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SHC: Lucky Number Sotera
Betting on "long-shot" priced stocks using favorable "governance handicap" odds
On January 9, 2023, Sotera Health (ticker: SHC) announced a $408 million settlement for Ethylene Oxide litigation in Illinois that caused the stock to double from $8.64 to $17.25.
Given the magnitude of the price move, it’s fair to say the market was pricing in materially higher “odds” of liability for ongoing Ethylene Oxide litigation in Illinois, Georgia, and New Mexico.
Interestingly, in November 2022, an argument could be made Sotera was signaling “asymmetric odds” - through governance and compensation decisions - that they expected much lower liability relative to market “odds”. This asymmetric signal - in turn - offered an “odds-adjusted” investment opportunity to those who paid attention.
Again, favorable odds do not guarantee favorable outcomes, but “long-shot” priced stocks, signaling favorable asymmetric odds via “governance handicap”, is arguably one of the better “bets” investors can find in markets.
Let’s unpack the odd-adjusted governance signals at Sotera.
Also, shoutout to Skele for first flagging this one to me:
Disclaimer: This newsletter is not investment advice. Views or opinions represented in this newsletter are personal and belong solely to the owner and do not represent those of companies that the owner may or may not be associated with in a professional capacity, unless explicitly stated.
Note: The inspiration for today’s write-up comes from the movie Lucky Number Slevin. I don’t want to spoil the ending, but it entails a drug store handicap horserace, entrenched standoff, bringing in specialists to solve complex situations, and overly elaborate plotlines.
Handicapping Sotera’s Ethylene Oxide Liability
The past 6 months have been a whirlwind for Sotera shareholders with the stock experiencing material volatility due to ongoing litigation - and uncertain liability exposure - for Ethylene Oxide (EO) emissions produced from sterilization facilities at the company’s Sterigenics unit:
So while Sotera doubled to $17.25 on January 10, 2023 following the announced $408 million settlement to Ethylene Oxide litigation in Illinois, the stock basically roundtrip an earlier $363 million jury award on September 19, 2022 which plummeted the stock 33% to $9.83.
Sandwiched between these two market “odds-adjusting” events was (arguably) another “odds-adjusting” signal that the market didn’t properly price in.
In my opinion, Sotera insiders were signaling favorable “asymmetric odds” through these options grants that they expected much lower liability relative to the market “odds”. This asymmetric signal - in turn - offered an “odds-adjusted” investment opportunity to those who paid attention.
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Handicapping Stock “Bets” with Governance “Tells”
When you think about it, corporate governance is a game of odds.
Boards and management teams are constantly making risk-adjusted “bets” and “calls” - expressed through various governance and compensation decisions - in hopes of beating the market established “odds” to generate excess returns and profit.
While there’s no guarantee these insider “bets” pay out, I believe paying attention to corporate governance decisions (i.e. “tells”) remains important - regardless of outcome - to help investors better handicap the “odds” they’re applying to a given situation/stock.
Just be careful insiders aren’t bluffing and/or playing tilted/desperate.
Governance “Tells”: Playing the Man, Not the Cards
Corporate governance disclosures, or “tells”, are a way to “play the man, not the card”.
We don’t know the exact hand being played, but we can often assess the risks and opportunities insiders are contemplating and/or risk-adjusting for by reviewing the governance decisions being made.
They’re “telling” you something with their decisions.
When the “odds” are really stacked in their favor, insiders are prone to making “all in” (i.e. huge options grant) bets. Conversely, when things are looking bad, you’ll see insiders “check” (i.e. cash award in lieu of equity) or “fold” (i.e. announce a large restructuring, unfavorable settlements, bankruptcy etc.).
Furthermore, the governance “tell” can often be clearcut and provide investors an opportunity to make their own odds-adjusted “call” informed by these governance “tells”.
Bear in mind investor should avoid relying on a single “tell” and ideally apply a mosaic of governance “tells”.
Let’s review some of the key governance “tells” at Sotera. (This doesn’t cover everything.)
Tell #1: Alex Dimitrief Appointed General Counsel
On November 2, 2022, Sotera announced the appointment of Alexander Dimitrief as General Counsel:
Mr. Dimitrief previously served in a variety of senior leadership roles at General Electric (GE), including as President and CEO of General Electric’s Global Growth Organization and as General Counsel of GE. Previously, Mr. Dimitrief was a Partner at Kirkland & Ellis LLP, where he practiced law for twenty years.
In my opinion, the major “tell” here is a high caliber, experienced general counsel and trial lawyer was willing to come out of retirement and take on the Ethylene Oxide lawsuits. He’s not going to take Sotera’s General Counsel job unless he’s confident there’s a path to resolve the lawsuits for meaningful financial upside.
Tell #2: Alex Dimitrief Accepts Options-Heavy Package
What leads me to believe he’s confident?
He accepted an options heavy equity compensation package with a $6.37 strike. He’s not going to accept 602,387 options unless he thinks the liability exposure is meaningfully lower than what the market is pricing. Consequently, by accepting options, that signals to me he wants upside leverage.
It also helps he’s making this “call” relying on his own experience and expertise in complex legal and regulatory matters, and would be serving as the key “point person” stewarding the litigation. He knows General Counsel is a fulcrum role for value creation at Sotera, and is agreeing to this options compensation package with a specific game plan in mind he thinks will be successful and directly create value.
Also - and I say this not knowing Mr. Dimitrief’s actual risk tolerance - lawyers are generally a risk-averse bunch and typically more focused on the downside than upside. They’re much more inclined to accept cash-heavy and/or conservative payment agreements. Consequently, it’s hard to imagine him taking this options-heavy deal if he felt the liability “odds” the market was ascribing was reasonable. He’d want to protect his downside if this were true.
Finally, Alex Dimitrief is a new hire who received this options-heavy package after an arm’s length, unencumbered negotiation. There’s always risk aggressive equity grants are driven by tilted/desperate insiders who are already pot committed with existing large equity stakes so his options-heavy package - as a new hire - helps to “de-risk” this concern.
Put it all together and these “tells” tied to new General Counsel Alex Dimitrief were, in my opinion, the most important signals that insiders saw “asymmetric odds” regarding ongoing Ethylene Oxide litigation.
Tell #3: CEO Receives “All In” Options Grants
Further reinforcing the “asymmetric odds” signal, CEO Michael Petras was also granted 2.1 million options. While the sheer size of the grant is “telling”, the timing/sequence also serves as a “tell”.
On November 4, 2022, the Board of Directors (the “Board”) of Sotera Health Company (the “Company”) approved an incentive award grant to Mr. Michael B. Petras, Jr. the Chief Executive Officer of the Company in the form of stock options (“Options”). The Options were granted on November 7, 2022, with a grant date fair market value of $5,250,000
This equity award was approved on November 4, 2022 and after new General Counsel Alex Dimitrief had joined the company. The timing of the grant could indicate newfound confidence in underlying legal developments (i.e. litigation and settlements).
I also don’t think the Board approves these awards without the new General Counsel’s sign-off with a compelling legal “game plan”. The CEO gets one chance to go “All In” and they’re not going to squander that call without risk-adjusting their liability exposure relative to what the market is pricing in.
Lucky Number Sotera
Lo and behold, on November 22, 2022, Sotera announced the jury in a second trial rejected a woman’s claims that exposure to Ethylene Oxide from Sterigenics’ Willowbrook, Illinois, facility contributed to her leukemia.
The verdict, delivered on November 18, 2022, came after a six-week jury trial, and the stock would pop 33% to $8 per share following the verdict. Good thing the CEO and General Counsel received their options on November 9th. Good timing!
Interestingly, the CEO option grants were made ~4 weeks into the second trial so it’s not a stretch to believe the company had risk-adjusted confidence they would prevail in that trial when making the grant. Alternatively, they started to make progress on settlement talks elsewhere (i.e. Illinois litigation?).
Anyway, with the $408 million announced settlement on January 9, 2023, it appears the Sotera is starting the process of settling claims, and lowering their liability exposure relative to the “odds” getting priced into the stock.
No idea if any of this is true, but that’s the read I’m getting based on the governance “tells”. It’ll be interesting to see how the stock responds to subsequent “odds-adjusting” litigation announcements (i.e. court rulings, jury verdicts, and settlement announcements)
Regardless, Sotera offers a case study on how investors can potentially bet on "long-shot" priced stocks by applying favorable insider “asymmetric odds” signals via governance “tells”.