McIntyre Partnerships commentary for the second quarter ended June 30, 2024.
Dear Partners,
Performance and Positioning Review – Q2 2024
Through Q2 2024, McIntyre Partnerships declined approx. -6% gross and -7% net. This compares to the Russell 2000 Value’s decline including dividends of -1%. In the winners column, CC, OSW, and MDRX contributed 100-500bps. In the losers column, LESL, GTX, and STHO lost 100-500bps, while SHC lost over 500bps.
Our Q2 returns were neither very good nor very eventful. Our benchmark, the Russell 2000 Value, fell roughly 4% and the fund fell roughly 3%. In general, I would consider a quarter where the fund outperforms our index by 100bps a mild success, although it feels much better when it accompanies positive returns. YTD, we continue to lag the index by ~500bps, driven largely by the fall in SHC and middling performance elsewhere in the portfolio. I will address SHC later in the letter. Since quarter end, our portfolio has benefited from the sharp rally in small cap value stocks, though we continue to lag our index.
The composition of our portfolio has been largely unchanged since the start of the year, except for my decision to significantly reduce our record label exposure. I continue to like the record labels and believe that both UMG NA and WMG, along with the entire music ecosystem, will continue to experience strong growth from increasing subscribers and prices for many years. However, UMG shares have appreciated substantially since our entry last spring and were valued at almost 30x consensus 2025 earnings, which do not differ materially from my estimates. While I think investors paying 30x earnings for UMG can expect to do reasonably well on their investment over time, I am not in the business of underwriting multiple expansion beyond a 50% premium to the market and I lacked a catalyst beyond earnings growth. As a result, I exited the majority of our investment.
More recently, I have come across several new potential investment ideas which I could see reaching a top five position size in the fund. If and when we reach a full position, I will update investors.
Portfolio Review – Exposures and Concentration
At quarter end, our exposures are 99% long, 6% short, and 93% net. Our five largest positions are SHC, OSW, GTX, CC, and STHO, and account for roughly 72% of assets.
Portfolio Review – Existing Positions
Sotera Health Company (NASDAQ:SHC)
I have previously written on SHC and outlined my thinking on a podcast, which partners should review if they want a longer explanation of our thesis. My goal in this letter is to provide a brief update on valuation and why I think SHC is particularly attractive from a catalyst perspective. First, SHC is ~10x my 2025 EBITDA and ~12x my 2025 EPS estimates. I consider these multiples an excellent entry price as I believe SHC can grow EBITDA around 10% a year with de minimis cyclical risk, which would result in SHC compounding at a high teens IRR through growth and returning cash to shareholders, assuming SHC maintains its current multiple. However, I strongly believe SHC has an opportunity for multiple expansion as the difficulties it has experienced in the past 24 months dissipate. For instance, before its legal troubles shocked investors, SHC traded as high as 22x forward EBITDA and 35x forward EPS. Further, SHC conveniently has a clear peer in STE, the other side of its sterilization duopoly. Currently, STE trades 15x and 25x consensus 2025 EBITDA and EPS, despite STE being only 50% exposed to the “crown jewel” sterilization services vs. ~90% at SHC. Given the higher growth and superior barriers to entry in sterilization versus STE’s other businesses, I would strongly argue that SHC deserves a premium to STE, as many sell side brokers had argued before SHC’s legal troubles.
On my estimates, we are buying SHC at a sharp discount to its previous valuation and the valuation of its closest peer. If my estimates are correct and SHC can close the valuation gap to STE, our investment will do exceptionally well. The key question is thus what is holding SHC back, and what catalysts could result in investors warming to the story and awarding SHC a higher valuation. I believe the primary issues have been SHC’s slowing growth due to excess inventory in the channel and SHC’s legal problems, both of which I believe could improve in H2 2024. On the first, prior to 2023, the medical ecosystem built up excess inventories due to hoarding during the global supply chain and COVID-19 crises. As these fears have dissipated, hospitals, distributors, and manufacturers have returned to normalized inventories, creating a headwind for SHC’s volumes. Since mid-2023, SHC has consistently communicated that they expected the issue to be resolved within a period of a few quarters. More recently, SHC has begun to communicate increased confidence that industry destocking has come to an end. Per management at the Jefferies conference in June:
Michael Petras, CEO:
As David referenced, the volumes have been a little bit more challenging in this business over the last several quarters because of destocking [filaments ]. So you see procedural volume has been good. Generally speaking in health care, and the disconnect that David is referencing is the fact that a lot of our customers have had inventory challenges over the last several years, which we're now-- to your point, though, we're seeing that stabilize. And we mentioned in our last earnings call, we'll continue to see that stabilize. And we're hopeful that as the year progresses, we'll continue to see rebounds in volume activities within the Sterigenics business and get to the more traditional levels as we get into '25.
David Windley, Analyst:
That's great. Michael, can you talk about the visibility? So you're talking about initial signs of stabilization, how much forward visibility into that? Do you have customer inventory levels, things like that, that you have some actual data on or customer dialogue on?
Michael Petras, CEO:
Yes. So it's more based on our interactions with our customers and the dialogue we have. We don't have access to their inventory levels or what sits in the chain between distribution or health systems or point of care. But in the interactions with our customers, we're seeing that stabilization. We're starting to see the volumes recover.
This is further confirmed by increasing sales guidance from manufacturers and increasing patient volumes:
As the destocking headwinds fade, I believe SHC can return to its historical EBITDA growth of ~10%.
On the legal front, the company’s issues are unfortunately long-term in nature, and thus difficult to prove definitively wrong at present. For instance, the earliest SHC could expect any pending litigation to head to trial is 2026, and it would take over 20 years to try each case individually. The long duration of litigation strongly favors settlement, which would almost certainly be an equity positive for SHC, but the inability to definitively “end” legal risk makes the timing of sentiment change harder to predict.
In my experience, legal risk tends to be resolved either in a large headline event, such as SHC’s settlement of Illinois litigation in January 2023, or gradually as investors wrap their heads around the risk. For instance, following SHC’s IPO, a dozen or so brokerage firms initiated coverage with barely a mention of the company’s personal injury litigation, which a quick scan of these initiations for the terms “litigation” or “personal injury” reveals. After the recent CA litigation made headlines in March 2024, at least four different brokers put out multipage analyses of the CA litigation. These analyses estimated the ultimate financial risk between at best only a few million in legal fees to as large as $1.5B in the worst-case scenario, with a settlement likely five or more years out. While I disagree with some of these brokers' specific claims, I do not disagree with this estimate range, and I believe SHC is a buy even in a worst-case scenario.
Over time, better broker coverage makes it easier for investors to conduct due diligence. This results in a more informed shareholder base that is less likely to overreact to headlines. As the stock becomes less volatile to legal news, this in turn results in more risk-adverse investors warming to the story. For instance, our prior investment in CC experienced significant volatility around legal headlines in 2019. By 2023 when a large settlement was announced, and then ultimately put at risk of falling apart, the stock reacted minimally in either direction as the shareholders already understood the risks. As this cycle plays out in SHC, I believe the stock can gradually experience multiple expansion, with the recent publication of easily accessible, good-quality sell side analysis leading the way.
Business Updates
The fund successfully launched our offshore vehicle in Q2. If any investors are interested in our new vehicle, I would welcome the conversation.
As always, please feel free to contact me with any questions.
Sincerely,
Chris McIntyre
McIntyre Partnerships
