Steris Plc (STE) — Q3 2018 Earnings Call Transcript

Thank you, Jamie, 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 do 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 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. 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 all 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-occurring 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 Mike.

Thank you, Julie, and good morning, everyone. It is once again my pleasure to be with you this morning to review our third quarter performance. For the quarter, constant currency organic revenue growth was 5.2%, driven by volume and 110 basis points of price. Gross margin as a percentage of revenue for the quarter increased 250 basis points to 42.6%. Of the improvement, 170 basis points is due to the impact from the divested businesses, with the remainder due to favorable product mix, price, and productivity improvements somewhat offset by the negative impact from currency. EBIT margin expanded 140 basis points to 20.8% of revenue for the quarter. 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 adjusted effective tax rate in the quarter was 22.6%, which added approximately $0.05 to earnings per diluted share. Included in the third quarter effective tax rate is the impact of the U.S. Tax Cuts and Jobs Act enacted in December. The tax reform's primary change is a reduction in the U.S. federal statutory corporate tax rate from 35% to 21%. As a March fiscal year-end company, we benefit from a blended U.S. tax rate reduction from 35% to 31.5% in the current fiscal year. Because tax law changes must be accounted for in the period of enactment, we have recorded a benefit in our third-quarter tax expense to account for the year-to-date effect of the blended tax rate, which will not be repeated again in the fourth quarter. While our assessment of the effects of the tax reform is ongoing, we do expect the benefit we recorded in the third quarter to result in a tax rate of approximately 25% for the full fiscal year, which is at the low end of our prior expectations. Net income in the quarter was $96.3 million or $1.12 per diluted share, benefiting from organic revenue growth, continued margin expansion, and the lower effective tax rate. Segment growth 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 $284 million of cash, $1.42 billion in total debt, and a debt to EBITDA leverage ratio of approximately 2.25 times. Free cash flow for the first nine months was $216.4 million, a 19% improvement from the same period in fiscal 2017, mainly due to higher earnings and lower requirements to fund operating assets and liabilities year-over-year. During the third quarter, capital expenditures totaled $38.1 million while depreciation and amortization was $44.7 million. We now anticipate that free cash flow will be about $300 million and capital spending will be approximately $160 million for the fiscal year. With the enactment of tax reform, we anticipate repatriating about $100 million of cash which will be used in alignment with our capital allocation priorities. Our capital allocation priorities remain the same: maintaining and growing our dividend relative to our growth, investing in organic growth in our current businesses, targeting acquisitions in adjacent product and market areas, reducing our total company leverage, and finally share repurchases if the other uses of cash are lower than our desired and do not offset dilution. With that, I will turn the call over to Walt for his remarks.

Thanks, Mike, and good morning, everyone. We are now three quarters of the way through our year and have delivered constant currency organic revenue growth at the high end of our expectations, growing 5% year-to-date, and are on track for another year of record earnings. Looking across our portfolio, we have high single-digit or low double-digit revenue growth across the majority of our businesses driven by solid underlying market trends and new product and service offerings. In particular, our healthcare specialty service segment has outperformed our expectations across the board, growing constant currency organic revenues 10% year-to-date. Life Sciences, whose capital equipment business has now had two strong quarters in a row with continued strong backlog, grew constant currency organic revenue 8% in the first nine months of the year. Our AST business continues to experience increased volume from our core medical device customers. In addition, I'm pleased to report that our facility in Puerto Rico, which is now back to normal production and has been since December, much faster than we anticipated. We originally thought that the hurricane in Puerto Rico could impact profit in our AST segment by as much as $3 million this year. Based on where we stand today, we now expect the impact to be just $1 million, all of which was incurred in the third quarter. In addition, we have recently launched our sustainable EO sterilization service offerings, which will assist customers in developing strategies to reduce the amount of ethylene oxide used during sterilization, at the same time achieving prescribed sterility assurance levels. That is good for our customers and good for the environment. Within healthcare products, we have solid growth in organic revenue fueled in part by many new launches including our newest 20-minute biological indicators for low-temperature sterilization named Celerity. This growth in recurring revenue has been a strong factor in our growth in healthcare for the last couple of years. Celerity is but one of about 30 new products we're releasing in our healthcare products segment this year. Healthcare capital equipment has had somewhat lighter revenue than anticipated, with shipments down year-over-year, but that is offset by a nice pickup in backlog on both a sequential and year-over-year basis and a pipeline of potential future business that is solid. As you know, capital equipment businesses can be lumpy, and we had strong shipments last year, especially in our fourth quarter, so we're optically concerned with healthcare capital. Moving on to the impact of tax reform in the U.S., Mike has already discussed the specific impact to STERIS in the third quarter and our expected outcome for fiscal 2018. Our best estimate as of now is that STERIS will have an adjusted effective tax rate in the low 20 percentiles in fiscal 2019, down from the mid-20s this year. Let me be clear; there are many complicated aspects of the new tax law and we and our advisors will continue to evaluate the impact of those tax provisions on STERIS and naturally, we'll be working to legally minimize our taxes. As is the case with many companies, the U.S. corporate tax reform results in significant additional earnings for STERIS to use to strategically grow our business and return value to our customers, our people, and our shareholders. This will make us more competitive with our global competitors, many of whom manufacture outside of America. One of our first decisions on that front that we announced in our press release this morning is that we will be paying a one-time special bonus to all U.S. employees other than senior executives. The total bonus payout is expected to be about $7 million, which we plan to exclude from our fiscal 2018 adjusted earnings. This is just one example of our continuing investments in our people who are the foundation of our success. Turning to our revised outlook for 2018, we are maintaining our outlook for 4% to 5% constant currency organic revenue growth for the full fiscal year. I would remind you that our fourth quarter last year was extraordinary, so we do have particularly difficult comparisons in Q4. Reflecting our expected operating performance at the high end of our previous guidance, plus the benefit of the lower effective tax rate, we now expect earnings per share to be in the range of $4.10 to $4.16, which is either 9% or 11% growth from prior year levels. We are very pleased with our overall performance so far this year and are on track for another solid year of growth and record performance and look forward to many more. Thank you for joining us today and for your continued support of STERIS. I will now turn the call back to Julie for Q&A.

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

Couple for me. First off on the med device customer demand, and we look across the industry this quarter, obviously pretty solid results for other companies, but seems like your business was a little bit better than otherwise would have been expected. Anything you can point to that might be one-time in nature or customer-specific that helped drive the strength in that business?

No, not really. Again we do seem to be picking up specifically the STE business where med device in general would drive that. We do seem to be picking up steam a little bit again I suspect we may be picking up a little share in that space.

And then maybe a follow-up on the expense side obviously on the tax benefit here and you mentioned the one-time bonus payment to employees. Are there other elements to the tax reform that are going to lead you to reinvest more aggressively on longer-term projects, innovation-related things? Just kind of curious what else you're doing with the windfall here to try and fuel future growth for the business? Thank you.

Sure. We have been long-term in-sourcer, onshoring people maybe before it was popular again for the last 10 years basically. And so that's something that is clearly a part of what we expect to do. We do like to make things, we like to design things, we like to sell things. So all of those things are a natural element of what we do. As a result, we've grown employment and we’ve been able to bring more money to the bottom line. But the Tax Act clearly incentives us to do more of that. All things being equal, there're projects - that if they were at the margin maybe not as attractive as we might have liked, they may be more attractive. So clearly capital spending in the short run is more attractive than it was two years ago, and almost any investment that gives a reasonable return in the U.S. is more attractive than it was a year ago. So, all things being equal we would expect to see some more investment in that space.

Just a couple of quick questions, maybe starting with AST. So that growth was obviously nice 2.5% on an organic basis. I guess Walt, you indicated a disruption from the hurricane was less than anticipated. Is there anything else to read into that growth rate? I recognized the comp was a bit easier, but was there any sort of perhaps on Puerto Rico, companies that were moving more aggressively to get volume through the facility given that they were coming up to speed as well?

I don't think so - you are correct you remember last year third quarter kind of all of our consumable or recurring businesses just had a slump around Christmas and at the time we really didn't understand it and to be honest we still don't really understand it. Our suspicion is it was just the way the holidays fell and people were taking off more time than normal and that seems to have come to fruition because we didn't see that in the third quarter. So that on a quarter-over-quarter basis is clearly the case across the board for all of our consumables, but when you look at it for the year, we’re still having a wonderful consumable year across the board, recurring revenue actually across the board. I don't think there's any overwhelming change in the Puerto Rico issue that is, yes there were things that were not done and yes there was a little bit of catch-up, but it turns out that they were not down as long as any of us thought that our customers were not. We got up in about a week and a half and we’re able to start processing and then they really have done a nice job, and you have to give credit to the Puerto Rican people they have just because they’re still living in pretty tough conditions, but across the board for what they're doing in all the medical device companies. And then those feed us, of course, in our plant as well, we’re just ecstatic at the work they are doing.

And then just two other quick ones. Just on HSS again really nice nearly 9% constant currency organic growth there, but the margin was down sequentially I believe 5.6% in the third quarter from 8ish in the 2Q. So again, anything that that sort of changed during the mix there to be thinking about and maybe what's the right way to think about directionally where you think that margin can go over time?

A year ago, we were in a very different situation. At that time, we acknowledged that we had over-invested ahead of the revenue we anticipated, and not only did we fail to meet those expectations, but we also incurred losses. This was particularly damaging in a service-oriented business. From that experience, we've taken a more cautious approach, ensuring we do not repeat past mistakes. Now, we have started to reinvest for future growth, but we will be much more prudent moving forward. While we may see some fluctuations from quarter to quarter, over the long term, we believe we will achieve the goals we set for ourselves.

And then last one, I know you're not providing 2019 guidance at this point and thank you for the color on the tax rate. Just two things come to mind. Number one, is there anything that you can say as it relates to Northwell and timing there? And then also obviously there was a meaningful portion of the margin expansion this year was due to the divestiture of the assets. So is it fair again to think about your typical 50 to 100 basis point underlying margin expansion targets is the right way to think as we move forward past this period of the divestitures?

So two questions I think in there, and I'll try to hit them both. Northwell no real further comment than what we've already said as you know than has been reported not us but by others that the building is essentially done and we have said that we are spending capital in that space now. So we fully expect to start up next year sometime and yeah we're giving no more guidance on that now, but we will in the future. So at a high level that's that conversation. We also have seen again continued interest in other places to do similar type things. It will not affect next year in any significant way other than potential capital spending, but we have some things that are looking more like fire and smoke now. So we are seeing some early signs that that may come to fruition more than the past year, year and a half. The last topic you raised was margin and generally speaking, I think you're on track. The bulk of the divestiture movement has occurred and so if you look year-over-year, quote, unquote, 'our normal cost reductions'. I will caution as always, we are in our planning cycles. We're thinking through what our strategic investments are going to be. And as you know, we don't always drop every dollar that we find into the bottom line. We invested for the future and we invested in our customers. And to us, tax is just one cost. So there are a number of costs that we will be working down next year and some of which is the tax rate and we want to make judicious decisions about what to do with those things.

Just to be clear, when we say next year, we mean…

Next fiscal year is always the next year for us, exactly.

I guess we see some of the benefit of your balanced or diversified business today, but Walt, just to make sure and check the box and hear your thought on the healthcare capital side again, any other color? I know it's the second quarter where and I know it can be lumpy, but any color on major product, products, or projects and replacement capital, anything that you could give us just to clarify what you're seeing out there today?

Sure. At a high level again, I would not characterize it and now I am talking more about the pipeline, which I think is your question: the hospital spending pipeline if you will. I wouldn't characterize it significantly different in North America than we have been characterizing it in the past. So we still see a solid pipeline in the future projects that we're seeing for the potential future for real projects that we expect to occur in the future still looks very similar that we've been talking about. It's solid to maybe slightly up. So that always makes us feel good, particularly given the level of uncertainty that's going on in healthcare reimbursement issues in the United States. In the rest of the world, actually the pipeline I would characterize and I think I did last time that the rest of the world seems to be picking up a little bit and particularly in certain areas. Europe has stayed strong for us, Middle East was pretty much a disaster for the last 18 months, but it is now picking up. So we look at EMEA as one unit that we see I think more strength there than we have seen in the past. Asia-Pacific was very strong the last couple of years; it flattened out this year, but I think we see a better future there in terms of pipeline. And Latin America, which has been really tough for us, has seemed to have bottomed out. So we have a bottom and maybe a little bit of pipeline there than we have in the past. So the rest of the world is actually looking stronger. I will add we talked about currency and the effects of currency a lot in terms of what hits the revenue, what it's a bottom line but that's I'll call the accounting version of currency. When we have - when the dollar strengthens to other currencies it is a headwind for STERIS because we tend to build in North America, most of those costs are U.S. based costs and so U.S. dollar based. Most of our competitors are not building in the U.S. and as a result, most of their costs are other than dollar base, so when the dollar strengthens we have a headwind selling both in the U.S. and outside the U.S. When the dollar weakens, we have a tailwind. So up until the last couple of months, we've been pretty much running into headwinds the last couple of months things are changing. Now I do not try to forecast currency but because if I could that, I wouldn’t be working here, but in any event, we do see some relief of the headwinds that we've been facing in terms of our currency for the last couple of months.

And then I guess just two quick follow-up on the AST obviously. People have talked about how strong it was. As you look at that close to 10%, high single-digit growth maybe gaining some share. Can you sustain a growth rate like that? I mean my recollection was that some of these - your facilities run pretty hot and that there wouldn’t be maybe capacity for you to sustain sort of increases like that without sort of expanding. So just love to get your thoughts there on what that could look like even as we’re looking ahead to next fiscal year? Thanks.

No question, if you have 60 points roughly and if you wrote 10% a year roughly that means you have built six points a year roughly. Now a plant is not a plant; the U.S. plants tend to be more concentrated as a result, tend to be larger, probably close to 2X larger and so that's one set of facts - it is very different to have to build a brand new Greenfield plant, as opposed to adding a couple of units inside a plant or adding on to a plant where we already have the ground, and we have a number of expansions which is a big piece of our capital spending. So we’re always expanding and I suspect we’ll always be expanding as long as medical devices keep growing which we don't see any end to that frankly. And so it's much less of a pain now when we - to the bottom line finance of the whole company STERIS in total and certainly AST when we’re doing that.

Walt most of your businesses are growing high single digits or low double-digits now. I mean you had a really incredible quarter in almost everything, with the exception of healthcare capital equipment. Could you give us a little bit of color on maybe the surgical side versus the infection prevention side - you said you're not worried about it. Like why should we not be worried about it?

First of all, let me address it in two parts. We're not overly concerned because, when you look at the longer term, growth hasn’t been rapid, and capital spending hasn’t seen significant growth either. From a long-term view, this doesn’t raise major concerns for us. Within each unit, we have product lines that perform well and others that struggle, which is the case at the moment. For instance, in the past couple of years, our ORI business has experienced significant growth, with last year's growth rate exceeding this year's. This can fluctuate quickly based on major projects. The same applies to our equipment management systems, which had strong growth last year but are showing less strength this year. It's a combination of product performances across different areas. In the IPT business, washing has been particularly robust recently, while steam sterilization has weakened. Hydrogen peroxide saw exceptional demand a few years ago but is currently performing moderately well. The fluctuation is noticeable, and when we review our overall performance, past and present, we feel confident about our position in the capital equipment sector. Additionally, I mentioned the challenges posed by a strong dollar, which are beginning to ease. This is beneficial for us, especially in markets outside the U.S., but even domestically, as many competitors manufacture overseas, which alters the dynamics of headwinds and tailwinds. Absolutely, there are significant differences in levels of importance and we have continued to pick up product launches in the healthcare products group in total and so we have continued to grow. I guess, just I would say 30 is a big number. But on the other hand, we're not I wouldn't suspect the number is going to be a whole lot less next year either. So we have picked up our product development. We have a broader product line today. So each of those product lines needs to be refreshed on a routine basis. So I suspect we will see more and more. And when I said the 30, that's a mixture of capital and consumables, but it is across the board in capital and consumables. We have a number of releases. I mentioned the biological indicator, that's a really nice change for us. We had a 24-hour biological indicator for hydrogen peroxide, which was the state-of-the-art. A few years back, we were the first also to have one that went across our line as well as the J&J line, which was state-of-the-art. People have caught up with us and/or passed us and now we have a 20-minute biological indicator in that space, which is state-of-the-art. So that's just an example, but I could walk through 10 examples like that where either we're refreshing or bringing new products to market. Our first and favorite type of acquisition is something that adds product or service to customers who are already serving in the space who are already serving. And so that would be the first. So I'll call it for lack of better terms end customer, end market or whatever you want to call it. That's our first choice, but we're always looking at extensions to do as well. So it could be a different product or service. It's more likely to be with the customer who are already serving hopefully in the same space, we're serving them, but if not, right next door we're serving them. So we do like adjacent or tangential whatever terms you like acquisitions, a lot better than the other kind. But we look at both all the time. We evaluate if we can bring something to them and/or they can bring something to us and we're really happy if the answer is yes to both questions.

Thank you, everybody for joining us this morning. We hope to see many of you as we get out on the road in the coming month.