Steris Plc (STE) — Q2 2018 Earnings Call Transcript

Thank you, Chad, and good morning, everybody. On today's call, as usual we have Walt Rosebrough, our President and CEO; and Mike Tokich, our Senior Vice President and CFO. I also have a few words of caution before we open for comments from management. This webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission, or rebroadcast of this call without the 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 STERIS' securities filings. Many of these important factors are outside of STERIS' control. No assurances can be provided as to any results or the timing of any outcome regarding matters described in this webcast or otherwise. 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. Adjusted earnings per diluted share, segment operating income, constant currency organic growth, and free cash flow are all non-GAAP measures that may be used from time to time during this call and should not be considered replacements for GAAP results. 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. STERIS' adjusted earnings per diluted share and segment operating income exclude the amortization of intangible assets acquired in business combinations, acquisition-related transaction costs, integration costs related to acquisitions, and certain other unusual or non-recurring items. To measure constant currency organic revenue, the impact of changes in currency exchange rates and acquisitions and divestitures that affect the comparability and trends in revenue are removed. We define free cash flow as cash flows from operating activities less purchases of property, plant, equipment, and intangibles, plus proceeds from the sale of property, plant, equipment, and intangibles. Additional information regarding adjusted earnings per diluted share, segment operating income, constant currency organic revenue growth, and free cash flow is available in today's release. With those cautions, I will hand the call over to Walt.

Thank you, Julie, and good morning, everyone, and thanks for joining us. Our second quarter came in generally as expected, and we maintain our outlook for the year. Mike and I have brief prepared remarks regarding results of the year so far and our outlook for the full FY2018. We will then open for Q&A. Looking at the first half of our fiscal year; we are pleased that our overall results are in line with our expectations. Turning just to the second quarter, we grew revenue 4% on a constant currency basis, and our profit and earnings were in line with the forecast. Of note, our Healthcare Specialty Services segment has now produced three consecutive quarters of higher than anticipated growth, growing revenue 10% on a constant currency organic basis for both the quarter and the first half. On the other hand, we believe the lack of growth in healthcare product capital equipment shipments in Q2 was largely a matter of timing. In particular, we saw solid underlying orders during the quarter, but we had lower shipments—about $5 million—of which was strictly due to the hurricanes in Texas and Florida. These shipments are expected to occur in the second half of the fiscal year and are reflected in our $15 million sequential growth in backlog. I will add that we have no substantial operations in the specific areas impacted by hurricanes, wildfires in Texas, Florida, and California, but we do have sales and service people in those locations. Fortunately, neither they nor their immediate families were injured in these natural disasters, and our people have worked admirably with their hospital and life sciences customers to accommodate their needs. For the full first half of the fiscal year, we are at the top end of our annual revenue guidance at 5% constant currency organic revenue growth. Our growth has been primarily volume with about 30 basis points in price so far this year, slightly above our flat pricing expectation. Profitability has improved nicely as well with a 380 basis point improvement in gross margin and a 190 basis point increase in EBIT margin. First, I have adjusted earnings of $1.79 per share reflect 7% growth over the prior year. We feel good about where we stand at the halfway point of our fiscal year, and we're reiterating our outlook for constant currency organic revenue growth of 4.5% and adjusted earnings per diluted share in the range of $3.96 to $4.09 per share. For the second half of the year, we have tough comparisons in the fourth quarter, as well as a headwind from the impact of storms in Puerto Rico, where we do have an ASD facility. Annual revenue from that ASD facility is around $10 million in normal operations. We have a great team in Puerto Rico, and they, along with their U.S. counterparts, managed this natural disaster as well as we could with substantial preparations before the hurricane landed, in concert with our medical device customers to their eagerness to jump in and help following the storm. Thankfully, all of our people and their immediate families were safe, and we were able to account for everyone rather quickly. Naturally, some of our people sustained considerable property damage and were left without many basic necessities, and we are working with them on those issues. However, they brought the plant back to full operational status in about two weeks from the relatively minor damage to our facility. Although we have been fully operational for about a month now and have been processing products since that time, we are dependent on our customers' ability to ship at their normal rates before our facility can operate near full capacity again. Our best estimate right now is that the negative impact of the Puerto Rico storms on profit in ASD will be about $3 million this fiscal year, virtually all of which will be recognized in the second half. Turning back to the Company as a whole, currency movement continues to benefit the top line on an as-reported basis. Given the six-month forward rates at the end of September, we now anticipate that revenue will increase by approximately $35 million this fiscal year, primarily due to the strengthening of both the British pound and the euro versus the U.S. dollar. We now expect as-reported revenue to be approximately flat for the full fiscal year, and the increase versus earlier expectations is largely due to currency. We continue to expect virtually no currency impact on profitability, even with a substantial swing in as-reported revenue described earlier. This highlights the natural FX hedge on profits built into our current business model. Despite the uncertainty in U.S. healthcare insurance programs, the markets we serve generally continue to be stable. The revenue stream that we have created in terms of product, customer, and geographic mix helps to balance our growth and fuel our ability to grow revenue mid-single digits organically and leverage that growth and business development opportunities for faster bottom-line improvement. We are pleased with our current performance and believe we're well-positioned for the future. We appreciate your continued interest and support of STERIS, and I will now turn the call over to Mike for a brief review of the second quarter before we open for Q&A.

Thank you, Walt, and good morning, everyone. 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 growth was 4%, driven by volume and 20 basis points of price. Gross margin as a percentage of revenue for the quarter increased 360 basis points to 42.2%, of which 260 basis points of the improvement is from the impact of divested businesses, with the remainder due to productivity improvements, favorable product mix, and price. EBIT margin at 19.2% of revenue for the quarter represents a 200 basis point improvement. Obviously, we are very pleased with our continued ability to expand EBIT margin and leverage revenue growth in addition to the favorable impact from the divested businesses. The effective tax rate in the quarter was 26.7%, up from both the prior year and first quarter as expected. Both the prior year and first quarter had favorable discrete item adjustments. We continue to expect the full year fiscal effective tax rate to be in the range of 25% to 26%. Net income in the quarter was $80.3 million or $0.94 per diluted share, benefiting from both organic revenue growth and continued margin expansion. Segment growth information has been detailed in the press release in both the tables and the copy. In terms of the balance sheet, we ended the quarter with $296 million of cash, $1.45 billion in total debt, and a total debt to EBITDA leverage ratio of approximately 2.3 times. While the U.S. dollar equivalent value of our British pound sterling and euros is dominated private placement, debt has increased due to the weakening of the U.S. dollar. We have reduced our floating rate bank debt by $58 million since the end of the first quarter. As we said last quarter, without additional acquisitions, we continue to anticipate leverage by the end of the fiscal year to be approximately two times debt to EBITDA. Free cash flow for the first six months was $144 million, a 21% improvement versus the first half of last year, primarily due to higher net income. During the second quarter, capital expenditures totaled $38.9 million while depreciation and amortization totaled $45.5 million. Our outlook for the full fiscal year free cash flow and capital expenditures are unchanged. Free cash flow is anticipated to be approximately $280 million and capital expenditures are anticipated to be approximately $180 million. With that, I will turn the call back over to Julie to open Q&A.

Thank you, Walt and Mike for your comments. Chad, we are ready to open for Q&A, so please give me instructions, and we will get started.

Good morning, guys. Thank you. I wanted to start a little bit on the margin side, it looks like gross margin came in a little better than we expected. Can you talk a little bit about mix versus price you might have had in effect on gross margin this quarter versus your baseline expectations?

Yes. Isaac, gross margin was up 360 basis points to 42.2%, similar improvement in the first quarter. About 260 basis points of that was really due to the impact of the divested businesses. If you recall, the divested businesses most of their costs were in cost of goods sold, so that's what we're seeing the biggest improvement. And then in addition to that, we did have both productivity improvements, in particular in our IMS North America business where that business continues to perform very well, and we continue to see improvements in gross margin there. We did have some favorable mix obviously with capital down a little bit, consumables, and service, especially consumables helped propel the margin several basis points. And then we did have pricing impact which was about 20 basis points on the top line and about 10 basis points in the gross margin.

Great. And then on the expense side, it looks like SG&A came in a little higher than we forecast; obviously, you have the upside gross margin to fund that. I'm interested in any potential areas of investment that you guys made that maybe came in ahead of plan because you have that extra profitability to work with, kind of curious where you're putting the marginal dollars? Thank you.

Yes. The bulk of the differential is foreign exchange, so our units that have OpEx in particularly the EU countries as well as Great Britain, it's an exchange rate issue. In terms of our run rate on a constant currency basis, it's very much what we expected.

Good morning. So very strong performance this quarter in IMS; you talked a little bit about productivity improvements given that the margins there are already in the high single digits. I think you said that was your expectation by the end of fiscal 2018. Where should we go from here? Should we expect the margins maybe to come down a little to the mid-single digits or what are you expecting in the second half for that segment? Thanks.

Sure. I would say a couple of things. First of all, clearly as we mentioned before, we had invested ahead of time, and the revenue didn't come, so now we've allowed the revenue to come without additional investments. We will be going forward. We do need to go back into the game of investing at hopefully the appropriate time, so we can continue to grow. So we may see a little bit of rocking around those numbers, but in general, our end-point numbers that we described are what we anticipate in the short intermediate term for that business. So we might be a little higher one month than we are one quarter and a little lower one month or one-quarter based on the timing of investments. But this is not like you have to build a plant and then start filling it. It's more modest incremental investment as a percentage of the total. So last year, we just got it way wrong. We missed both directions—growth and investment. That's an unusual occurrence for us, and we've been doing service for a long time, so we don't expect that kind of a significant change again.

And the $3 million hit from the hurricanes, if it is on AST operating income, would you expect the majority of that to be realized in the third quarter or is it maybe more evenly spread in the second half?

It will be stronger in the third quarter than the fourth. We would expect our customers, as they bring their plants—most of them are bringing their plants up—they're doing volume, as just they're doing relatively more limited volume. A large part of that is because of energy issues or people issues in some cases, but generally speaking, it's energy issues. Almost all of our customers have generation capability, but they don't always have enough generation that is generator capability to run all their machines and do all the things they need to do. And then there are some people issues as well. So as we— they should be coming up and getting more close to full volumes, so as we approach the end of the quarter, we think we'll see much more at full volumes. So it will be more heavily seen in the third quarter.

And then finally, I wondered if you can comment on hospital spending globally, if you're seeing any material change by region. And what was the performance on an organic basis in the international segment for the quarter that is it? Thank you.

Yes, sir. From an international standpoint, looking at both the quarter and the year, we continue to see good growth in both Europe and APAC, slightly slower growth, although we are growing in Latin America and North America. Although for the quarter, obviously, with healthcare capital equipment being down a little bit, North America was more under pressure just based on the timing. And I would add to that Europe, which we call EMEA. Europe itself has been now for quite some time steady to nice slightly growing, if you will. The Middle East has been very difficult, but it seems like we should see the bottom of that trough, and there is some life in the Middle East again. So although it's not the levels it was three years ago, it is picking back up for us.

Yes, hi, good morning. Walt or Mike, so I just want to be clear on the hurricane impact on the possible capital side. So you obviously said $5 million; what's the right way to think about the organic constant currency growth then for the quarter, if you adjust for those shipments that you didn't get? And I know volume plays a very large part in the equation particularly on the capital side. So anyway, that to sort of think about one in EPS impact from that delayed shipment was?

Sure, Larry, you've asked multiple questions, so I'll try to kind of break them out. Those orders were again largely Florida and Texas for the capital equipment orders, and it was hospitals that obviously were under pressure from the storm, and they did not want to take new capital into their facilities or haven't shipped during that timeframe. So it was around $5 million. Orders of magnitude, that's probably about a $2 million to $2.5 million impact on bottom-line profitability in the quarter. We would expect to see that reverse. I think, Larry, that we would expect that to reverse kind of the exact same way that we talked about AST; that is, I would expect to see it more in the third quarter because most of the hospitals were not severely damaged. They just couldn't take equipment during that timeframe. And so the bulk of that should reverse in Q3, and there will be some of the drags into Q4 would be my guess. So—in terms of relative growth or growth numbers, the hurricane itself is about $5 million, which is roughly small one, 1%-ish for the total business; of course, as you get down to smaller pieces of the business, it's a larger percentage 2% or 3% for healthcare capital probably. But orders of magnitude, it did not have a huge impact on revenue growth for the total company. Now the other side is we did see more orders than shipments, and so our backlog picked up $15 million, only $5 million of which is the storm. So we have $10 million more in backlog sequentially than we did before that is purely a matter of—I'll call it normal time differentials across quarters. That just happens in the capital business. But the $5 million is purely due to the storm.

So 5% was a constant currency, is that the right way to think about it on a normalized basis with $5 million in comparison?

Yes, orders of magnitude, you're not too far off, because those 4% roughly for the total business is about a point, so without doing the exact math that's close.

Okay, perfect. And then two other questions, maybe talk a little bit about what's going on in Life Sciences that backlog continues to do well. And then Walt, I guess just a bigger picture question around the endoscopy markets. I know you're obviously a competitor in a variety of different places there, but that market continues to be growing very nicely, and just want to get your thoughts on perhaps additional opportunities to expand into endoscopy broadly.

Sure, Larry, and I'll separate again two questions. The Life Science business in total is doing very nicely, as you've observed, not only of the consumable side of the business, which has been a long-term good grower for us is continuing to grow in the mid to high single-digit range. But the capital business has clearly begun to come back, and we're just seeing order rates and, as a result, backlog that we haven't seen in a decade or more. In our pipeline appears to be about the same as what our current run rates are. So we're anticipating it's hard to forecast more than a year or two out, but our view is that this level of orders and shipments in life science will continue probably 12 months to 18 months at least. So we're feeling quite good about that. A piece of that is the market this business supports biologics and vaccines, and that's a nicely growing market that had spent a fair amount of time consolidating over the last few years that is pharma in general, and we think that consolidation phase for at least our pieces of the business is largely finished. And then the second piece is we've done some nice progress on work, particularly in the hydrogen peroxide area where we're in our capital equipment, where that is a growth area for us. So it's a combination of the market growing more rapidly and us having a nicely set of products to put into that market in the space. So the life science guys have done a nice job of that. As it relates to endoscopy, we do view the endoscopy market as a growth market and growth opportunity. US Endoscopy has now, which we purchased five plus years ago, has been growing in nearly double digits almost every year in the top line and therefore above, and certainly double digits on the bottom line. So that has been a growth opportunity, and we continue to look for ways to expand. We've done a number of smaller acquisitions in that space to add into what the US Endoscopy people care. And then we also view that as an opportunity in our Healthcare Products segment both on the consumables and on the capital side. So we continue to invest in that space.

Okay. And then lastly just on ASD. I guess Sterilmed was moved into that piece, I believe. Can you just help us think about the impact of that on the growth there?

Yes, Larry, as we talked last quarter, we believe that for the full year we will have about 100 basis points, which is basically every quarter, 100 basis points, both top and bottom line impact because that business, as we've discussed, is actually declining in both top and bottom line year-over-year. So about 100 basis points is a fair number to use.

If you think of ASD is pure ASD, absence Sterilmed would be about 100 basis points stronger.

Top and bottom.

Right. Okay. Perfect. Thanks, guys.

Hey, good morning and thank you for taking the questions. How are you doing?

Great.

Could you maybe go a little bit more detail on the Healthcare Specialty Services and talk about the trends you're seeing in North America IMS versus the offsite central processing model and the UK and Europe? And are they both growing like equivalently? Are they both growing double-digits or is one growing faster than the other?

I would step back and say that in general the IMS business in North America is the driver for that double-digit growth rate. And so now I'm talking more—longer-term the last 12 months, not the last three. The European business in HSS or the outsources did have some nice growth in Q2; some of that was currency, but some of that is also called natural growth in the European business. And we are also, as we talked about, moving instant repair into the European model, and that is causing us to experience some nice growth, and we're reversing in working to do the opposite in the U.S.—move more of the outsourcing business in HSS. We think both are significant growth opportunities for the future, but they're both still relatively nascent businesses right now.

Okay. I can help me explain the sequential margin improvement in the Healthcare Specialty Services now - if it's a tremendous amount of improvement year-over-year, but a lot of that did it investors but you saw a big improvement from 1Q to 2Q and a big jump there? What drove that?

Well, I mean again as we've talked, it's largely a matter of allowing our revenue growth to catch up to the costs that we had put in place. So at a high level, that's it, and it's been obviously both sequential over the last two or three quarters as well as the comparison year-over-year, you are correct, the comparison year-over-year, the removal of the laundry business has clearly helped that. But on a sequential basis, it's also improved.

Some of that, Matt, is also volume. We grew $3 million in total sequentially, so...

And didn't raise our cost.

Right, exactly.

We grew into our cost basis.

And then switching to - what is the acquisition pipeline look like for you guys right now? Your leverage is down significantly, and is there an opportunity to start adding to the various platforms?

Absolutely. We believe that we passed the bulk of the synergy integration. That doesn't mean we still have—it means we still have IT type systems and back office type systems we are working on, but the bulk of that integration is complete. So we do not feel any concerns about adding other businesses. And as you mature, our leverage ratio, we've brought it down as we suggested we would, so we are actively looking at things. We never discuss specific pipeline issues, but we are looking at a number of opportunities. We just wish they would come in the timing that we would like them as opposed to the timing that they occur.

And then last question just on the last divestiture that I don't think is closed yet. What impact did that have on the guidance and what's the latest update on that?

Yes. As we mentioned last time, the purchaser has had difficulty with financing and some other issues, and so that has not closed. It's not material really to the business in any way. There's no profit impact either past or forward of consequence. The revenue impact is in the $10 million-ish number per quarter, roughly speaking, and we have not anticipated that in our guidance going forward. So we've anticipated no—in fact, there's no growth, so since our revenue guidance as far as on growth, we're not anticipating any growth—the numbers really to be there or not. It's not clear to us that deal will close. And so the longer the time takes, the longer it is, but it's really not a material conversation for us.

Good morning. Thanks for taking the questions.

Good morning.

Just a couple for me at this point in the call. Could you just clarify for us, Walt, on the growth in the pipeline on healthcare capital? Should we think about that as traditional replacement capital just in terms of our flow-through versus more than new project type builds, and maybe if you would expand upon that a little bit? Just if you are seeing any kind of changes in the capital environment.

Yes. So the short answer to that is we have not seen a significant change in that space now for a long time, several years. That is, it is not growing rapidly. It's also not shrinking, so it's been kind of flat to modest single-digit uptick, if you will. And there are differences that it has floated back and forth between what I call major projects and replacement. The last I'd say couple quarters, it's beginning to look at our normal rates if you will, 60% to 70% replacement, 30%, 35% of new capital, if you will, or large projects. So the nature of the projects has started looking more similar. A couple things have changed, though, that we're seeing more and more particularly in the operating room area which also affects CSDs. We are seeing more Ambulatory Surgery Centers being built both by freestanding Ambulatory Surgery Center units, if you will, some are for profit, some not for profit, and we're seeing more of those being built by hospitals as outposts, if you will, for their major hospitals, as more and more surgeries are being brought to that level because we can get people out quicker. So, for example, we're seeing a lot more orthopedics being done in either overnight surgery or even day surgery. So we're seeing more of that being built out in the suburbs, if you will, as opposed to inside the major center downtown. So a bit of a shift there in the last 12 to 18 months, but in total, it has not affected the spend greatly.

In Life Science, there is no question. In Life Science that the new technology that we have brought forward in hydrogen peroxide sterilization for their facilities has been a strong driver for both of them to do more and has helped us grow the business. It's just—that technology is a particularly good technology for that space, and we've capitalized on it. As it relates to disposables, it's unclear depending on how fast those markets grow. How that affects us, but on the one hand, if we will do less clean-in-place kind of work if disposable small disposables are used; on the other hand, we sterilize those disposable units of AST. So we may see a shifting of revenue from one to the other. But with the growth rates we are experiencing, we still review that as a growing market. Thank you, and I can squeeze one more in if we have time?

Sure, Chris.

Just curious if you're seeing any additional opportunities, I'm assuming predominantly outside the—would have to be outside of the United States with your outsourced initiatives there. Can you bring on incremental capacity from private hospitals? Are you starting to see that, and if so, is that something that could either further enhance the AST margin or should we think about that as more of a sustainable growth driver to keep us in the kind of the high single digits when we think about that franchise longer term? Thanks again, and congratulations on a good quarter.

Thanks, Chris. Yes, we do see there are a couple of countries that we're looking at that we may put in the HSS model of outsourced CSDs, and that would bring up the growth rate because we're relatively significant in the UK, which is our principal country. We have facilities in both Netherlands and Italy, and those are both we think opportunities with a couple of other countries that I will go into at this time. But we are looking at a couple of other countries in that space. The real growth opportunities in the U.S. market though, and that's where we're focusing most of our efforts.

Yes, good morning. Just a couple of questions, Walt, I was wondering given you're pretty much finished with the planned divestitures as you exit fiscal 2018. Do you feel comfortable that the businesses you have right now are the ones you want to be in?

That's unfortunately a conversation. Divestitures are a lot like conversations about acquisitions—the less you talk about a before and the better. But if you look broadly across what we're doing, our four major segments? We think all those segments have good opportunities, and we think all of those segments have—across most of those segments there's a tie to one or more of the other businesses within another segment or completely across segments. So we think we do have a very nice portfolio in terms of sterilization and in procedural areas that are commonly in the same spaces as those sterile units. So in my mind, there's not a significant divestiture in the short and medium-term anyway.

Okay, thanks. And again now, when we look at the strength you're seeing in terms of the backlog and the large projects that you're bringing on. Is it more a case of increasing the sell-through to existing customers or are you also seeing a lot of new customers coming onboard now?

It is a combination. It is principally sell-through to existing customers, but we do see entrance in that space. The vaccine biologic space is an exciting space in Pharma right now, and there are some new biologics being developed by folks out there, so we see both. But the principal numbers are with the people that are already in the space.

Okay, thanks again for taking questions.

Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Julie Winter for any concluding remarks. Thank you, everybody, for joining us today. We look forward to seeing some of you on the road in the coming months and chatting with you soon.