STERIS plc

NYSE:STE

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, everyone, and welcome to the STERIS plc Second Quarter 2023 Conference Call. [Operator Instructions] Please also note, today's event is being recorded.

At this time, I’d like to turn the conference call over to Julie Winter, Investor Relations. Ma'am, please go ahead.

[Julie Winter, IR]

Thank you, Jamie, and good morning, everyone. As usual, speaking on today's call will be Mike Tokich, our Senior Vice President and CFO; and Dan Carestio, our President and CEO. And I do have a few words of caution before we open for comments.

This webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission or rebroadcast of this call without the express 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 our 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' 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, adjusted operating income, constant currency organic revenue growth and free cash flow will be used. Additional information regarding these measures, including definitions, is available in yesterday's release, also including reconciliations between GAAP and non-GAAP financial measures. Non-GAAP financial measures are presented during this call with the intended 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.

[Michael Tokich, SVP, CFO]

Thank you, Julie, and good morning. It is once again my pleasure to be with you this morning to review the highlights of our second quarter performance.

For the quarter, constant currency organic revenue increased 7%, driven by volume as well as 290 basis points of price. As anticipated, the divestiture of the renal care business impacted our comparisons to the prior year by about $45 million, as detailed in the press release tables. Our year-over-year growth rates will be impacted by this divestiture for one more quarter.

The integration of Cantel Medical continues to go well. We achieved approximately $15 million of cost synergies in the second quarter, bringing our first half total to about $35 million. We are on track to achieve our stated goal of approximately $50 million in fiscal year 2023.

As anticipated, gross margin for the quarter decreased 140 basis points compared with the prior year to 44.8% as pricing, currency and the favorable impact from the divestiture of Renal Care were more than offset by lower productivity and higher material and labor costs. Material, labor costs continue to be a headwind and totaled about $30 million in the quarter.

Despite the decline in gross margin, EBIT increased 50 basis points to 23.8% of revenue compared with the second quarter of last year, which reflects the benefit of realized cost synergies from the Cantel integration, currency impact and lower-than-anticipated SG&A expenses driven by disciplined cost management and reduced incentive compensation. The adjusted effective tax rate in the quarter was 22.8%.

Net income in the quarter increased to $200 million and earnings were $1.99 per diluted share. You will notice that we reported a loss on a GAAP basis in the quarter.

At the time of the Cantel acquisition, we determined the fair value of the Dental segment based on projected cash flows discounted at rates reflecting market costs of capital and market EBITDA multiples. Macroeconomic conditions, including rising interest rates, inflationary pressures on material labor costs and uncertainty regarding the impact of such economic strains may have on patient and customer behavior in the short term triggered an interim assessment of goodwill in the quarter.

Revised cash flow projections and a current market weighted average cost of capital resulted in an estimated fair value of the Dental segment below its carrying value. Therefore, we recorded a $490. 6 million noncash impairment charge related to the goodwill associated with the Dental segment. Our long-term outlook for the Dental segment is unchanged. And we continue to see significant growth opportunities in the dental space for STERIS.

Capital expenditures in the first half of the fiscal year totaled $198.7 million while depreciation and amortization totaled $272. 7 million. Year-to-date, our capital expenditures have been higher than anticipated, primarily driven by the timing of investments in the AST segment. We still expect our full year capital expenditures to be approximately $330 million.

Free cash flow for the first half of the year was $138.2 million. Free cash flow was limited by higher-than-planned capital spending, mainly due to timing and higher-than-planned levels of inventory. We do not anticipate the same level of spend in the second half of the fiscal year for either which will contribute to a significant step up in free cash flow. All in, we now anticipate that free cash flow for the full year will be about $600 million or a reduction of $75 million from our original guidance.

I will now turn the call over to Dan for his remarks.

[Daniel Carestio, President, CEO]

Thanks, Mike, and good morning, everyone. Thank you for taking the time to join us to hear more about our second quarter performance and our outlook for the rest of the fiscal year.

We continue to see strong demand for our products and services. And as you've heard from Mike, we had a solid quarter despite the ongoing macroeconomic challenges. I will review the highlights of the quarter and then shift my commentary to our outlook.

Total company constant currency organic revenue growth was 7% in the quarter. Once again, foreign currency was more impactful than previously planned on our as-reported revenue, but we are pleased with our operational performance.

From a segment perspective, Healthcare constant currency organic revenue grew 7% in the quarter. As we discussed last quarter, by August, we had an improved visibility on supply chain challenges and that we anticipated that we would start to see better component deliveries in the quarter. We received several key components, and we're able to step up our shipments in September. We continue to expect to see significant levels of capital shipments in the second half based on our backlog, the inventory of key components that we have or will continue to receive.

Reflecting that scenario, capital equipment and service growth remained solid in the quarter as we continue to see good demand from our customers.

Consumables were about flat on a constant currency organic basis. Our consumable growth is limited due to a lack of procedure growth on a year-over-year basis. As we have said before, we do not expect a significant pickup in procedures in the coming months, but we are optimistic we will get back to 100% pre-pandemic levels over time.

Hospital capital spending remains robust as evidenced by our Healthcare backlog, which totaled over $500 million at the end of the quarter. Orders for the quarter were approximately 60% for replacement products and 40% for large projects.

Despite the uptick in shipments at the end of the quarter, we believe approximately $60 million in capital equipment shipments were delayed in our second quarter, further strengthening our confidence in the second half.

Longer term, our portfolio at STERIS is essential to surgeries, either directly in the operating room or in the core support sterile processing department and we believe this provides us some insulation to our revenue base from our customers' rising cost of capital.

Moving on to AST. AST grew constant currency organic revenue 19% in the second quarter as we continue to benefit from underlying demand from our core customers. In the second quarter, [MevX] improved significantly on both a year-over-year basis and sequentially, which pushed our growth rate into the high teens. As you have already witnessed, shipments can be lumpy with this segment of the business. Similar to Life Sciences, these are large pieces of capital equipment that are not booked as revenue until they are fully installed and tested.

From a profit perspective, increased energy costs, both in the U.S. and internationally, are impacting margins for AST. All signs indicate this will continue at least through the winter. We continue to look for ways to recoup these costs as the contracts allow in the timing of our increases.

Life Sciences revenue was flat on a constant currency organic basis compared with the prior year. Solid service revenue growth was offset by declines in both capital and consumables. We believe capital equipment shipments are just a matter of timing as about $10 million slipped into the third quarter versus our expectations. And as a reminder, the business had a very strong shipment quarter in Q1. Also, our backlog continues to hover around $100 million. We are optimistic about the long-term demand for our capital equipment in this segment.

On the consumables side, we're about flat from a constant currency organic revenue perspective. This is primarily due to inventory management by our customers, in particular, in our barrier products line. Again, not concerned about the long-term underlying trends for the business as aseptic pharma production demand remains very strong.

Our Dental segment declined 3% on a constant currency organic revenue perspective. While procedure volumes for Dental continue to hover around 95% of pre-COVID levels, year-over-year procedures have declined in the low single-digit range. We believe this is due to the current macroeconomic conditions. Despite the decline in revenue, operating margins were over 25% as we manage spending and experienced some relief on our supply chain costs.

Turning to our full year outlook. Constant currency organic revenue growth expectations of 10% remain unchanged. However, based on the ongoing foreign currency challenges, we are revising our as-reported revenue. As-reported revenue is now expected to grow 8%, a reduction of 1% from the prior expectations due to continued foreign currency fluctuations. For the year, currency is now expected to reduce as-reported revenue by $150 million and adjusted EPS by approximately $0.15. The primary drivers of this continue to be the weak euro and British pound.

Reflected in our revenue outlook is improved pricing. We are now expecting around 250 basis points for the year. Combined, pricing and disciplined spending will contribute to higher-than-planned operating margins for the fiscal year. This will help offset the impacts from foreign currency and additional supply chain inflation. For the year, we now expect an incremental $90 million in extraordinary supply chain and labor cost inflation, an increase of $20 million over our prior expectations.

Factoring in these elements, our expectations for earnings are unchanged at the $8.40 to $8.60 range for the full fiscal year. However, with an additional 5% impact from foreign currency, we believe the high end of that range is less likely.

Overall, our business continues to perform very well in this environment. Our teams and portfolios continue to come together to better meet the needs of our customers and the breadth of our offering allows us to take advantage of several significant trends in the industry by leveraging our relationships to cross-sell within business segments and deliver value to our customers.

Before we open for Q&A, I did want to address the challenges the industry is facing on ethylene oxide. As you all know, ethylene oxide is essential to the supply of sterile single-use medical devices throughout the world. To date, the industry does not have an alternative to EO. And currently, in the U.S., there is very limited capacity to manage the long-term growth expectations for the medical products industry's demand for ethylene oxide processing technology.

At STERIS, we take our responsibility very seriously as a provider of these crucial services and have always been committed to strict regulatory compliance and quality standards for the safety of our people, our facilities and the communities in which we operate. We are stewards of the long-term success of our business, which I believe is exemplified by our actions. We have regularly updated our processes and equipment used within our facilities to reflect the adoption of new technology and deploy the best practices possible.

In addition, we have led the industry in developing sustainable EO cycles, which significantly reduced the amount of EO gas used per cycle. And we have worked closely with the U.S. FDA to ease the regulatory transition for our customers so they can more easily adopt these cycles. This diligence is consistent with the way we have operated our contract sterilization business for many years. I am confident in how we have run and continue to run these facilities and the improvements we have made to our process within the AST segment.

With that, I will turn it over to Julie to begin the Q&A.

[Julie Winter, IR]

Thank you, Mike and Dan, for your comments. Jamie, can you give the instructions, and we'll get started on Q&A.

[Operator]

[Operator Instructions] And our first question today comes from Matthew Mishan from KeyBanc.

[Matthew Mishan, KeyBanc]

Just first, how should we think about the second half acceleration in organic growth? And kind of what are the key drivers around that?

[Michael Tokich, SVP, CFO]

Matt, the main driver is, as we continue to talk about is capital equipment shipments, in particular in our Healthcare segment. That is really going to be the factor that drives us from about 7% constant currency organic revenue growth to 13% constant currency organic revenue growth around there to achieve our 10% for the full year. So it's all driven by our ability to ship capital equipment in Healthcare.

[Matthew Mishan, KeyBanc]

Have you secured the components necessary so that you do have the confidence that you will be shipping those?

[Daniel Carestio, President, CEO]

Matt, this is Dan. I would say we have a lot more confidence today than we had 3 months ago. There's no guarantees as it relates to the current environment with supply chain. But we do have a lot now that's in stock, and we are aggressively shipping as we can finish off machines.

And I think that in terms of level of confidence from our suppliers that those shipments will continue to come in, in a more predictable fashion is pretty high.

[Matthew Mishan, KeyBanc]

And then lastly, does it require an inflection in Dental? Or is it possible that you're still going to get the 10% with Dental like remaining flat to down?

[Daniel Carestio, President, CEO]

We believe the Dental business is going to stay suppressed until procedures come back. And I think that's tough to predict when that's going to happen, given that these are highly elective. And currently with inflation and everything else, it's something that we believe is good. We've got it modeled to stay where we got it year-to-date, more or less.

[Operator]

Our next question comes from Mike Matson from Needham & Company.

[Mike Matson, Needham & Company]

So I want to ask about the -- there's kind of a big difference in the growth between the AST business and then the consumables on the Healthcare side. And since I assume a lot of the AST volume is medical devices that are getting used in procedures or maybe will get used in procedures eventually. How do you kind of explain that? Do you believe that we're still below pre-COVID levels in terms of procedures, which kind of hurt your consumable growth in healthcare, but AST is still really strong?

[Daniel Carestio, President, CEO]

Yes. I mean it's -- there's three components of revenue, right? I mean there's price, there's share and then there's just volume growth. And what I would say is, generally speaking, for medical products, we've seen some recovery in terms of higher end, higher value whether that's neuro or whether that's spine or whether that's ortho, we have seen some recovery in those procedures. General surgery, we haven't seen any difference. In fact, it's still hovering at this pre-COVID -- not back to those pre-COVID levels and that's largely a function of staffing in the health care network.

The other side of that is we're doing everything we can to recoup price as costs go up in that business. We have a long history of being able to successfully do that with our customers. And then the other component is share. Maybe we picked up a little bit of share over the last couple of years, and there's a long tail on that in terms of annualizing those run rates.

And keep in mind, too, there is a significant portion of our business that's not pure medical products. There is some level that is process type disposables. And that part of the market continues to grow at a pretty high rate, and we've been benefiting from that.

[Mike Matson, Needham & Company]

Okay. Got it. And then in terms of the EO regulations, I guess, do you have any sense for the timing on when those are going to be revealed? And then do you -- how do you feel in terms of where you're at with your PO practices? I mean do you think there's a potential that you would have to make any changes? I mean it seems like you really putting into place some pretty rigorous processes to reduce admissions. But I don't know if there's any way to go beyond what you've already done there, but --

[Daniel Carestio, President, CEO]

Yes. What I would say is this, I think we expect to see a rule draft sometime in the first calendar quarter out for public viewing. I mean, I've said that before, but I think it actually may happen this time. And so I do expect to see something out in public domain sometime in the first calendar quarter of the year.

Now having said that, what I would say is that we have consistently invested and found ways to improve our processes. And I would say generally above and beyond the regulatory requirements that are out there. If I look back in our history, a couple of notable examples of those types of improvements would be where we proactively invested in our abatement technology and this is over decades, not in the last 18 months, including upgrading our flares with wet scrubbers and using catalytic oxidizers and developing also in the last few years, we've installed full abatement systems in our outbound warehouses in the U. S. AST locations for capturing any potential fugitive emissions.

Within and around all of our EO chambers, we have significant safety measures and enhancements in place, including locks that don't allow the chamber door to be open until the prescribed amount of EO is met in terms of the chamber to ensure the safety of our people and maximum capture of ethylene oxide.

And then also a significant thing around the STERIS AST, in particular, the U.S. locations is any of those sterilizers that have or had back vents have always, I repeat, always been tied into the emission control systems for maximum destruction of any potential gas coming out of the facility.

[Mike Matson, Needham & Company]

Okay. Got it. And then just one on interest expense. It was a little higher than -- or I guess I should say other expense, but I think it's mostly interest. So it was a bit higher than what we expected. Is that because interest rates have gone up? And how much of your debt is variable rate? I don't know if you can give us any guidance on what to expect for the full fiscal year for interest expense, but --

[Michael Tokich, SVP, CFO]

Yes, Mike, it's definitely -- the rates have gone up. We're all in about 3.6% total, which is definitely higher than where we have been. And unfortunately, our projections are that rates will continue to rise. Currently, we sit at just over $3 billion of total debt, and it's about 70-30 fixed versus floating is our percentage.

[Operator]

Our next question comes from Jacob Johnson from Stephens.

[Jacob Johnson, Stephens]

Just on the Life Sciences segment, it looks like the backlog growth decelerated some this quarter, kind of flattish growth volumes down. Can you just talk about demand trends from that end market? It sounds like maybe some of this is related to the timing of shipping orders, but any thoughts on that end market?

[Daniel Carestio, President, CEO]

Yes. I mean as those -- I'm sorry, this is Dan. As -- those shipments can be lumpy, so can orders because they tend to be pretty high value. I'm confident that our backlog, if we can can hold that around $100 million, that is absolutely outstanding for the long-term success of the Life Science capital business. And so I'm happy where it is, and our order intake is strong as well as we look into the future. So I think we just got to get the stuff shipped out of our plants, and we'll be working on that diligently over the next 6 months.

[Jacob Johnson, Stephens]

Got it. And then just circling back on the Dental impairment. I think some of it’s related to near-term performance, but I suspect some of that might be related to rising interest rates. Can you just talk about those dynamics? And then I think you mentioned in your comments, no real change to your long-term outlook for that business, but I figured I’d ask about that as well.

[Michael Tokich, SVP, CFO]

Yes, certainly. And as I did say at the end of that paragraph in my prepared remarks, we believe that long-term outlook for Dental segment is unchanged and that we continue to see significant growth opportunities in that space.

What’s really driving that is really – what’s driving the impairment, and we have to look at this at any time we have any indicating factors that goodwill will be – may be impaired the estimated fair value of that segment, maybe below its carrying value. And really what’s driving that is use of discounted cash flow model at interest rates, in particular, the rising interest rates in addition to the inflationary pressures we’re seeing on labor and material costs are really the two key factors that are driving us to impair all of the goodwill associated with the Dental segment.

[Operator]

Our next question comes from Jason Bednar from Piper Sandler.

[Jason Bednar, Piper Sandler]

And great to hear the progress in the component source in the quarter. It sounds like that's really going to contribute to a nice step-up in growth here in the second half of the year. But I'm going to pack a few questions in here on this topic. Dan, can you say whether those capital equipment delays late in the quarter that you referenced, are you catching up on those real-time? Is there anything we should consider with respect to your capacity to deliver against that backlog? Because, again, that is a pretty big step-up in growth. I just want to confirm that.

And then finally, I can't imagine this is more aggressive shipping suddenly stops at the end of this fiscal year. So I guess, is it right to think of this equipment momentum continuing into fiscal '24 as well?

[Daniel Carestio, President, CEO]

Okay. Yes, sure. Thanks, Jason. In terms of your question around capacity, what I would say is this is we've been building machines without components now for the whole fiscal year basically. And because the demand is high, we can't lose a manufacturing slot. So we have a number of machines that at the end of the quarter, we're finished awaiting a $7 part before we could ship it to our customers. It's not literally, but almost literally, yes. So we continue to manufacture every slot that we have and then finish out equipment as those components show up on our docks, if you will. So I think we're in pretty good shape.

But we've also historically have shown our ability to flex manufacturing pretty considerably in terms of -- if you look at historical performance of STERIS, we typically have a bigger back half than front half in terms of capital shipments. So our teams are able to do that, and they have a long history of doing that.

In terms of momentum going into the next year, I think that's something that it's hard to look at right now, and it's not something we're discussing in terms of our future outlook in terms of what's going to happen in the -- I mean we've got 6 months left to deliver on that's critically important for STERIS and our customers right now.

[Jason Bednar, Piper Sandler]

Okay. Yes, fair enough. That's helpful. And then maybe a couple of clarification points. Mike, can you just confirm that the reaffirmed earnings guidance year-to-date contemplates additional rate increase, like it looks like we're going to be dealing with here over the coming months?

And then secondly, just on the higher inventory levels that are causing free cash flow, the free cash flow guidance cut, does that continue -- do those inventory levels continue beyond fiscal '23? Do we get a reversal at any point? Just how do you see that playing out?

[Michael Tokich, SVP, CFO]

Yes, definitely on the inventory levels, we've continued to hold higher inventory levels all this year projected, the rest of this fiscal year, even last fiscal year. So hard for me to sit there and pinpoint exactly when we will turn that spigot off and once we do obviously, we will see a nice benefit to working capital. I don't know if that's going to be in '24 or beyond or timing, it's just too hard to predict at this point in time. We're just happy to get the inventory components and to shift the equipment for the customer. So more to come on that.

And yes, we did bake in increased continued increased interest rates in our forecast. So that is already contemplated.

[Operator]

Our next question comes from Michael Polark from Wolfe Research.

[Michael Polark, Wolfe Research]

I want to ask about the back half and then '24 on equipment. And then maybe 1 or 2 follow-ups. On the back half, just as we consider our models, 13%. Real revenue growth for the total company year-on-year, but December quarter, lower than that. March quarter higher. Any flavor you can provide on phasing because clearly, the toggle in the spreadsheet is the Healthcare equipment revenue, and it's some pretty big numbers, and it's obviously difficult to predict quarter-to-quarter. So I think it'd be helpful just to level set like how you expect this to unfold the next 6 months between December versus March quarters?

[Michael Tokich, SVP, CFO]

Yes. In just looking at it, obviously, in order for us to meet our intended free cash flow, we need to ship capital equipment earlier so we can collect. So I would say that Q3 would be a little bit higher from a growth standpoint than Q4 would be if we're modeling this.

[Daniel Carestio, President, CEO]

Yes. But I would also say, to use your words, it is difficult to predict. And in terms of revenue recognition, at the end of the quarter, it's a different world today in terms of getting things accepted and received around the holiday season than maybe it was in the past with labor shortages. So we believe we're going to deliver on the year and I think trying to be extremely precise from Q3 to Q4 is a little tough right now.

[Julie Winter, IR]

Caps do get much higher -- sorry, Mike, in the fourth quarter, we have 11% comps, constant currency organic -- Q4. So certainly, the comp issue as well in the fourth quarter.

[Michael Polark, Wolfe Research]

You talk me up versus my initial stab sequentially. So okay, I will consider. I appreciate that comment. And then I guess, look, I understand you're not going to comment on fiscal '24, but these equipment revenue numbers are potentially very large in fiscal '23. And I guess we have to take a stab at publishing a fiscal '24 framework. And it just seems kind of reasonable to think total company equipment revenue might kind of be down in fiscal '24 on a very significant comp as you unlock the backlog. Is that an unreasonable thought?

[Daniel Carestio, President, CEO]

Keep in mind, a lot of that backlog is in large project that could extend out into future fiscal periods. So it's -- the short answer is we don't know right now. I mean if order rates stay high like they have been, then there's no reason why we shouldn't continue to do incredibly well on capital. If they slow down, then that will impact it.

I mean the good thing is, is that we have an awful lot of other business in healthcare that tends to buoy us on when capital slows and when capital is going great, it helps.

[Michael Polark, Wolfe Research]

If I could add one more on Life Sciences consumables, the kind of inventory management that you called out at production facilities. I mean, what inning do you feel like we're in did that just kind of start in biopharma? Are we halfway through the game? Any flavor for how long that's been kind of happening would be helpful?

[Daniel Carestio, President, CEO]

Yes, I think it's been happening now for a couple of quarters, and I think that we'll see a reverse trend in the back half of the year.

[Operator]

[Operator Instructions] Our next question comes from Dave Turkaly from JMP Securities.

[Dave Turkaly, JMP Securities]

Maybe just I've been jumping around, so I apologize if somebody hit this, but you mentioned the price again and almost 300 bps. It's a lot different than a lot of the companies we cover. So I was wondering if you might be willing to give us a little color either on divisions or geographies or products or like where it's mainly coming from or any of the drivers there? And do you think that's sort of sustainable?

[Daniel Carestio, President, CEO]

I think it's sustainable in the sense that we have an obligation as we have sustained higher cost to pass that on, wherever we can and wherever our customers can accept it. So that's something that I don't think is going to change assuming that we consider on this -- we continue on this rate of relatively high inflation and especially when there are certain components of inflation that are unique to STERIS in terms of having more meaningful impacts on costs, whether that's electricity or steel or electronics or things like that. So I think that that those trends will continue as long as they need to.

In terms of breakdown of price by segments, we don't really weigh into that. I mean, clearly, health care hospital systems is tougher than some where we have contracts. But as those contracts roll from a GPO perspective, then we'll be incorporating appropriate new pricing levels.

[Michael Tokich, SVP, CFO]

Yes. The one thing I can say, Dave, is that we are getting price across all of our segments.

[Operator]

And ladies and gentlemen, at this time, I'm showing no additional questions, I'd like to turn the floor back over to Julie Winter for any closing remarks.

[Julie Winter, IR]

Thanks, everybody, for taking the time to join us. We will be on the road quite a bit over the next few weeks, and we look forward to seeing many of you in person.

[Operator]

And ladies and gentlemen, with that, we'll conclude today's conference call and presentation. We do thank you for joining. You may now disconnect your lines.