certainly be a headache.

Chris: Yup. It will be a headache. And if it were occur, it's a buying opportunity in my opinion. But basically once you are done that settlement, there will in the future, as people develop cancer in the future in this area, the 2 cancers, the breast cancer and blood cancers. And so there will be future cases, but like the farther out you get from having been exposed in the 80s when it was a more risk the weaker the cases get overtime and also you're talking about probably, I think 10 or 20 cases here would a good hire kind of like, you know, think about that like the settlements. The real settlement average underneath is probably 400 thousand dollars. This company does like 600 million dollars a year in EBITDA. Let's say fast forward one year, so we're not really talking about of needle moving number of cases, right? Like this is going to be a small trickle future problem, not exactly sure what's going to happen. So while the litigation will continue, the bulk of it is [inaudible], 99% of it has been settled, right?

Andrew: I think we've hit the Illinois one well. You talked about New Mexico, there's not a lot going on there. I do think a couple people who've looked at the stock, maybe haven't fully open in, they look and say, all right, well they settle it in Illinois but there's still several cases outstanding in Georgia and I think both you and I think, "Hey, Georgia, yeah, they're probably going to lose some money there", but the Georgia, it is not a big concern, right? The headline number for Illinois was the first case they lost for, like, I think it was 360 million all in, that's not going to happen in Georgia. I think they're going to be fine in Georgia, but why don't you just quickly address the Georgia risk here?

Chris: So, one of the things that makes Illinois plaintiff friendly, which does not work in Georgia is that an Illinois, they allow you to go to court alleging one molecule can cause it, right? So the point is that you have a carcinogen and you established that it can cause cancer. You then have to show how it did cause it, it's called causality. Okay, this causes cancer, how did it cause your cancer? So there's causality generally and then there's causality specifically, like, your specific cancer. In Illinois, it can be one molecule [inaudible] we could talk about what science you could prevent, but [inaudible] you're going to have to go to court basically, because if that's good enough to get to court, we're going to court on any of these things, right? In federal cases, I believe it is called Daubert, is how you set up causality. So it's not enough to say it caused my cancer, you have to explain to me how it caused my cancer and there's no studies that explain to you how it causes cancer. So like ethylene oxide litigation has been thrown out several times in federal courts because it doesn't meet the next standard to actually go to trial.

Georgia law is more similar to federal law than to Illinois law and so it is going to be harder for those 300 cases in Georgia to actually get to court. So nothing about it will surprise me. But I definitely think the odds are 50%. They actually don't even end up getting into court because I think for people to kind of follow the news in this was at Zantac would like, the judge, there was like, whatever that case is, the judge was like, "Yep. You don't have
tough stuff to go to court." Because reality is once you go to court, it's sort of like this play where there's like you present an expert, we present an extra room, we act like it's 50/50 but if you actual evidence is like, 90/10 putting 2 people on the stand is inherently unfair to the defendant, right? Because this is already misrepresenting what the odds are. Right? So that's why I like it. I think it's unlikely to go to court in Georgia. There's only 300 cases in Georgia and the other interesting thing is the Georgia has a 250 thousand dollar [inaudible] punitive damages.

There are some people will look at it and there are cases that are bigger but I think in Georgia the 3 standards are: you can't be drunk, which doesn't apply here. You can't be intentional, which is like, I stabbed someone to death so it does not apply here. And then the other one is a product liability and there's no product that we're talking about it since it's the emissions, not the actual product. So there's an absolute cap on punitive damages that will fly here. And so, they're not going to get $400,000 a case, they're gonna get legal fee. If they get to court, they'll get legal fees.

Andrew: When we started this, we were like we're briefly gonna adjust the the legal case and then of course, you know, the legal case I think it's also because both you and I get a little excited remembering the diligence on it, but we spend 20 minutes on the legal case. At this point, I think we've addressed, hopefully, we've addressed [inaudible]. We've talked about multiple, we've talked about business quality, I think, if I had to sum up those, I'd say this is a fantastic top 1% style business at a market multiple price. We've talked about the legal cases and how there are some catalyst to putting those behind them, the settlement getting finalized in May or June, the Georgia case is hopefully getting dismissed. I think we've talked about all those. I just want to talk a little bit about the go for it, right? Like it's entirely possible you and I are just sitting here holding our [inaudible] shares and for the next 10 years, for the next 3 years were just compounding in the market. multiple keeps expanding but there's a couple other catalysts here. So I want to talk about those, [inaudible] but the main one I look is I say hey the private equity owners here still own about 67% of the company. I think they've been involved in Cetera for about 10 years at this point, and you have to look at that ownership, the fact that company IPO to few years ago and say, "Hey, they probably want to exit at some point. So, is there a catalyst around the private equity exiting? Is there a strategic merger selling this in private or your company? These guys just tendering for all bunch of shares? I don't know but talk about that stuff.

Chris: Yeah, I think like you certainly have an aligned ownership and board structure. Like it, this [inaudible] company with 2 owners. I believe it's like roughly 60% still owned by the private equity firms GTCR and Warburg, top-tier, well-respected, intelligent, private equity ownership, it's not who is there, whatever the term. And so, you have a very good setup in that. The people in charge of the stock understand it. We talked a little before we hopped on the call about how the background checks of it, they intended actually to sell this to another private equity firm but because of the legal liabilities, it is just an awkward spot to sell 100% of business so the IPO did it instead. So the point being that like...

Andrew: No smart, no sophisticated buyer will take the whole thing. So maybe selling a junk of it to unsophisticated buyers.

Chris: Yeah, but so the point being like, it was a likely already shops. It has plenty of people already familiar with the asset. It's a very leverageable asset. It sucks a little bit of private equity guys because you're gonna have to pay a high EBITDA a multiple so you're going to have to put a bunch equity but you can throw 7 terms of leverage on this company without a problem.

Andrew: It's been 7 and a half times lever. I mean, before the IPO it was right?

Chris: For the most of its history, it has been 7 and a half times lever without really a problem because it grows and doesn't have any cycles. So what's going to happen? So it's a very private equity attractive story. I think the setup from here is these guys, private equity firms, this is not an [inaudible] department that like just got hired out of nowhere, right? They got to find guys that know how to tell the story to people and explain to people and find the pitch and go to the right conferences, they all have the rights, all side coverage, it's not an orphaned weird asset and so I think the story for here is, they have to pay down a little bit of debt because it's settlement funding this year. So it's a little bit of a weird uptick that this year's free cash flow isn't around. But like, 12 months forward, it's going to be BuyBacks. I mean, dividend, whatever you want to talk about with like their cash, MNA, whatever exactly it is, it kind of depends how the stock trades but it is not one of these things where I think if 2 years from now, the stock is at the same price, you're just going to like wait it out and see what happens. I think you're going to absolutely see these guys put this thing up for sale if it's not gonna happen in the public market.

Andrew: And it's 550 EBITDA this year, 2 years from now it's almost unthinkable that EBITDA wouldn't be 600 or 650 or something and that's ignoring MNA, I just wanted to briefly touch on MNA. This is a 55 to 60 percent outsource business. It's been in private equity hands a lot that outsourcing race increases and it's kind of a duopoly that there are some smaller players out there. And MNA I mean, I think the other thing the reason private equities loved this so much is and management talk about, they clearly want to do MNA, MNA has been in their jeans and I think MNA can be really, really interesting here. Do you want to just talk about the ball ton possibilities and why that kind of is good for these guys?

Chris: Sure. So there is 2 other divisions, one of which is nordian, which is basically a monopoly supplier of cobalt, I'll just very, very quickly head on it, the barrier to entry there is you have to talk someone into putting a new thing that could blow up a nuclear reactor. So there's no competition whatsoever for that thing. It's a nice little business where there's 10% top line too. Say that's like, 10% of EBITDA and then, Nelson Labs is 15% and Nelson Labs is the other third division, which is about 15% of EBITDA also and it's really the MNA story for this business. It's where they want to direct the most of their MNA and what they do is they are adding a little bit of a cost for its revenue thing. And so it's a very minor part of the story in my opinion frankly, but another little part of the story is that you should see a normalization in that business. So what Nelson does is it does you want to make a heart sent, okay but you want to use a new plastic. How do you get that through FDA approval and Nelson does everything from like providing, consulting on like, this is what the FDA is looking at now and here's where we're at to we're going to take a rad and sell a piece of the plastic into the rat and like let it live for a couple weeks and then break his neck and look at what happened to the rat. Like, that's what we do. And so that's kind of what it does. But it's a pretty niche kind of thing. And again, the pitches that it's like sterilization, 20 years ago, does it make your beer better? No, this is not an area that you guys really know about out. [inaudible] we are on top of the science, we're on top of the stuff, we're on top of what the FDA wants...

Andrew: ...And hey J&J, do you want the headlines J&J breaks 5 rats necks during testing for a device. You give that reputational risk to us.

Chris: Yeah exactly. You just sort of play it off and there's a lot of smaller players out there to kind of do this stuff and so there's an opportunity to like roll it out and build this business. And also, while you're building the business in MNA, you also grow your share with the companies because the more bulk you have, the easier the contract is, do you really want to have this in-house? You know what I mean? So it has this nice kind of thing. And frankly, a lot of the customers, I mean, almost all the customers are the same customers that Sterigenics has so there's a complete overlap. In legal liability, they had separate go-to-market kind of things, so there really are 2 separate businesses inside that. [inaudible] coming to several businesses, but there's a very obvious overlap in that. They basically sold almost
the same exact apartment inside like the metaphase films. And so I think overtime, they've done well in acquisitions in the past. Right now, the segment has this little revenue growth versus cost kind of thing which is mainly just hiring people to its people business, not an asset business really. But I think there's a very nice core business, it is already growing least a 10% toppling. If you actually throw an MNA pipeline, there is a lot of these companies out there that you could look to roll up. There are a lot of these countries when we grew up. You can easily push this to like a mid teens. You're taking all the free cash flow but like you could definitely see the single 15% top line and 15% nonsensical top-line growers, do not trade 15 times earnings.

Andrew: And most importantly, the MNA should be pretty accretive because A, there aren't a lot of other buyers for smaller companies in this industry you would think and B as you were alluding to they should have fantastic synergies, right? "Hey, we're going to buy you. We're the largest player in this work industry when we buy you, if you're a one-off sterilization facility, we deal with every single major medical player in the world, we plug you into all of them to fill your supply. If you're just a quirky little consulting's it. Well, we have reputation. We have relationship with every major medical person, you might only be working with one or two, so you should have great like cross-selling synergies through those things." So, all your amination should be quite accretive if done correctly.

Chris: It looks and has been with them. Let's say in the last one month, it has a very classic-looking private equity role of strategy of you get the bulkhead going...

Andrew: Exactly.

Chris:.... the man that lower multiples, we traded in a higher multiple and then there's a tremendous process energy across the [inaudible].

Andrew: Last question that I'm going to ask you and then maybe we can do [inaudible] to wrap it up. You talked earlier about there's a trend towards outsourcing both because it makes sense, it's doesn't make your beer better, but also because you kind of want to avoid the legal headache. So why not put that on to outsource. One person did comment, "Hey, is pricing in this industry gonna go crazy now that the legal overhangs over there, they used to take 3 to 5% pricing. Can they just start going back to custom be like, hey nobody wants to deal with this legal risk. We've got all these legal costs, like does pricing accelerate because nobody wants to take on new risk from this?"

Chris: I think that is a very high probability kind of event. I think it's very captive at this point man wise. Yeah, I think the answer is yes, and I also think it's high probability for all the reasons you laid out. But like, you're certainly not paying for it anyway, so you don't need to talk anymore into wanting them, so that's on Cetera at $17 a year.

Andrew: Oh, cool. Look, I think we hit everything. Hopefully, we've covered great business, reasonable multiple, potential catalyst, legal [inaudible], anything we didn't talk about here that you think people should be thinking about or that you kind of think about with the company?

Chris: No. I mean we didn't talk about learning and Nelson but I don't think...

Andrew: ...small pieces of the business you know, yeah.

Chris: I think that they're pretty fun and interesting. I particularly like morning. I think it's just a fun company.

Andrew: Anytime you can deal with Russian nuclear waste why not get excited about it, right?

Chris: Exactly. The only final thing is your mustache. We haven't addressed your mustache.

Andrew: The classic elephant in the room. I shaved it yesterday. I had a meeting with a group of guys, I thought they would be figuratively tickled by the mustache so I shaved it and thinking about keeping it for a while. I was telling you before I can only see above your mouth, when you popped on the zoom and I thought you were joining me in the mustache grew.

Chris: I try to shave my face one time a year to just keep track of what it looks like and I do a little mustache.

Andrew: Next time you come on the Pod when you come on for the 4th appearance, I expect you to have a mustache to join me.

Chris: Sounds good.

Andrew: Cool. Chris, this has been awesome. I appreciate you coming on. I mean you and I we've been following it for a while, you more successfully than me, but this is a really interesting story and I'm with you, you know, I think this is a great business treating at a reasonable multiple. And I think you just get a little tail wind as people get more and more comfortable with the legal overhang beam behind them, and their results produced. And it's hard to see how the results don't come in at this point.

Chris: Yeah, absolutely.

Andrew: Cool. Well, Chris McIntyre, thanks so much and we will chat soon.

Chris: Yeah, sounds good. Appreciate it.

[END]