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STERIS plc
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Good morning and welcome to the STERIS Plc first quarter 2019 conference call. Please also note, today's event is being recorded.
I would now like to turn the conference call over to Ms. Julie Winter, Senior Director, Investor Relations. Please go ahead.
Thank you, Jamie, and good morning, everyone. As usual, on today's call we have Walt Rosebrough, our President and CEO, and Mike Tokich, our Senior Vice President and CFO.
I do have just a few words of caution before we open for comments from management. This webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission, or rebroadcast of this call without the expressed written consent of STERIS is strictly prohibited.
Some of the statements made during this review are or may be considered forward-looking statements. Many important factors could cause actual results to differ materially from those in the forward-looking statements, including without limitation, those risk factors described in STERIS's securities filings. The company does not undertake to update or revise any forward-looking statements as a result of new information or future events or developments. STERIS's SEC filings are available through the company and on our website.
In addition, on today's call, non-GAAP financial measures, including adjusted earnings per diluted share, segment operating income, constant currency organic revenue growth, and free cash flow will be used. Additional information regarding these measures, including definitions, is available in today's release, including reconciliations between GAAP and non-GAAP financial measures. Non-GAAP financial measures are presented during this call with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making.
With those cautions, I will hand the call over to Mike.
Thank you, Julie. Good morning, everyone. It is, once again, my pleasure to be with you to review the highlights of our first quarter performance.
For the quarter, constant currency organic revenue growth was 5.3%, driven by volume and 80 basis points of price. Gross margin for the quarter increased 10 basis points to 42.3% and was impacted favorably by price and divestitures, largely offset by the impact of currency changes and our investments in outsourced reprocessing.
During the first quarter, we adopted a new accounting standard relating to the classification of retirement benefit plan costs. The new standard reclasses components of benefit plan expenses between operating expense and non-operating expense. While this change has no impact on net income, it does have a negative impact of about 20 basis points on EBIT margin in the prior year, which has been recast in our press release and financial tables. Reflecting that change, EBIT margin for the quarter at 17.9% of revenue, representing a 40 basis point improvement. EBIT margin expansion was limited somewhat by our investments in both our IMS business and in R&D in our healthcare products business.
The adjusted effective tax rate in the quarter was 16.8%, somewhat lower than we had anticipated due to the benefit related to stock compensation expenses. We continue to expect the full-year effective tax rate to be in the range of 21% to 22%, as our first quarter tends to be lower than the full year. Net income in the quarter grew 17% to $85.6 million or $1.00 per diluted share, benefiting from revenue growth and a lower effective tax rate.
Walt will cover our segment performance in his comments momentarily, but I do want to point out that we have changed the way we report segment operating profit to align with how we manage the business. As a result, similar to many of our peers, we no longer include certain corporate cost allocations in segment operating profit. We have provided a recast of fiscal 2018 quarterly results in our financial tables within the press release to assist you with this reporting change.
In terms of the balance sheet, we ended the quarter with $218.5 million of cash and $1.3 billion in total debt. Free cash flow for the quarter increased to $75.8 million, mainly due to improvements in working capital and the timing of capital spending and the increase in net income. During the first quarter, capital expenditures totaled $27.7 million, while depreciation and amortization was $46.9 million.
And finally, our Board of Directors approved an increase of $0.03 in the quarterly dividend to $0.34 per share. This increase aligns with our capital allocation priorities of growing our dividend in line with our earnings. This marks the 13th consecutive year of an increase in our dividend.
With that, I will turn the call over to Walt for his remarks.
Thanks, Mike, and good morning to everyone.
As you heard from Michael, we had a solid start to our new fiscal year and are quite pleased with our first quarter results. In total, we grew revenue just over 5% on a constant currency organic basis, with solid growth in each of our business units. Similar to last year, our AST segment led the way with 9% constant currency organic revenue growth, stemming from increased demand from our medical device customers.
While the underlying growth of the business is expected to remain steady, our year-over-year revenue comparisons will be impacted for the rest of this fiscal year, as we have exited our contract with Sterilmed as of August 1. The reduction in revenue from this contract is about $14 million for the balance of the fiscal year. We anticipated this exit in our plans, so there is no impact to our revenue outlook due to this change. Also, this was basically a breakeven business for us, so there is minimal impact on earnings.
Healthcare Specialty Services constant currency organic revenue grew 6% during the first quarter versus difficult comparisons in the prior year. As we discussed at the beginning of our fiscal year, we are working on several new opportunities for outsourced reprocessing in the U.S., none of which are generating significant revenue at this time. In addition, we talked about the substantial startup cost investments that we will incur as we move forward with these opportunities. Those investments are reflected in the segment's lower operating income year over year, as we anticipated.
Healthcare Products constant currency organic revenue grew 4% for the quarter, with 5% growth in service and 2% growth in capital equipment. While shipments for healthcare capital equipment were a bit lighter than we planned, our backlog at quarter end was higher than anticipated and increased over $40 million from the same time last year. We continue to expect mid-single-digit growth in healthcare capital equipment for the year and believe that underlying fundamentals remain stable.
Healthcare Consumables revenue year-over-year comparisons continue to be impacted by last year's divestitures, but the organic revenue growth remains mid-single digits.
From a profit perspective, we were impacted in the quarter by our planned increase in R&D spending, the negative impact of divestitures, and unfavorable currency movements year over year.
Finally, Life Sciences constant currency organic revenue grew 3% in the quarter, with growth across the business. The overall growth rate was limited by the timing of capital equipment shipments, which we expect to occur over the coming quarters. Profit improved very nicely, as we benefited from increased volume and favorable mix, and in particular, mix within the capital equipment shipments.
Putting it all together, even with the planned investments we have made in our businesses, we were able to grow adjusted earnings per share 18% year over year to $1.00 per share in our first quarter.
With this solid start to the year, our outlook for the full year is largely unchanged. The only significant update is our expectations for currency. At the start of the fiscal year, we anticipated approximately $30 million in revenue benefit from currency movement. Based on the nine-month forward rates at the end of June, the year-over-year revenue impact is now expected to be only about $5 million favorable, a $25 million decline in as-reported revenue versus our original expectations. Despite this significant change in reported revenue, we continue to expect about $5 million positive impact of currency on reported EBIT for the year, as our costs will also be reduced if forward rates hold as of the end of June.
And finally, our current assessment of tariffs also suggests about $1 million of annual negative cost impact, primarily in steel and electronic components. I would add that electronic components supply chain lead times are becoming more difficult, but at this time, we don't anticipate any significant shipment delays.
All in, we continue to expect 4% to 5% revenue growth on an as-reported and constant currency organic basis, which we expect to leverage to deliver adjusted earnings per diluted share in the range of $4.63 to $4.75.
Before we open to Q&A, I also want to discuss a recent management change. As disclosed in our 8-K filing earlier this week, I recommended and the board appointed Dan Carestio to the position of Chief Operating Officer. Dan has been with STERIS for over two decades, starting as a product manager in our Life Science business in 1997. Since then, he has held roles of escalating responsibility, including running the AST and Life Science segments. His teams are responsible for the remarkable turnaround in Life Science the past 10 years and the improvement of the STERIS AST business. He was also a primary player in the successful purchase of and then led the integration and management of the Synergy Health AST business.
Early this year, Dan assumed responsibilities for STERIS's infection prevention products in our Healthcare segment in anticipation of Sudhir Pahwa's impending retirement. Since IPT and Life Science share technologies, manufacturing plants, and R&D resources, Dan has worked hand in hand with that part of our Healthcare business for years. As COO, Dan will now have responsibility for all our business segments, including manufacturing, marketing, R&D, sales, and service.
That being said, Dan's elevation to COO in no way suggests that I'm planning on leaving STERIS soon or that the board has chosen a successor for my position. I intend to continue to be actively involved in running the business and do not have a definitive timeline for retirement. I look forward to working even more closely with Dan and with the rest of our senior executive team over the coming years.
I would be remiss if I did not point out the remarkable job Sudhir Pahwa has done leading the infection prevention team in our Healthcare Products segment. While he's now retired from his full-time general management responsibilities, he will remain an advisor to management on a part-time basis. We thank Sudhir for all he has done for STERIS, and particularly for leading our IPT business for the past 10 years.
With that, I will turn the call over to Julie for Q&A.
Thank you, Mike and Walt, for your comments. Jamie, would you please give the instructions and we'll get started on Q&A?
Ladies and gentlemen, we will now begin the question-and-answer session. Our first question today comes from Matthew Mishan from KeyBanc. Please go ahead with your question.
Hey, great. Thanks for taking the question, Walt, Mike, Julie.
Good morning, Matt.
Good morning, Matt.
Hey, I just wanted to first get a little bit more clarification on the exit from the Sterilmed contract. What drove that? And then also, the $14 million headwind was included in the 4% to 5% organic growth guidance at the beginning of the year and it's not incremental?
Matt, you are correct. So when we did our 4% to 5% revenue as reported in constant currency organic revenue guidance, we assumed that we would exit this contract, so it is already included in that, so it is not an additional headwind.
And then on...
In terms of the rationale, a lot has changed versus the original thinking of that contract, and so that's point one. Point two, Synergy did that. And part of their rationale was to help them enter the U.S. market, and so it was not a profitable situation. And so there's no reason for us to need to do a non-profitable situation to help entry into the U.S. market, so I think that at a high level explains it most carefully.
Okay, that's fair. And on Healthcare Specialty Services, are there any updates to the ORC contracts? How are the launches progressing, and is quoting and interest still picking up?
A three-part question there, I think, I'll try to get to them all in one time. As I mentioned, we're not at a point where there's any significant revenue coming from the ones – we do ORC work, but the ones we've talked about, newer ones, there's no significant revenue coming from those. That's the first point. We have said and continue to think that it will be the back half of the year when we start seeing revenue from those operations. I don't think we have any significant change in our views of timing or process, if you will. If anything, my experience is all projects like that tend to lag a little bit. We've tried to incorporate that in our forecasting, but if anything, they tend to lag what people's point estimates generally are.
I guess the last thing I'd say is, we do continue to have customers discuss with us the idea of doing this, and I don't see any abatement of that conversation. I think I've hit everything you asked, but if not, I'm happy to take a follow-on.
Hey, Matt, I'd just like to add also. We have started to secure buildings. We actually have started to spend capital on some of those projects. And obviously, we've also started hiring people, which is one of the reasons you are seeing a year-over-year decline in the segment operating income for HSS. So we are moving forward.
Okay, great. And then last, I'll squeeze one last one in. On the M&A pipeline, it's been a while since you've done anything particularly material. I know the timing is unpredictable. But have you walked away from deals recently, and what reasons have you looked at some stuff and said no, it's not for us?
We see a lot of deals, and I would say the preponderance of the deals that get shown to us are not for us, just because they don't fit our strategy. But in terms of things where we think it would fit our strategy or may fit our strategy, then the question is price, and then there are two different issues. One, what is the timing of those things? Is the seller interested or not? And then the question is, what is the price that either the seller or, if it's an auction type situation, is the price more than we want to take a look at? And that has occurred the last several years. We don't win everything that we try to get. But we're reasonably successful. If it fits our strategy, we're reasonably successful at making it happen.
The timing is the more difficult one. But at today's valuations, it does sometimes push the envelope in terms of whether or not it makes sense to us financially. So we've seen more things we think are a little pricey for us than we would like to do than let's say four years ago. And then secondly, we are seeing a pickup I would say in the pipeline. We're seeing more things than we saw six or nine months ago, I would say.
Okay, thank you, all, Mike, Julie.
Our next question comes from Jason Rodgers from Great Lakes. Please go ahead with your question.
Yes, in the Healthcare Products segment, would you separate out the impact of divestitures on the operating income there and why divestitures would hurt profitability here?
So, Jason, the divestures that we're talking about in Healthcare Products are affecting our Consumables business, which is why you're seeing as-reported revenue decline. But as Walt said, our organic revenue is growing mid-single digits. So that's about the issue there.
Then from a profit standpoint, that business was much smaller. It actually incurred a little bit of a loss in the first quarter last year. So that is what's impacting also on the Healthcare Products operating income standpoint is we have a slight loss there from last year.
Wouldn't that make profitability higher this year then?
A relative loss, not loss of profit last year. It was not a highly profitable business, but it did make money.
It made money last year. It did make money this year, I guess is an easier way to say it.
And the timing of that was – they happened to have a particularly good quarter in the first quarter of last year relative to their history. This was the HCS business we divested. It was not a particularly profitable business, but they had a good first quarter last year.
Okay, that makes sense. And then as far as just profitability overall in that segment, when might we expect that to turn positive?
That segment is pretty profitable, but year over year as we see capital shipments pick up, we've got $40 million of increased backlog. As that ships, you will see profitability improve.
And, Jason, we do have $2 million or over $2 million of R&D expenditures there that we signaled that we would continue to increase R&D spending in particular in that segment, and that is going to be a little bit lumpy over the year, but we definitely are still anticipating to see higher R&D expenses for the year.
Sorry, I meant to say growth in profitability.
It's okay. I understand.
I didn't mean to say profitable. And then as far as the Specialty Services segment, would you be able to quantify those investments in the U.S. to outsourced reprocessing, and how should we think about those going forward?
Jason, I would say that there's several million dollars in the quarter that we are seeing as an expense as we make the investments. If you recall, for the full year after you take in the revenue and all the expenses, we were going to be – what was the number, Julie, do you remember?
A $2 million to $3 million loss this year with investments of $10 million in total, including R&D and in the (20:32) space.
Yeah, relative loss.
Relative loss.
Right. Reduction.
Okay. And then finally, just aside from the tariffs, I wondered if you can make a comment on what you're seeing in the way of raw material costs and if the pricing that you're getting is more than offsetting these costs.
Yes, if you look in total, our raw material costs are up a bit. And it's the tariff-driven that we've already discussed plus a little bit on the petroleum side. The things that are related to petroleum are the two biggest factors that are driving it. And we have been able to get a little bit of price, and so that has helped it. But predominantly we have offset those cost increases with productivity increases in the plants, either through design or through labor productivity.
Thanks a lot.
You bet.
Our next question comes from Isaac Ro from Goldman Sachs. Please go ahead with your question.
Good morning, guys. Thank you, just a couple for me. One is on just the COO appointment. First off, congrats to Dan, but it would be helpful, Walt, for a little more context as to why now. You've been around for a while and running the business with good success. Can you talk a little bit about how the division of responsibilities will play out and how that might translate into performance in the business?
I don't think I'll comment on division of responsibilities per se other than Dan will have full line responsibility for those operations, so he will take a more active role. The fact of the matter is, he had line responsibility for half the business already, so this adds on the balance of the pieces of the Healthcare business that he did not have. But more as a magnitude, that's the principal division.
In terms of improved performance, it does allow me to do some other things both inside the operations. It's not like I will leave the operation. As you know, I'm an operator, and so there are things that I am working on personally in that space and will continue to. And then on the other side, it does allow me more flexibility of M&A and doing some things internationally than I would have been able to do otherwise.
But I wouldn't expect a major, some major significant change here as Dan is picking up more of that responsibility and I will be shifting some of my work to other areas. But generally speaking, he was doing half that as it is. And the guys who are running those businesses that are reporting to him all know what they're doing, and I wasn't managing them minute to minute anyway.
Okay, that's helpful. And just on the Life Science business, I appreciate your comments on the earlier part of the call. But if I look at the comps, this was your easiest comp of the year, and it seems like the end markets for that business are actually pretty healthy. So can you help us think through some of the moving parts that you have baked into the assumptions for the rest of the fiscal year and what that means for growth for the total year at this point?
You're correct in all the question. We don't see anything significantly changing in Life Science. And so the capital shipments clearly is a matter of timing, and that tends to be lumpy. But we also see variations in timing on the consumable side and we think we've seen just a little variation in timing. We don't see a significant change in our go-forward look. The pipeline, if you will, looks consistent. So it's just one of those – the quarter was a little slower than we might have expected, but we don't expect that to carry on into the future.
Okay, thank you, guys.
On the capital side, we don't – I mean no is a big word, but we have so many shipments scheduled that we are highly, highly confident that that one will reverse its situation.
Understood.
Our next question comes from John Hsu from Raymond James. Please go ahead with your question.
Good morning. Maybe I could start on SG&A. It looks like spending came in a little bit higher than we had expected for the quarter, and I did get that there was a reclassification from non-op. but outside of that, was there any timing or pull forward on spending in the quarter?
No, John, not really. The biggest issue we talked about in total was the R&D piece in spending, and that does hit, if you will, SG&A unless you break it out separately. But no, nothing out of the ordinary that we would say has caused us any difference in what our views have been or would have been.
Okay, great. Thanks for that, Mike. And then on AST, it looks like margins actually, even with the reclassification, hit a record high. So with the 40% operating margin in the quarter, I guess with expansion projects still slated to come on throughout the year, how sustainable is that?
First of all, as I've mentioned before, it used to be if we did an expansion, that highly affected the profitability, particularly if it was a significant expansion of the unit, but that's when we had eight plants and expanded one. So it's 16% or 12% I guess of the business. Now we have 60 plants. So when we expand one or two or three, it does not have that kind of material impact, so that's point one.
We have expansion, we will continue to have expansion we think for a long time, so that is built into the process. There may be some variation if we're building a particularly expensive plant. But other than that, we see that as normal. I will also remind you that there's a lot of capital on those plants, so it does have to make very nice margins to have good ROICs. But having said that, these are nice margins, and we have no reason to believe that they're not sustainable.
Okay, great. And then the last one, backlog, you mentioned earlier that there was a pretty strong uptick on the Healthcare Products side. But, Walt, maybe you can give us just some color on the complexion of the backlog and where things stand right now as far as replacement versus project-based.
We haven't seen a significant change in replacement versus project. It is strictly a matter of when orders come in, when customers want the deliveries, and when our factories can deliver them. So you put those three things together, that creates the differential between order rate and shipment rate, which is backlog. And it just so happens we've had a pretty strong set of orders the last two or three months, some of which were the customer doesn't want them for four or five months and some of which our plants are running pretty heavy. So we cannot add a whole lot more shipments at any given time. So it's a combination of those, but it's purely a timing question. But it's clear the order rate has picked up the last six months or so.
Great, thank you for taking my questions.
You bet, thank you.
Our next question comes from Mitra Ramgopal from Sidoti. Please go ahead with your question.
Yes. Hi, good morning. Walt, I was just wondering if you could provide a little more color in terms of the increased R&D spending on the healthcare product side in terms of some things you think you probably need to offer as you look ahead in terms of growth opportunities.
As you know, our number one priority in spending money once we pay our dividend is to invest or reinvest in the businesses that we currently operate in. There's no question that is the highest returning process as long as we have a good place to put it.
And so we have ramped up R&D the last several years. Some of that is a function of the mix of the products and businesses we have. Operating room integration, which is the fastest growing area in the surgical space over the last couple years, is a high R&D spender. It looks more like computers than it does patient room equipment, if you will, or something like that. So it is a higher R&D spend, so that has increased it.
But we also have seen some opportunities we think for new products in the space, and so we've ratcheted up our R&D spend. And one of the things we've done is, just like we believe in insourcing of manufacturing, the more we can insource our R&D work and/or to invent things instead of buying things that other people have invented, the better our returns are. So we've continued to add to that muscle in the business, and I don't see that stopping.
Okay, thanks. That's great. And also on the investment theme, you talked about focusing somewhat on outsourced reprocessing on the HSS business. And I was just wondering the timeframe in terms of investments there and when you expect to maybe start getting some returns on those.
I would say there are two groups of investments in that regard. We do, I'll call it small project outsource work, and those returns are very rapid. You have to invest up front, like all services, and hire people, train people, do all those things, but they start returning pretty nice margins in three to six months, so it's a relatively short turnaround.
Now, when you talk about building a new ORC and staffing it and staffing management and all that, that's a longer-term return. As we've mentioned, those businesses will start out the first several months losing money, and then they'll turn into breakeven and then relatively low profitability. Over a couple years, we will get to what we would call steady-state margins for that particular facility. So those are longer-term returning investments. We have a mix of both in that business, so you'll see a spread between those.
And then the second piece, not unlike AST, once you have a facility in place and if you gather more customers for that facility, you might have to make some incremental investment in equipment or something and a few more people, but you don't have the all-in fixed costs that you do there. So as you fill those out, you also increase the profitability of the centers. But because we're in a startup mode, not unlike what we were 15 – 20 years ago on AST, we will see lumpiness in those returns as we add new facilities.
Okay, that's great, and finally, Mike, just a quick question on the share repurchase. It seems like it ticked up a little this past quarter. I was just wondering how much you have available on the share buyback.
Mitra, we still have about $125 million remaining under the board authorization.
Okay, thanks again for taking the questions.
Our next question comes from Dave Turkaly from JMP Securities. Please go ahead with your question.
Hey, good morning, just a quick follow-up for me on the AST side. I know you were asked about the sustainability, but I'd love to get any color on the double-digit growth area that you're in.
And then as a follow-up on the profitability, that 40% that was mentioned, could you just comment on pricing there? Can you get pricing there? Are you able to raise prices there, and then anything that's changing on the input cost side? Thanks.
Several questions. Clearly, our medical device business across the board had a nice last three months. And so we live off their work, so as we see more procedures and more devices being implanted and used, the better off we are, and clearly we reflect that.
Secondly on price, we do get modest pricing improvements; that is, typically our contracts in that space are three to five years. Probably now between 80% and 90% of our business is on contract, and so that is built in. But again there are, I'll call them for lack of better terms, inflationary type cost increases or price increases. So we do get some price increase there.
In terms of the input costs, no question, we are seeing pressure on labor costs, and labor is a big piece of that business. So labor costs around the world, as you know, are increasing, particularly in the U.S., and so we do see that pressure. But on the other hand, we're working on productivity. So we try to offset as much as we can in terms of labor cost components with productivity. Those are probably the biggest components that I would mention. I'm trying to think if I've hit all of your questions.
Sorry it was so many, but yes, you got them all. Thanks a lot.
And our next question comes from Chris Cooley from Stephens. Please go ahead with your question.
Hey, good afternoon, everyone, or I should say good morning, everyone. I appreciate you taking the question, just maybe one quick one at this point in the call from me. Walt, would you mind giving us a broad overview or state of the union when you think about the competitive dynamics in the industry? I know there's been a lot of chatter recently about asset sales that are pending, new entrants on the sterilization side from a contract perspective, as well as maybe migration to disposable scopes, just a number of moving parts I know you've addressed on a one-off basis, but maybe just some early, if you could, address just the competitive backdrop in the industry. Thanks so much.
Sure, Chris, good to chat with you again. First of all, in terms of, I'll call it the general industry backdrop and not necessarily competitive, I'll come back to that one, I think many times people look at healthcare and all of the changes that do occur and more importantly all the changes that are discussed, all the potential changes that are discussed, and we forget this little detail that healthcare is still built on the concept of first do no harm. So it is appropriately a highly regulated careful industry in general. So even though relative to healthcare there are rapid changes relative to many other pieces of the economy, they're pretty small changes.
So I have found in my own experience in the last 30 years or so dealing in this space that we move more like a battleship then we do a PT boat as a group. And there are changes. The changes tend to occur when governments change things, significant reimbursement changes or significant approaches to things. But even then, things still tend to turn relatively slowly. That's point one.
Secondly, from a competitive space, there have been a number of changes. There are businesses being purchased and businesses being bought and different players in the space. But generally speaking, we work in a highly competitive environment in medical devices. The R&D and barriers to entry are very different than they are in the pharma space, for example. And so being in a very competitive environment all the time and having price pressure from our customers all the time, particularly if you are not in the physician preference space, which we generally aren't, that has been the way of life for this business for 35 – 40 years, not 35 minutes. And so I don't see a radical change there.
We clearly have seen more consolidation in the space that is. And as you know, the larger companies in healthcare have typically – and med device now I'm talking about, healthcare in general too I guess, the larger companies have tended to consolidate. But that is a continuation of a long-term trend, that's not something that's brand new. We often see both vertical and horizontal consolidation in the business. Sometimes it continues and sometimes it stops and reverses.
Again, there will be a lot of change. But in terms of our space and our competitive space, I don't see those radically or having radically changed the past. But now at a high level – that's the high-level thing you asked for. It's very different business unit by business unit by business unit and it's different between AST and healthcare in general. There are fundamental differences between those businesses. But the things we've talked about or I've talked about here are characteristic across the board on all those businesses, in my view.
Thanks much.
And, ladies and gentlemen, at this time I'm showing no additional questions. I'd like to turn the conference call back over to management for any closing remarks.
Thanks, everybody, for taking the time to join us this morning, and we look forward to seeing many of you as we get on the road this fall.
Ladies and gentlemen, the conference call has now concluded. We do thank you for attending today's presentation. You may now disconnect your lines.