Steris Plc (STE) — Q3 2019 Earnings Call Transcript

Thank you, Jamie, and good morning, everyone. As usual on today's call, we have Walt Rosebrough, our President and CEO; and Mike Tokich, our Senior Vice President and CFO. I do have just 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. Redistribution, retransmission or rebroadcast of this call without the expressed written consent of STERIS is strictly prohibited. Some statements made during this review may be considered forward-looking statements. Important factors could cause actual results to differ materially from those in the forward-looking statements, including risk factors described in STERIS's securities filings. The company does not undertake to update or revise any forward-looking statements as a result of new information or future events. 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, constant currency organic revenue growth, segment operating income, and free cash flow will be used. Additional information regarding these measures, including definitions, is available on today's release, including reconciliations between GAAP and non-GAAP financial measures. Non-GAAP financial measures are presented during this call to provide greater transparency to supplemental financial information used by management and the Board of Directors in financial analysis and operational decision-making. 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 the highlights of our third quarter performance. For the quarter, constant currency organic revenue growth was 6.9% driven by volume and 50 basis points of price. Gross margin for the quarter increased 20 basis points to 42.7% and was impacted favorably by currency, price and the impact of divestitures, somewhat offset by higher labor costs and the impact of tariffs. EBIT margin for the quarter was 20.8% of revenue, a substantial increase from second quarter levels and 20 basis points better than the third quarter last year. EBIT margin was negatively impacted in the quarter by 40 basis points due to higher than anticipated calendar year end employee healthcare benefits claims activity causing an increase in SG&A for the quarter. The adjusted effective tax rate in the quarter was 18.9%, somewhat lower than we had anticipated due to favorable discrete items. Net income in the quarter grew 11% to $107.2 million and earnings increased 13% to $1.26 per diluted share benefiting from both revenue growth and a lower effective tax rate. In terms of the balance sheet, we ended December with $225 million of cash and $1.25 billion in total debt. During the third quarter, capital expenditures totaled $50.7 million. Given our spending to date and plans for the fourth quarter we are reducing our expectations for capital expenditures by $10 million to approximately $180 million for the full fiscal year 2019. As a reminder during the third quarter, we announced a restructuring plan that will generate profit improvement of approximately $12 million over the next two years. In addition, we adopted a branding strategy that included phasing out the usage of a trade name associated with certain products in the Healthcare Products segment. These two items have resulted in a significant increase in depreciation and amortization for the quarter. Unlike the P&L, we do not adjust the balance sheet nor free cash flow for these items. Hence, depreciation and amortization for the quarter was significantly higher at $82.7 million, primarily due to $36 million in accelerated depreciation and amortization associated with both the restructuring plan and the branding strategy. Free cash flow for the first nine months increased to $252.9 million, mainly due to improvements in cash from operations. We are updating the full fiscal year 2019 free cash flow expectation to include higher working capital requirements, costs associated with our plan to redomicile to Ireland, and restructuring plan costs. Free cash flow is now expected to be approximately $330 million for the year. With that, I will turn the call over to Walt for his remarks.

Thanks, Mike, and good morning everyone. Fiscal 2019 is shaping up to be a strong year for STERIS fueled by solid demand from our customers across all four segments. For the first three quarters we’re ahead of our expectations for revenue growth and as a result are increasing our full-year constant currency organic revenue growth expectations to be approximately 6%. Each of our business segments has contributed nicely to our revenue growth so far this year. AST and Healthcare Specialty Services are leading the way with 8% constant currency organic revenue growth year-to-date. In AST we continue to see solid underlying demand from our core medical device customers. Our Healthcare Specialty Services segment continues to exceed our revenue expectations driven primarily by strength in the United States. Their profitability has improved as planned as we have successfully leveraged the investments made over the past year. Healthcare products, constant currency organic revenue has grown 7% so far this year with strength in both recurring revenues and capital equipment. Even with the growth in capital equipment shipments, our healthcare backlog has also grown nicely and is anticipated to ship over the next few quarters. We expect a solid fourth quarter in healthcare capital shipments. And finally, Life Science constant currency organic revenue has grown 5% year-to-date with growth across the business. Our fourth quarter last year was a strong record quarter for Life Science capital equipment shipments, which we do not expect to replicate this year. Backlog has stayed relatively steady compared to last year and is certainly above our historic levels, which gives us comfort that the underlying trends we have experienced over the last year will continue. As I mentioned earlier, we now expect our overall constant currency organic revenue growth to be approximately 6% for fiscal 2019. As a result, we are confident in our ability to deliver another record year with adjusted earnings per share in the range of $4.74 to $4.84. I will note that when we raised our outlook for this range last quarter, our thinking was that the effective tax rate would come in around 20%. With the continued favorability on the tax rate in the third quarter due to favorable discrete items, we will likely have a modest upside on the effective tax rate for the fiscal year, but we're not certain enough or substantial enough to guide that rate. We appreciate your taking the time to join us this morning and your continued support of STERIS. I will turn the call back to Julie to open for Q&A.

Thank you, Walt, and Mike for your comments. Jamie, we're ready to start Q&A if you'll give the instructions.

Maybe you could start with the guidance, the organic revenue guidance, I think it implies a pretty decent deceleration in the fourth quarter. What's driving that? The comp looks to be pretty consistent with the third quarter, but is it just conservatism or is there something else that you can point to, maybe from a segment standpoint?

Sure, John. A couple of points to make. First, we've been talking for a long time about trying to move our revenue pattern a little bit away from the fourth quarter. We traditionally have a very strong fourth quarter. We like to run our factories more level-loaded to the extent possible, and as a result, we've been trying to pull that forward. We've had some success with that this year, so I expect relative strength due to our strong performance in the first three quarters. There is also one less shipping day this year than last year, which doesn't have a big effect on capital equipment but does affect the recurring revenue. And I would say you're probably correct; we may be being a bit conservative because the end of March falls on a Saturday and Sunday, and we don’t like to run our plants shipping on those days. Additionally, we have Brexit coming on March 29, which is two days before our fiscal year-end, adding some uncertainty about how shipment patterns would play out. So, we are being a bit conservative with our forecast, but we're comfortable with the 6%. We'll see how the end of March turns out.

And then I guess taking a step back, your organic growth over the last five years has probably been in the 4% to 6% range. This year you're now guiding 6%; you mentioned there's another 50 basis points from the Sterilmed contract that you're also navigating. Are you at a point where you believe you can drive consistent organic growth at the 6% range or better?

I think it's early for us to say we're going to move above our long-term target of 4% to 6%. Clearly, we're at the top end of that range right now. We could possibly tip over a little bit, but I think it’s too early to say that. We're currently looking at next year's plan as we speak and will discuss more about that when the time comes.

And then last one from me on cash flows. I think you're clear about some changes in cash flow from operations, higher working capital, plans to redomicile, and restructuring. Can you talk about what's driving the reduction in CapEx by $10 million versus prior guidance?

Yes, John, it's mostly due to the timing of projects. We set out a goal at the beginning of the year, and we're just behind our original plans from a timing perspective. It's nothing more than that.

Just a quick follow-up to that; you've baked some significant investments for outsourcing projects, and I believe there's an upfront CapEx cost associated with that. Relative to your comments, Mike, is everything tracking in line for the $10 million in revenue you were expecting from outsourcing for the year?

Actually, as you can see from our Specialty Service business in healthcare in the United States, it has had an outstanding year in growth on both sides of the equation; the Instrument Management business is growing nicely and the Outsourcing business is growing slightly ahead of our expectations. This year we had forecast about $10 million growth. As we sit here today, we've already exceeded that number and fully expect to meet or beat that objective. So, everything is going quite nicely for us.

I was wondering if you can comment on how the restructuring profit improvement of $12 million over the next two years should flow through the P&L? Specifically regarding the gross margin line, what can we expect moving forward?

We anticipate that the $12 million will happen over the next two years. The majority of it will actually occur in the second year. In our fiscal year, we anticipate it'll be more back-end loaded as we implement our plans to close and consolidate manufacturing facilities, and do some product rationalization which will take some time. So, I would say these savings will be more back half loaded next year, with the bulk of it happening in fiscal year 2021.

And I had a question about M&A. Given the current environment, can you provide any update on how we might proceed into the next fiscal year? Anything to hint at in terms of M&A?

We have an active funnel. Most of what is active are relatively small tuck-ins compared to the businesses they are being integrated into. That's our favorite type of acquisition. We've had a few of those this year and we have a good pipeline going forward. In terms of a more significant acquisition, there are things we are looking at. We've been doing that for some time, but many times private companies have that decision to make themselves. Additionally, the market is relatively high in price across the board, and we want to avoid overpaying for something we might purchase. Therefore, it’s a combination of those two factors that might delay a purchase. You should not be surprised if we make a significant acquisition tomorrow morning, but you also shouldn't be surprised if we don't make one into next year. It's all about timing.

Just want to clarify your comments on the implied outlook for fiscal fourth quarter. It sounded like a lot of the items you talked about had to do with timing and maybe just a little bit of conservatism. I want to clarify that you're seeing no change in spending patterns in your end markets, just to look at it from the demand side.

Isaac, you read that absolutely correctly. From the demand side, I would say this is more about supply side than demand side. All of our units are experiencing solid growth from the demand side. We anticipate continuation. The timing issue is one less shipping day, which translates to a point-and-a-half on the consumable side if everything runs to the number of days. That can have a significant effect on growth rates in a given quarter. However, in terms of the pipeline, we see no difference in the healthcare capital pipeline compared to what we've talked about for the past 18 months. On the consumable side, we have seen no change in ordering patterns. I would not suggest that our full year numbers are reflective of what we have seen and are still seeing in the pipeline compared to what might be implied by the fourth quarter.

Okay, that's helpful context. I want to follow up on the expense side. Could you talk about whether the incremental costs on the free cash flow guidance from the redomiciling effort will run into fiscal 2020 or is there a one-time effect there?

In regards to the Ireland redomicile, most of the expenses will be incurred this fiscal year from a P&L standpoint, which are adjusted out, and a cash standpoint, which we do not adjust out. We anticipate early on it would cost us about a $5 million impact. Right now, that estimate has been revised to about $10 million, which is one reason we are taking down free cash flow. Additionally, the healthcare claims activity that we discussed was higher than anticipated in the fourth calendar quarter, and this contributed to a 40 basis points impact on our EBIT margin making it significant for us in our third quarter.

But Isaac, I would not characterize that as a significant change when looking at it over the course of the year. I view it as a timing adjustment. We've been seeing elevated claims activity recently, and while actuaries try to capture these trends, I wouldn't expect a significant effect for the full year. If you look at the figures over the first nine months, they're not particularly significant, and I think they will stabilize over the next twelve months.

Regarding your HSS segment, nice operating leverage in the quarter. Can you talk about that going forward and how we should think about further investments in that segment compared to what we saw this quarter?

Yes, we've talked about that in the past, and I don't feel differently about that at this point in time. The outsource reprocessing business remains relatively small, so as we make investments, we anticipate more fluctuation on a quarter-to-quarter basis. Over the long term, we foresee that well positioned in the mid-teens range for return on sales. While we invested heavily last year and early this year, that has impacted margins initially, they are now flowing through almost as expected but slightly ahead on revenue.

Walt, could you provide some thoughts on hospital spending globally? Are you seeing any material change from what you said last quarter?

Really the short answer is no significant change in the pipeline that we see. First of all, our backlog is at record levels, significantly higher than before. This indicates strong shipments ahead. Our pipeline also continues to stay solid, so we’re feeling positive about healthcare, though we don’t have as much visibility there as we do in Life Science due to its longer pipeline. We're still seeing noteworthy projects but may need some time to develop.

And Mike, as for the tax rate, could you provide an estimate for the fourth quarter and maybe a yearly estimate for fiscal 2020?

Yes, as we've been saying, approximately 20% for the full year will be our effective tax rate. We did experience some favorability this quarter mainly due to some stock comp deductions. We still expect the low twenties or around 20% approximate range for the fourth quarter, and we will guide in the May timeframe as we look towards next year.

What is the current debt to EBITDA ratio, and what is the target for that?

We are currently just under two times levered. Remember, we took leverage up to about 2.9 times with the acquisition of synergy just over three years ago, and we've been working to bring that down to somewhere in the low two ranges. While we don't have a specific target, we feel comfortable operating at these levels.

Historically, STERIS was well under two, and while we've increased those debt levels, as we’ve noted, our capital structure's optimum range is between 1.5 and 2.5. We don't feel pressured by capital structure issues.

Walt, can you help us understand the AST segment which is seeing operating margins over 40% and growing 6% off of a previous high. What's driving this upside to the operating margin in AST? Is it utilization of the capacity that you brought online over the last 12 months or a change in mix?

Yes, Chris, the underlying driver is the growth in the business. As many medical device makers are having solid quarters, we tend to benefit from that demand. We have expanded geographically and in capabilities, and this expansion is paying off. While there have been negative effects on margins due to depreciation and early startup costs, we're seeing our utilization rates exceed expectations. I wouldn't suggest we will always be over 40%, but I've been pleasantly surprised with the results, given the capital investments made.

Regarding the Life Science backlog, we saw phenomenal growth last year. It was up 43% in the prior quarter, then down 7% this time. Are we starting to approach a normalized capital growth rate?

Chris, your question is excellent. We don't expect the 30% to 40% growth rates in this business to continue. Although shipments tend to be lumpy in Life Science, we maintain a consistent backlog. Currently, our backlog is roughly the same as it was last year. I don't expect a large downturn, nor a significant upturn, as it appears steady state.

So, looking at cash flow, your original guidance was $340 million, now it's at $330 million. If I'm reconciling these, you're accounting for additional expenses to redomicile to Ireland and restructuring. And in essence, I'm trying to work back to that $340 and understanding what the essential factors are. Am I understanding this correctly?

Yes, Chris. There are three driving factors. First, there's an increase in the redomicile expenses by about $5 million. Secondly, there are some restructuring costs from a cash perspective, similarly about $5 million. Lastly, we have additional working capital requirements, mainly due to inventory increases as our backlog is high. With some of that backlog beginning to shift into Q1, we must build the products, leading us to about $10 million in increased inventory. This helps reconcile the difference. Then, consider the $10 million in reduced CapEx which brings us to the $330 million.

So, the underlying leverage isn't tapering; it's just the different factors offsetting one another partly...

Exactly. Additionally, we do not adjust the P&L like we do with restructuring and Ireland expenses; we continue to account for these in free cash flow and on the balance sheet.

And Chris, as we've said, we have demand to ship more than we are now forecasting. It's a matter of our ability to match the orders. If a customer calls up a week before the end of the year and says, 'Hey, I need to delay this two weeks because my construction isn't going as anticipated,' we have already built that product. Therefore, certain products can be specific to the order, and as such, we have to forecast some of that slipping into next year. This is the same logic for revenue.

On the ORC centers, congratulations on launching that revenue in the U.S. You mentioned three centers that you had contracted. Are one, two, or three of those centers currently open, and do you have plans for more than three contracted centers at some point soon?

Matt, one, two, or three of those are open right now. As I mentioned previously, we're not going to disclose specific customers. However, we intend to transition various contracts from their facilities to ours, along a continuum of outsourcing. For example, in the U.K., we have some customers where we handle the entire process in a center located offsite and we transport it back and forth. We are also working in many places to gradually increase our level of engagement over time. We did achieve our yearly target and are quite comfortable with the growth in this business.

This is a new model for the U.S. Can you provide insight on how the transition has gone with those customers as you moved it from their facilities or operations to yours?

Like all transitions, some customers are a bit testy and others have been easier. We’re not trying to transition the entire facility at once, and that approach benefits both us and our customers. In some locations, there’s absolute capacity, and we must rebuild, requiring us to set up offsite operations. The transition is gradual rather than a switch that turns off immediately, helping ensure we manage expectations on both sides.

Walt, I know you mentioned significant acquisitions come with a lot of deliberation. What qualifies as a significant deal for you? Are there more options in that space?

I define significant deals as those larger than 10% of the business we are integrating into. We focus on tuck-ins, and that remains our preferred option. We've been considering several larger acquisition opportunities for a time, but the current high market prices necessitate caution regarding valuation. You may see we have some potential, but it's really a matter of timing; they can come or go.

Mike, how confident are you that you've accounted for all the potential tax reform changes in your low 20s guidance?

We're confident we've included all finalized elements from the Tax Cut Jobs Act in our projections. However, as new proposals emerge, we cannot speculate on those. As it stands, we feel very secure in what we've completed.

If only we could get tax laws around the world to stop changing, our forecasts would be more reliable.

Thanks again, everybody, for joining us today and for your continued support of STERIS. We’ll talk to you again next quarter.