STERIS plc

NYSE:STE

Earnings Call Transcript 2023-Q4

[Operator]

Good morning and welcome to the STERIS plc Fourth Quarter 2023 Earnings Conference Call. [Operator Instructions] Please also note, this event is being recorded.

I'd now like to turn the conference over to Julie Winter, Investor Relations. Please go ahead.

[Julie Winter, IR]

Thank you, Chad, and good morning, everyone. As usual, speaking on our call this morning 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 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' 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 our release, as well as 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.

[Michael Tokich, SVP and CFO]

Thank you, Julie, and good morning, everyone. It is once again my pleasure to be with you this morning to review the highlights of our fourth quarter performance. Following my review, Dan will comment on the full year of fiscal '23 and talk about our outlook for fiscal '24.

For the quarter, constant currency organic revenue increased 16% driven by volume as well as 330 basis points of price. As anticipated, gross margin for the quarter decreased 240 basis points, compared with the prior year to 43.1% as pricing and currency were more than offset by unfavourable mix and approximately $15 million in excess material labor inflation. We incurred approximately $90 million in higher material and labor costs during fiscal 2023.

We achieved approximately $10 million of cost synergies from the integration of Cantel Medical in the fourth quarter, bringing our full year total to just over $55 million. We are proud of the work our folks did to integrate Cantel Medical into STERIS, over achieving our projected total cost synergies ahead of schedule. We have substantially completed the integration process and going forward, we will no longer be tracking and reporting cost synergies from Cantel.

EBIT margin increased 20 basis points to 23.8% of revenue compared with the fourth quarter last year. This reflects a reduction in SG&A as a percentage of revenue somewhat offset by the gross margin pressures I mentioned earlier. The adjusted tax rate in the quarter was 23.6%, net income in the quarter was $229.2 million and earnings were $2.30 per diluted share.

Capital expenditures for fiscal 2023 exceeded our plan and totalled $362 million, while depreciation and amortization totalled $553 million. Our capital expenditures spending was higher than anticipated, primarily driven by the timing of investments in our AST segment.

Total debt remains just over $3 billion, reflecting borrowings to fund a few small acquisitions during the year and opportunistic share repurchases. We remained active buying back stock in the fourth quarter and in total, repurchase 1.6 million shares in fiscal 2023 for a total spend of $295 million.

As we anticipated last week or as announced last week, our board has authorized a new repurchase program for up to $500 million in buybacks. For fiscal 2024 we would anticipate returning to our normal cadence of repurchasing shares only to offset dilution. Total debt to EBITDA at the end of the fiscal year is just under 2.3 times gross leverage.

Free cash flow for fiscal 2023 was $410 million. Free cash flow was limited by higher than planned capital spending and pressure on working capital, in particular for inventory and receivables.

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

[Daniel Carestio, President and CEO]

Thanks Mike and good morning, everyone. Thank you for taking the time to participate in our fourth quarter and full year call. I will cover a few of the highlights of the year and then the address our outlook for fiscal 2024.

As you heard from Mike we ended the year strong and grew revenue 9% on a constant currency organic basis in fiscal 2023. This is impressive performance in particular given the macro challenges we faced all year. We are cautiously optimistic the supply chain challenges have eased in a meaningful way and surgical procedure rates are improving. Our fourth quarter and full year results are reflective of that.

At the business level, our healthcare segment revenue ramped up throughout the year, culminating in 11% constant currency organic growth for the year, with very strong performance in the fourth quarter. Healthcare capital equipment grew 15% for the year on top of double-digit growth last year. The team did a great job working through the whip inventory and shipped $50 million more capital equipment in the fourth quarter than we did in third.

Having the components we needed to get those products out to our customers was essential and it was a huge lift by our supply chain and manufacturing teams. While we still have pockets that are challenging, we are feeling much better about the availability and access to components for our capital equipment, heading into fiscal 2024.

In addition, our backlog continues to hover around $500 million despite the strong shipment during the quarter. $500 million is a very solid place to start the new fiscal year. Of note, our orders are shifted again towards large projects, which represented 50% of the capital equipment orders in the fourth quarter. Remember that large project orders tend to have longer lead times.

Healthcare consumers also finished the year strong as we saw restocking of products as surgical procedures continue to increase sequentially. For the year consumers revenue grew 5% about in line with our long-term expectations, although revenue was a bit lumpier from a quarter-to-quarter perspective than we would normally anticipate.

Our healthcare service revenue finished strong, growing 8% for the year with solid growth across all the business aspects. Our AST segment grew 12% on a constant currency organic basis for the year, despite a reduction in demand for single use bioprocessing disposables. As healthcare procedures continue to rebound, the underlying demand for our products from core customers in medtech remain very strong.

As mentioned last quarter, about 10% of the AST business is comprised of bioprocessing customers, which slowed for the first time during our third quarter. That trend continued into the fourth quarter where once again we saw a decline in revenue of about $5 million. We believe the trough will come in the first half of our new fiscal year, and while we would expect to return to sequential growth in the second half, we do not expect to return to year-over-year growth until fiscal 2025.

Our customers in that space have made significant investments to expand their manufacturing capacity for the long term growth and we have every belief that that growth will return once we work through the short term destocking.

Turning to life sciences, constant currency organic revenue grew 5% for the year, with a strong finish in the fourth quarter, despite the reduction in bioprocessing and vaccine demand. As anticipated, the $10 million in capital equipment that we couldn't ship in the third quarter came through in the fourth, contributing to a record quarter of capital shipments.

Consumables also finished strong as we worked through supply chain challenges, including more normalized shipping to Asia Pacific, and we were able to make progress towards more normal delivery times. Service grew mid-single digits for the year, with solid performance and equipment maintenance and installation of new capital equipment. Backlog is holding just over $100 million, and that is a great place to start the new fiscal year.

Dental was about flat on a constant currency organic basis for the year. Procedure volumes remain at approximately 95% of pre-COVID levels due to the broader economic pressures impacting consumer spending. Based on market data, STERIS is performing better than market and benefiting from pricing and modest share gains.

Turning back to the P&L, even with favorable pricing, gross margins were down 180 basis points for the year, as our cost increased at a rate faster than we could recoup. We did a nice job managing SG&A in the year and improved EBIT margin by 10 basis points in the face of the gross margin declines. Unfortunately, part of that was due to lower incentive compensation for our people, which we'll be working hard to get back in fiscal 2024.

Interest and taxes were a bit of a headwind to bottom line growth, but we finished fiscal 2023 at $8.20 and adjusted earnings per diluted share, an increase of 4% from fiscal 2022. While that is certainly lower than our standard earnings performance, our five-year CAGR for adjusted EPS is still in impressive 15%.

As I said in the beginning of the call, we feel optimistic heading into fiscal 2024. Our strong fourth quarter allowed us to level out our performance between fiscal years more than anticipated. We also saw nice signs of improvement, which began in the third quarter and continued to improve sequentially, leaving us optimistic that we have a few tailwinds in fiscal 2024. In particular, we anticipate continued recovery of healthcare procedures and easing of supply chain issues as well as foreign currency levelling out.

For fiscal 2024, total revenue is anticipated to grow 7% to 8%, with about a 100 basis points in positive foreign currency impact. Constant currency organic revenue is expected to grow 6% to 7%. That includes about 200 basis points in favorable pricing. Gross margins are expected to improve modestly as some of the headwinds faced in fiscal 2023 abate.

EBIT margins are anticipated to be about flat as we absorb approximately $40 million from incentive compensation year-over-year and cost increases above and beyond normal inflation for material in labor of about $30 million. Interest in taxes will be a bit of a headwind, some of which will be offset by a reduced share count, reflecting the additional purchases made during fiscal 2023.

Factoring in all of those moving pieces, our outlook for adjusted earnings per diluted share for fiscal 2024 is $8.55 to $8.75. To assist you in your modelling, we do anticipate that our revenue and earnings will be weighted towards the second year -- the second half of the year. In the first half, we anticipate continued impact from a reduction in bioprocessing demand, resulting in difficult comparisons within AST that will impact our growth and profitability.

For both revenue and EPS, we would expect the split to be 45 in the first half and 55 in the second half. As we look at our healthcare capital equipment, backlog remains strong and we believe in fiscal 2024 we will return to a normal cadence of shipments, which generally start lighter in the first quarter and then build throughout the year.

Our plan assumes we get back to normal lead times by the end of the fiscal year, and while we do not provide quarterly guidance, I would note that the anticipated cadence of capital equipment revenue, combined with a significantly higher interest expense and tough comparisons in AST with bioprocessing will limit our Q1 earnings growth potential.

That said, the tide is turning. We are feeling good about the direction where we are heading and the outlook we have provided for fiscal 2024. As we have said before, our continued long-term goal is to grow revenue mid-to-high single digits and leverage that growth to deliver double-digit growth and earnings. We strive to achieve this while also generating solid free cash flow, continuing to reduce our debt levels and grow our dividend.

Before we open for Q&A, I do want to make a few comments on the draft rules issued by the EPA last month. As you all know, over the past few years, we have made significant investments consistent with our practice of continuous improvement within our facilities. Our sustainable EO program and total permanent enclosure investments, position us very well to comply with many of the draft requirements.

We believe the EPA understands the weight of this regulation and its impact on the security of the vital US sterile device supply chain, and we are confident there will be a reasonable outcome for the final rules. Behind the scenes, we are partnering with our industry association in terms of our response to the agency.

Thank you. And with that, I'll turn the call back over to Julie to open it up for Q&A. Julie?

[Julie Winter, IR]

Thanks Mike and Dan for your comments. Chad, if you could give the instructions for Q&A, we'll get started.

[Operator]

[Operator instructions] The first question will come from Matthew, mission from KeyBank. Please go ahead.

[Matthew Mishan, KeyBanc]

Hey, good morning and thank you for taking the questions. Hey Dan, could you talk or Mike, can you talk a little bit more about the implied operating margin assumption of kind of flat kind of year-over-year? Outside of incentive comp, is there -- what else -- what are the other major moving pieces there?

[Daniel Carestio, President and CEO]

Yeah, the next biggest piece is labor costs have gone up across the board as the people we hired last year are more costly. So that's definitely going to hurt us a bit. We also are going to return more to somewhat pre-COVID levels than our spending, especially around travel. And then also FX is actually going to get negative to us in the operating expense, but by the time it gets to the bottom line, it'll be about neutral to us.

[Matthew Mishan, KeyBanc]

Okay. And then I'm having a little bit of problems modelling flat based upon some of the assumptions below the line. What are -- can you more explicitly call out the assumption for share count and for interest expense in 2024?

[Michael Tokich, SVP and CFO]

Yes. Share count will just be -- just over $99 million, interest expense and other will be approximately about a $10 million to $15 million headwind in total. Most of that, as Dan alluded to in his comments, most of that interest expense headwind is going to hit us in the first half. Majority is actually hit us in the first quarter because that's when we started seeing rates significantly rise was in the second quarter and for sure in the second half.

[Matthew Mishan, KeyBanc]

I'll jump back in the queue. Thank you.

[Operator]

And the next question is from Dave Turkaly from JMP Securities. Please go ahead.

[Dave Turkaly, JMP Securities]

Hey, great. Good morning guys and congrats on a strong wrap to the fiscal year. I was wondering maybe if we could get some thoughts, given how this quarter even played out divisionally in terms of how you're getting into the numbers in terms of the growth for fiscal '24. So, I'm sure healthcare's not growing 20%, but even if we're looking at ranking them, sounds like AST may be some tough comps, so maybe it's healthcare, life science, AST, but any color around sort of secular growth rates or what you think for those businesses to start this year?

[Daniel Carestio, President and CEO]

Yeah, Dave. So if you look at our total company, right, so we would say that on average, most of our businesses other than AST grow mid-to-high single digits. AST obviously, right around double digits, 10% grower this year, that is the case with healthcare potentially outpacing their normal growth. But Life Sciences would be in that same range, and then Dental would be single-digit growth in total.

[Dave Turkaly, JMP Securities]

Got it. And then I wanted to just ask a follow-up on free cash flow. We had a bunch of company's reports. I can jumping back and forth, but I think you guided to $700 million this year, and I think the comp was 409. So I'd just love to get your thoughts, Mike, on what exactly is happening there.

[Michael Tokich, SVP and CFO]

Yes. This year, we were under significant pressure from a free cash flow standpoint on both our receivables increased because just the timing of the revenue, a big bulk of our revenue is in Q4. So we were unable to collect. So that will push into FY '24. Our inventory, as we've been talking about all year, has been high. So we've got to take that down. So we're anticipating to take that down in FY '24.

And then also in FY '23, capital expenditures were higher than we anticipated originally. So the combination of all three really put pressure on FY '23 free cash flow. As we look into '24, the big change where we're going to get a nice impact is going to be lower inventory our ability to collect those receivables and then just growing net income in total will get us to about $700 million in total free cash flow.

[Operator]

And the next question will be from Mike Matson from Needham & Company.

[Mike Matson, Needham & Company]

I wanted to ask one on the EPA requirements for ethylene oxide. The comments that you made were, I guess, kind of vague. I guess the way I would interpret them and correct me if this is wrong, is that you are expecting some sort of changes in the final rules. I don't know if you're willing to comment on what areas you think maybe need to be changed.

I know [indiscernible] kind of called out the 18-month timing and some of the employee safety requirements in there. And if the final rule ended up looking like the proposed rule, can you comment on whether or not you would meet those standards and whether or not there'd be incremental costs to get there if you don't?

[Daniel Carestio, President and CEO]

Yes. I think there's still a lot. It's got to get worked out in the final definition of the rule. And my speculation is it probably gets extended in terms of comment period at this point. I would tell you that from a niche perspective, we're really confident where we sit in terms of our ability to meet as written and what could possibly be modified. As it relates to FIFA I think we got a little more gas over that. As we are no one in the industry right now are capable of meeting some of the stated exposure level standards. So I think that's got to get sorted out. And I think it will through the process.

[Mike Matson, Needham & Company]

Okay. And then just on the Dental business, so it was down in '24, most down in most quarters at least. You said 95% of pre-COVID levels. But I would assume if you stayed at the 95% in fiscal '24, then you should be able to get back to flat or even maybe some modest growth there. Is that a reasonable assumption?

[Daniel Carestio, President and CEO]

That's correct. Yes, that -- assuming that it sustains at that level and some of the modest level of pricing adjustments we've been able to put through, through that business, we believe that we can grow the revenue in the low single digits range.

[Mike Matson, Needham & Company]

Okay. And then just in terms of the share repurchases, so you stepped in to buy back some stock in '23. You said going forward with the new authorization, you're not planning to do anything other than just offset dilution. But I guess, what drove the decision to buy back stock in '23 rather than prepay debt? Was it just opportunistic? I know the stock fell on some of the ethylene oxide concerns and whatnot.

[Daniel Carestio, President and CEO]

Yes. It was just exactly that, Mike. It was just opportunistic based on where the share price moved down, largely on some of the yield litigation issues and things that the industry are facing. So we saw it as a good opportunity to invest [indiscernible] stock.

[Operator]

And the next question is from Jacob Johnson from Stephens.

[Unidentified Analyst]

This is Mac on for Jacob. Just a couple of quick ones for me. And to follow up on the EPA question earlier. Can you comment on some of the initiatives that you already have put in place and do you think these give you a competitive advantage as compared to some of your competitors will have to install those in the future?

[Daniel Carestio, President and CEO]

Well, what I'll tell you is some of our practices, I mean we've had our employees in what I would categorize as hot zones wearing full PPE, SCBA, self-contain breathing apparatus for over 10 years in our facilities. So I think we're already ahead of most of industry in terms of safeguarding our employees. We've installed on all of our outbound warehouses, abatement systems to scrub any fugitive emissions that's coming off product post aeration process.

Those are completely installed operational in the U.S. facilities. A number of other things in terms of just basic engineering design around our facilities where we have complete capture of everything in the chamber rooms as well as sealed drum storage rooms, which are also fully abated in the event of a leak and a number of different engineering controls that we have in place as it relates to the design of the facility.

In addition to that, we've been working hard with our customers and also pushing industry very hard to reduce the initial concentrations that are used in cycles and we've been very effective in moving many of the higher concentration cycles that are touching 650, 700 milligrams per liter down closer to 300 milligrams per liter. So it's a much lower input in which much makes handling products, especially post processing, much safer.

[Unidentified Analyst]

And then also, can you touch a little bit on your capital allocation priorities in terms of the buyback that you previously announced and also M&A for the year?

[Michael Tokich, SVP and CFO]

Yes. So our capital allocation priorities have been the same for more than a decade, increased dividends off the top invest ourselves, so continue to spend money from a capital expenditure standpoint, especially growing and investing in our AST expansions. Then M&A and then finally, repurchases typically just to offset dilution. So those four categories have remained. The other one that we -- from time to time, we'll put in there is focus on paying down debt as we're almost two years into the Cantel acquisition that is being a little bit less focused on as our debt levels now are in what we'll call very reasonable ranges at 2.3x levered.

And as Mike -- as you heard Mike asked the question earlier about the opportunistic share repurchases, that -- that has not happened very often as a company. But again, we felt that it was advantageous to us to do some of that opportunistically in the third and fourth quarter of this fiscal year.

[Operator]

And our next question is from Michael Polark from Wolfe Research.

[Michael Polark, Wolfe Research]

Two-part on AST. I want to understand the margin trend there kind of pushes and pulls as kind of a steady guide lower throughout the last fiscal. Where does it where does it bottom? And what's the good input for segment margin in fiscal '24? And then related in AST, you've been very clear about destock in bioprocess. I'm wondering what your feel for potentially a similar dynamic is in kind of your core medical device customer base.

The world is kind of emerging from COVID procedures seem to be back. A lot of the interventional medical device companies are holding way more inventory than they used to. Is there any kind of risk a little bit of a destock cycle there for you or not, how are you thinking about that in fiscal '24?

[Daniel Carestio, President and CEO]

Yes. I'll address the latter first in terms of recovery in med tech. I don't think so. Really, what we're seeing in terms of our med tech customers is they're really rebuilding the inventories that they have and they're still, in many cases, hand to mouth in terms of being able to deliver for hospitals right now.

So it's not as if they're flushed with inventory across the system. And so I would assume we'll see some continuing build of inventory of anticipation of surgeries continuing at the rates they're at as well as there's a lot of pent-up demand that's got to be worked off over the next coming months or a year or so.

So I don't think there's a lot of risk in terms of any type of inventory pullback from a med tech perspective. I think it's pretty robust. In terms of the other question around the AST margins, I mean, the short answer is there were inflationary pressures, in particular, on energy and labor. And the labor is baked in is what I would say, and we can leverage that over scale as we get volume coming through. It tends to help a bit.

Energy, my crystal ball doesn't work when it comes to electricity pricing in Europe anymore. So it is what it is. It's high right now. It was high this winter. In theory, it should come down some over the coming months or a year, but your guess is as good in mind on that.

[Michael Polark, Wolfe Research]

Helpful. And then maybe just a request for a feel for hospital spending patterns on capital equipment kind of made comments about good mix of new large projects in your new orders. What's your crystal ball say about how new spend patterns show in fiscal '24?

[Daniel Carestio, President and CEO]

It's interesting, and we're pleasantly surprised every month when we see the orders coming in strongly, very strong as we did in Q4. And our backlog is sitting at $500 million in Healthcare, which is either at or near all-time record highs basically. You got to think of it this way.

Most of what we sell in terms of capital is necessary to facilitate volume of procedures and recovery of volume of procedures through the hospital. I mean the sterile processing department equipment we sell in terms of washers and sterilizers and sinks and everything like that. You got to think of it more like a utility, and it's not a nice to have, it's something you need to have in order to accomplish the growth for patients in terms of procedure volumes.

So we've been somewhat immune to the financial lows of the Healthcare sector, I would say, in terms of hospital spending. And I believe that will continue in terms of the long term. I think over time -- and I don't know if that's six months or a year from now, you're probably going to see some de-escalation in terms of just infrastructure build-out that we're seeing right now. And one would also think that as things tighten a bit in terms of capital. It generally has the impact of slowing down the replacement business a bit, which we tend to pick up then on the service side. But as of right now, we seem to be doing pretty well in terms of order intake.

[Operator]

[Operator Instructions] The next question is from Jason Bednar from Piper Sandler.

[Jason Bednar, Piper Sandler]

A bit of a related follow-up there on Polark's question asking on segment margin, but I'll focus on the place for margins actually in the opposite direction. Healthcare margins improved sequentially now, I think, five quarters in a row. Can you talk about your comfort level on the year-end or full year margin levels in that segment as we look forward to fiscal '24, again, in the context of your overall guide as well?

[Michael Tokich, SVP and CFO]

Yes, we should continue to do fairly well and increased margins in Healthcare. We anticipate that we will continue to get price within Healthcare. We also anticipate that some of the pressures surrounding inflation, material and labor cost ease. We should also be able to get some productivity increases in our Healthcare business just because we had to touch the products so many times last year with parts availability that should help us improve. So I would anticipate that the margin is Healthcare gets slightly better. EBIT margins in Healthcare get slightly better in FY '24 for those reasons.

[Jason Bednar, Piper Sandler]

Okay. That's helpful. And then maybe another follow-up but bigger picture on Dental. You've had that asset now for a couple of years. I know you've gotten this question in the past, but maybe just to revisit it. Can you update us on your thoughts regarding that category, mostly your commitment to that end market. On one hand, it's a good category for roll-ups. It's fragmented. There are a lot of private companies out there that aren't runs in a super-efficient way.

So that's an opportunity, but it's also a drag on growth in margins for the overall franchise. And it's tough to forecast, I think, strong mid-single-digit growth for that market even longer term. So maybe you disagree there. But again, just love your updated view on just as we head into year three steroids commitment and participating in that metal market.

[Daniel Carestio, President and CEO]

Yes, we remain committed. We need to see it through in terms of recovery. We didn't anticipate last year the sliding into an economic recession that was going fork this progress made in terms of procedure recovery that we're seeing Dental and now it's become an economic issue. So I think we need to see that play out over this fiscal year and see how the business performs.

There's still -- I would just reiterate, there's still a lot of opportunity for operational improvement, deliver improvement in the business, and that's something that STERIS as a long history as good operators of being able to really drive improvements with the business. It would be nice to see the volume resume. It makes -- it makes all those good things that we're doing much more visible in terms of bottom line performance when the volume comes back.

[Operator]

And our next question is a follow-up from Michael Polark from Wolfe Research.

[Michael Polark, Wolfe Research]

I was just looking at a lot of great data disclosed in terms of the reporting. I could explain sequentially the Healthcare consumables line, notable step-up there, clearly levered procedure and throughput. Healthcare services line stepped up notably sequentially, and I struggle a little bit kind of tying that to an end market development. So kind of what happened there Q-over-Q, it was a double-digit increase?

[Michael Tokich, SVP and CFO]

Yes, Mike, a big portion of that was we actually had parts availability, so we're actually able to get parts into our customers' hands and fix some of their products. So that is a main driver of that plus we shipped some capital equipment. Obviously, in third quarter, we were able to install that in the fourth quarter, so we generated revenue there. Those are the two main drivers of that business for Q4 improvement.

[Operator]

And ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Julie Winter for any closing remarks.

[Julie Winter, IR]

Thanks, everybody, for taking the time to join us, and we look forward to seeing many of you on the Ross summer.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.