Steris Plc (STE) — Q1 2015 Earnings Call Transcript

Thank you, Jane, and good morning, everyone. It's my pleasure to welcome you to STERIS's fiscal 2015 first quarter conference call. Thank you for taking the time to join us this morning. As usual, participating in the call are Walt Rosebrough, our President and CEO; and Mike Tokich, our Senior Vice President and CFO. Now just a few words of caution before we begin; 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. I would also like to remind you that this discussion may contain forward-looking statements relating to the company, its performance or its industry, that are intended to qualify for protection under the Private Securities Litigation Reform Act of 1995. No assurance can be given as to any future financial results. Actual results could differ materially from those in the forward-looking statements. The company does not undertake to update or revise these forward-looking statements, even if events make it clear that any projected results, expressed or implied, in this or other company statements will not be realized. Investors are further cautioned not to place undue reliance on any forward-looking statements. These statements involve risks and uncertainties, many of which are beyond the company's control. Additional information concerning factors that could cause actual results to differ materially is contained in today's earnings release. As a reminder, during the call we'll refer to non-GAAP measures including adjusted earnings, free cash flow, backlog, debt-to-capital and day sales outstanding, all of which are defined and reconciled as appropriate to reported results in today's press release or our most recent 10-K filings, both of which can be found on our website at steris-ir.com. With those cautions, I will hand the call over to Mike.

Thank you, Julie, and good morning, everyone. It is again my pleasure to be with you this morning to review our first quarter financial results. Following my remarks, Walt will provide his commentary on our performance. Let me now begin with a review of our first quarter income statement. Total revenue grew 12% during the first quarter driven by a 3% increase in organic volume and a 9% increase from acquisitions. Pricing and foreign currency were both above neutral to revenue during the quarter. Gross margin as a percent of revenue for the quarter increased by 160 basis points to 41.5%. Gross margin was positively impacted by favorable product mix and foreign currency, somewhat offset by higher material costs and inflation. EBIT margin expanded by 110 basis points to 13.6% of revenue. The improvement in EBIT margin was driven by higher organic volumes and improved gross margins, offset by lower EBIT margin attainment from our recent acquisitions, which was anticipated and negatively impacted EBIT margins by 50 basis points. The effective tax rate in the quarter was 37.8% compared with 36.7% last year. During the quarter, we did have unfavorable discrete items impacting our effective tax rate. We anticipate a full year effective tax rate of approximately 35%, which includes the assumed renewal of the tax extenders which have not been reflected in our Q1 results. Even with the higher tax rate, net income increased 23% to $32 million or $0.54 per diluted share compared with $26.2 million or $0.44 per diluted share last year. Moving on to our segment results, Healthcare had a very good quarter, growing revenue 17%, in total of which 4% was organic growth. Healthcare service revenue grew 43%, driven by acquisitions and strong organic growth. Consumable revenue increased 12%, while capital equipment revenue grew 1%. Healthcare backlog at the end of the quarter was up 4% from the prior year levels to $125 million, an increase of 13% sequentially. Healthcare operating margins increased by 220 basis points to 9.8% of revenue. The increase in operating income year-over-year was driven by volume, product mix, and productivity, somewhat offset by higher material costs. Life Sciences’ revenue declined by 2% during the quarter. Strong performance in both consumable revenue, which grew by 6%, and service revenue, which grew by 9%, was more than offset by an 18% decline in capital equipment revenue. As you already know, capital equipment tends to vary quarter by quarter within this segment. Backlog in Life Sciences at the end of the quarter was $46 million, an increase of 3% compared with the prior year. Life Sciences’ fourth quarter operating margin of 20.4% of revenue is down slightly from the prior year reflecting the decline in revenue. Revenue for Isomedix increased by 6% in the quarter to $51.2 million. Expanded capacity contributed to revenue growth within the segment as well as increased demand from our core medical device customers. Isomedix operating margin was 31.7% of revenue, an increase of 50 basis points as compared to the prior year. In terms of STERIS’ consolidated balance sheet, we ended the quarter with $157.9 million of cash and $658.7 million in long-term debt. Our debt to EBITDA ratio now stands at approximately 2.2 times, well within our covenant maximum of 3.25 times providing us liquidity to invest in the business. Our day sales outstanding improved by two days to 62 days at the end of the quarter. Our free cash flow in the quarter was $23.1 million, an increase of $12.1 million compared with the prior year. Capital spending was $23.3 million in the quarter, while depreciation and amortization was $20.4 million. With that I will now turn the call over to Walt for his remarks.

Thank you, Mike and good morning, everyone. We appreciate you joining us for our first quarter call. Mike has covered the financials, so I will focus on a few qualitative highlights from the quarter. We are pleased to start a new fiscal year with strong results that are in line with both our expectations. As you would expect in the first quarter of our fiscal year, sequential organic growth has slowed somewhat but we are still delivering solid revenue growth along with the results of our recent acquisitions. Our healthcare segment had strength in both consumable and service revenue and flat capital equipment sales. In the consumable franchise, we had growth across the board, and in particular, instrument cleaning chemistry such as Prolystica, high-level disinfection chemistry for GI departments, and the new necessary products in our U.S. endoscopy business and the consumable and sterility assurance products that are related to our growing installed base of V-PRO hydrogen peroxide sterilizers. On that note, we have received FDA clearance for the use of our V-PRO verified biological indicator with most of J&J Sterrad hydrogen peroxide sterilizers during the quarter. We continue to be optimistic about the success of our V-PRO equipment and the related consumables. Our service business in healthcare is also growing, in part, from the IMS acquisition that closed in May. Revenue from IMS accounted for about two-thirds of our healthcare service revenue growth in the quarter, but our organic growth was nice as well. Our integration plans are well underway for IMS, and we are successfully integrating our specialty service businesses. As you know, we are expecting both revenue and cost synergies in this business and we are seeing indications of both. Beyond the IMS acquisition, we saw strong specialty service organic growth as well as an increase in installations from the high level of capital equipment shipped in the fourth quarter. In healthcare capital equipment, our shipments were a bit softer than we anticipated in the quarter as organic revenue was down slightly. However, with the very strong shipments we experienced last quarter and our backlog showing growth both sequentially and year-over-year, we believe this to be timing. We continue to feel that the hospital capital spending remains stable as we have said for several quarters and that our shipments will pick up over the course of the fiscal year. On the Life Science side of our business, we had another strong revenue quarter for both consumables and service, which has helped us maintain our operating margins, offsetting net growth. Our capital equipment shipments were lower than we had anticipated. As you know, capital shipments in Life Sciences are particularly lumpy, this is the consecutive quarter without year-over-year growth. In particular, we have seen some softness in the former side of the business where there are economic issues impacting growth for the industry, especially in Eastern Europe. However, we have seen orders picking up for the past several weeks, and our backlog is back to historic levels. As a result, we expect sequential improvements in the business. For the year, we anticipate that shipments will improve, but overall capital equipment will remain under pressure causing total Life Science revenue growth to be headed somewhat. We expect the strength in service and consumables to offset any weakness in capital from a margin perspective. Isomedix revenue continues its growth pattern, posting 6% revenue growth in the quarter. This reflects filling in capacity we have added in the past couple of years due in large part to continued demand from our core medical device customers. As you already know, we are planning to add additional capacity in this segment, as volume has somewhat outstripped our long-term expectations. From a total company perspective, we did a good job of maintaining gross margin sequentially holding steady at our year-end level despite substantially less volume. As we anticipated, the impact of the IMS acquisition is somewhat dilutive to operating margins in the quarter, although in total we did see nice year-over-year improvement. We have work to do to get to our full year anticipated 15% margin rate which is just as we planned at the beginning of the year. Our first quarter is on our plan to meet that target and we believe we are well positioned to continue to do so for the balance of the year. And of course, we are very pleased that our people produced adjusted earnings per share at $0.54 for the quarter, an increase of 23% over the prior year. This is a great start to our year and we have increased confidence in our ability to meet our full-year adjusted earnings per share guidance of $2.78 to $2.91. With that, I will turn the call over to Julie to begin the Q&A portion of our call.

Thank you, Walt and Mike for your comments. We are now ready to begin the Q&A session, so Jane would you please give the instructions and we will get started.

Great. Thank you for taking my question. Just for the modeling purposes to start, what was the healthcare capital equipment year-over-year minus Eschmann?

The organic healthcare capital equipment was down about 6%, Matt, that excludes Eschmann.

Eschmann is the only adjustment.

Right, it’s the only adjustment.

And if I remember correctly I think the backlog you reported for that business at the end of the last quarter was up 5%, can you kind of walk through a little bit of delta between the backlog that you reported at the end of the last quarter and maybe the overall result in the quarter?

Yes, you are correct. The backlog was up in the fourth quarter, 5% year-over-year, and we ended the first quarter up 4%, it’s about $15 million in total backlog increase.

No, I was talking about, I am sorry if I wasn’t clear, I was talking about the 6% decline in capital equipment sales in the quarter versus the backlog actually ending up at the end of the previous quarter up of 5%? Whether there are some timing differences or some orders delayed, just a little bit of color on that?

I would not say that there were significant timing delays; it’s more that we need to sit down and do the actual math. It’s like an inventory problem, so it’s exact same math, but backlog is up for the quarter and shipments were down a bit for the quarter. But again, mathematically it’s just a matter of timing, but there was no significant change in order pattern or any significant change in delays and shipment for the quarter. We were just off a bit versus prior year and slightly behind our expectations, and that’s not unusual; several million dollars can move either way pretty easily. So nothing that I would call significant, which is why we think our capital forecast for the year is still steady.

Okay. And then on healthcare side, you were the lead manufacturing and sourcing initiatives were those net costs in the quarter or net savings?

I will have to get on the detailed map but I think on net it's about a wash; if you compare it to last year though, that's the savings.

Okay. And just lastly on Isomedix, was there any downtime or extra cost associated with the FDA warning and can you give the update on how that’s progressing?

We have continued to do routine reporting with the agency to correct any deficiencies that they view have occurred or are occurring, and there are increased costs which we have put into both our plan and then to our actual. So we do anticipate spending significantly more in the quality side of that business, but in terms of – that we did incur some of that cost in the quarter, and we did – and we indeed anticipate incurring more; but those costs are anticipated or assumed or put into our plan and are offset by increased deficiencies due to the growth in the business and utilizing the capacity. So the numbers you see include those costs.

Right. Thank you very much.

And in terms of disruptions, there was no disruption in the quarter. We actually did have a couple of cobalt loadings which does cause a little lessening of revenue, but it is typical for us to have cobalt because we have a number of plants. It's just we had a little more than normal in this most recent quarter.

And Matt just to give some context, we are talking about single-digit millions here of that cost increases.

Okay. Thank you very much.

Thanks. I am sorry I missed it very end of that last question but the material cost that you have added in your commentary color there and then I think you mentioned inflation as well. Any other specifics that you can point to?

Those are the two major drivers that we have seen, both materials some of that being chemicals and then on the inflation just normal inflation raises kick in and the like year-over-year.

Yes, I wouldn't characterize anything radically; normal inflation as you know oil has picked up a bit in the last quarter. So anything that's oil related may have a little pick up, and then we are seeing some commodities picking up a little bit but again, it's not anything that's a ramping inflation.

Great and then IMS closing, I know the operating margin is somewhere around 10 and I think you guys thought you can get it up to 15; how quickly do you think that can occur?

All of the improvements in the IMS integration will not fully be materialized for a body team. When we look at the integration plan, that's roughly the timing of the completion; full completion integration is often the case, some of those occur relatively quickly – which they are just as we would plan. Some of them take longer, and that’s indeed what's going on. This is generally not an integration where we were looking at for example having two factories, you pull one factory and you only have one. This is largely we expect to see the results of the cost side of the integration. We expect to see the bulk of that occurring as we grow into our service force.

And if we look at that, if some of the businesses run around the 15 rate, I mean is that the limit where they can go or do you think now that given that you have more scale that sort of you look at those deals together and think that hey, we can get there operating margin there, maybe into the 17%, 16% range from sort of that 15 base?

We appreciate the confidence. We like to walk before we run. 10 to 15, we think it's pretty good approach, and we will work on the balance after that. And as a general statement as you know I like businesses to be over 15. I started to get little handsy in this kind of space I get handsy where they get upwards to 20 or over 20 but we do not see a constraint on that objective. We will walk before we run.

Last one, thank you and Isomedix, you mentioned capacity are you at full now in terms of where you stand versus what you built out?

The answer is no. It is geographically differential if you will. We have certain plants sort of pretty close to capacity. We have certain plants that have ways to go. Some of that is because of recent capacity adds and so you can't make a general characterization that all of Isomedix will add capacity; but we do have room to grow in certain of our facilities, we have facilities that are fairly full. And part of what we do is we work with our customers to the extent we can if we have a less full plant and we can move some of their businesses to one of those, we do that as long as geographically appropriate. But in general, we are fuller than we were let's say two years ago or so. And we are approaching capacity and certain of those factories but that's why we are adding capacity in the near future. So we generally would not want to ever get to where we are running full capacity because then we have no room for growth. We try to put the capacity in place ahead of the growth.

Thanks a lot.

Good morning and thanks for taking the question. Can you hear me okay?

Very well Chris. Thank you.

Super. Hey I just want to drill down on a couple of items if I may. I know you don't like to give single product guidance but when you look at the healthcare capital orders that you were able to realize during the course of the quarter and then what comprises the backlog? Could you kind of characterize maybe just broadly where you are seeing maybe stronger demand or demand is more in line with the expectations from the capital perspective and then similarly, what do you think is taking place that's allowing your orders to pick backup on the Life Science side? I realized again that business is historically very lumpy. But three quarters in a row down what gives you some confidence that turns in the coming quarters? Thanks so much and I have got one follow-up if I could after that.

Sure. I am going to break those into two questions, Chris. On the first, in the healthcare side, I wouldn't characterize any significant change in mix in healthcare one versus the other in terms of products. Now we do have, as you might expect sometimes we have new products coming and what we do our people might slow down a little bit on the sale of the older one; our customers may slow down on the purchase of the older one waiting for newer one, and we are always releasing products in kind of all of our families. So there may be some minor variations going on there, but as a general statement I would say relatively speaking the IPT segment has been strong, part of that is driven by the particular strength in hydrogen peroxide sterilization, so V-PRO has been quite strong. Our washers have been very strong; they have softened a little bit, and our sterilizers have picked up, but I would not characterize anything as overwhelming strength or weakness and things do have been flow a little bit across the product lines. Now this is a little bit or memory reach but we were very strong in surgical a couple of quarters ago. I remember it and we have kind of gone back to the mean, and that's the way things tend to run. So again there is nothing that I would say mix-wise, I think the product that I would point out. We have seen mix in geography. North America has stayed very solid for quite some time now as we have said. We have seen kind of a back and forth across the ocean that our European business has picked up nicely, MEA has picked up nicely for now a fairly long time, six to nine months, so I would say that they have been strengthening; and whereas a year or two ago, they were showing weakness. We have seen the Asia-Pacific market and the Latin American market trade places and that's not particularly unusual that they are smaller businesses, so we do give more variation there. Last year we were talking about how great Latin America was and how weak Asia-Pacific was. Right now we would say Asia-Pacific is stronger and Latin America is weaker, but those are relative statements and nothing that I would consider out of the ordinary. So in healthcare, yes there is some movement around, but it's what I would call normal movement. On the Life Science side, we have clearly seen the pharma guys the last year so backing off a bit and particularly Eastern Europe, and there is a lot going on these Eastern Europe these days and there is we are seeing some more consolidation in that space. So we have seen some reduction there. And the good news is we have actually seen the research market starting to pick up a little bit and research has been non-existent; I am overstating a little bit for fact but research has been very dead for a long time. We are talking not months but years. And that seems to be actually picking up a little bit. So we are feeling better about that. And then on the pharma side, because these orders are longer-term in nature, we do have visibility and we have seen a number of orders coming in recently on the pharma side, and we are seeing some more pipeline. Lastly, we have some new products in that area that are coming, which we are confident. So if you put that all together, that's what creates our view of the future on the Life Science capital side. Although we do think it is still under pressure, it's not where we would say the healthcare space is. But again the converse is the consumable service side has been quite strong. It's not unusual that people don't buy new stuff; they have to service the old stuff. So there is some increase in that as a result of that my view but that would be I think pretty decent summary Chris.

Okay. That's great. I really appreciate the color. And if I could just squeeze one more kind of big picture question in, you guys are doing a great job on the leverage story here. Clearly you have additional capacity from a credit perspective. Help us and you have increased – sort of in the morning of course to penny for the quarter now. So help us just think a little bit about capital allocation and in particular you have done – you have clearly rolled up the service business on the healthcare capital side of the opportunities to grow abroad and maybe not so much from an inversion standpoint but just to maybe offset or hedge domestic growth. Just kind of help us think about how you are thinking about the capital structure in the forward growth outlook as a result of maybe using capital or not using capital. Thanks so much.

Sure Chris. I would say we have not changed our view of how we allocate capital. That is we do. We protect the dividend and we intend to grow the dividend. We intend to provide funding for the businesses we are already in to grow and defend and grow those businesses. Thirdly we look for acquisitions and in looking for acquisitions we look at two factors. The first is that it return the cost of capital that we are comfortable with, and the second is that we compare to buying back our own stock. So we look at both those factors when we are making those decisions and then lastly, if we have not exhausted our capacity we look at purchasing back our own stock. As you guys know I guess the modest shift is four or five years ago, we had less opportunity on the acquisition side and more opportunity on the stock buyback side. So we did that. The last year, year and a half, we have seen more opportunity on the acquiring businesses that fit our business and less as a result; less on the stock buyback that we will make those decisions exactly the same way, and you never know what you can and can't get done on the acquisition side but we do have a robust pipeline, and we still think we have opportunities there. In terms of the international versus U.S., we have grown interestingly enough, our ratio of revenue in U.S. versus O.U.S. has been roughly constant the last five or six years; the organic growth O.U.S. has been faster than inside the U.S. and we have done more acquisitions inside the U.S. We have done some deals outside the U.S. Eschmann is the most recent, another one; but we would certainly consider acquisitions outside the U.S., we do have those in our pipeline as well as those inside the U.S. We don't radically favor one versus the other. If you look at what's the total market and what's the business and how does it fit, the strategic fit to us is the number one criteria.

Thank you.

Okay. Thanks so much for taking my question. And Ed this just follow-up with the last question but I saw I guess a news yesterday about a partnership with an Italian sterilization company and I know my Italian is not very good but if you can provide some greater detail on that or is that a new opportunity, an update on the existing relationship? And what's incorporated into your guidance as it relates to this opportunity and I guess broadly speaking, what do you consider your near and long-term opportunities overseas?

Sure, the company you are discussing is Service Italia. It's a relatively small investment for us. You are correct it is a combination of the two things: it is a historic relationship that Service Italia has purchased services and goods from us for a number of years. So we have dealt with them for a very long term. And they have been a good customer of ours. So we are doing two things simultaneously: the first is we are clearly expanding that customer relationship, so they are going to be purchasing more of our equipment and services, and then secondly, we will be potentially entertaining doing some joint venture type of work with them as it relates to hospital outsourced sterilization of reusable surgical equipment. And so we are looking, it’s an exploratory issue at this point in time. We do expect to do some business; I don't think you will not see material change in the next 12 to 24 months as a result of this, which is why we didn’t make an announcement; it's not material for our earnings rate or holdings. It is material for them which is why they didn’t make an announcement; but it's an interesting opportunity for us. We will be again gaining some business and we are also finding and learning more about that side of the business.

Okay. And can you provide or I guess you already provided some color on this already but what's embedded into your guidance for all this speaking as it relates to underlying utilization trends or procedure volumes at this point?

We if you look kind of generally speaking, we are still seeing what we think are single-digit kind of underlying growth rate if you will pretty much across the board for our long time; we are talking about North America now, pretty much across the board in all of our lines. So that's kind of our expectation and so far in terms of what we are seeing in terms of share value amount not revenue necessarily because revenues change, but we think we are still seeing orders of magnitude that level of volume.

Okay great. Thanks so much.

Hi good morning. Walt, so for the 15% target for operating margin for the year, obviously you start off the first quarter very nicely at 13.6%, but certainly that implies some acceleration through the year and so I am just curious about sort of how we should think about that getting. I understand the fourth quarter should be the largest of the year given the historic seasonality, but it also implies that we probably need to move up to 15% in the next couple of quarters, and so I would like to sort of get a sense of that and then remind us, there are a lot of factors this year that impact that margin about what really drives it from the levels where we are now towards that 15% for the year?

Sure and I will step back and say from beginning, we don't provide quarterly guidance. And so I am not going to do so. Here in the annual when we laid our plan out at the beginning of the year, we did say that our best expectation was it would be similar to or mirror our last year's timing and so we don't have a difference of views on that today. That first quarter came in pretty much as we expected, and we kind of expect similar things going forward. So we don't have a change of view at all there. In terms – and it is mathematically correct, you can't start below the average and get to the average unless you get above it. So that's true but if you were back and looked at our previous years, you would see that there – that we have had a ramping during the course of the year and then actually we moved up year-over-year too. So in both ways to look at it, we are on a northbound expressway and so we intend to continue that. Part of the issue is purely volume that is the back half of the year is stronger than the first half of the year; when that happens, our fixed costs don't rise, and so there is a bit of timing question and we don't amortize our plans and equipment and all that on a per-use basis, it's on a per-day basis. So that creates a part of it. The second part we have talked about is we bring IMS in and integrate with those other businesses we expect to see margin expansion there, and then the third significant piece is we have continued down on our insourcing path and we fully expect to see significant reductions in our cost as a result of that insourcing. We see more into the year to the beginning. All three of those areas we think that we are on the pathway that we are literally on our plan; we are on the pathway to get where we expected to go. So we fully expect to achieve those. But those are probably the biggest issues that we need to – those are the biggest issues we need to in order to meet the plans we have in place.

Okay. That’s great and Walt just a couple of other quick ones but along that line with that explanation, you did indicate in your prepared remarks that you felt more confident today in the ability to hit the year-end numbers of those three sort of factors that you mentioned: volume, IMS, insourcing etc., are you more confident in all those that makes you say that or is there something that you see today that is more specific to one of those that can give you that greater confidence?

Yes, I would say the answer in general is yes that is since all three of them are kind of headed down a year – a plan and year as pathway, and if I were off any of those three, I would be less confident. The fact that I am on those three makes me more confident. So it's true pretty much for us to board but in terms of I suspect in terms of any one item when we bought IMS we bought our IMS; now we have been running IMS for a while that's coming out looking like we thought it would, and that's always a little bit of a pig in a poke. Any acquisition no matter how much you think no matter how much you do due diligence, there is something in the books, bit to it; and we are finding that what we purchased is what we expected the purchase. The early on indications both on the revenue side, the customer acceptance side, and on the cost side we have not seen anything that detours us from our original thinking and that's always a comforting fact even if it's only a couple of months.

Okay. Perfect. And then just lastly on I think I heard the contribution from Eschmann in the quarter but I was wondering if you could also help us understand the contribution from IMS particularly since you closed it intra-quarter.

Yes, from a revenue standpoint, there were about two-thirds of our total service improvements. Service grew 43% total sales so they were two-thirds of that on the revenue side. And then basically by the time they got to the bottom line, they were in roughly the 10% margin area, which we anticipated would occur.

Thank you very much.

Good morning. How would you characterize the new product pipeline in healthcare currently versus how it was the same time last year?

I wouldn't characterize it any different at all. We had a number of products that we were bringing to market and we have more, so I wouldn't characterize it any different at all.

That was it. Thank you.

This concludes the conference call. Thanks everybody for joining us and your interest in STERIS and have a great day.