Firstlight Management Calls on the Board of Directors of Sotera Health Company to Launch Sale Process for Nelson Labs

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.

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SOURCE Firstlight Management LP