Steris Plc (STE) — Q4 2022 Earnings Call Transcript

Thank you, Ted, and good morning, everyone. As usual, speaking on today's call will be Mike Tokich, our Senior Vice President and CFO, and Dan Carestio, our President and CEO. I do have a few words of caution before we open for comments. This webcast contains time-sensitive information that is accurate only as of today. Any redistribution, re-transmission or rebroadcast of this call without the expressed written consent of Steris is strictly prohibited. Some of the statements made during this review may be considered forward-looking statements. Many important factors could cause actual results to differ materially from those in the forward-looking statements, including without limitation, those risk factors described in Steris' securities filings. The company does not undertake to update or revise any of these forward-looking statements as a result of new information or future events or developments. Steris' SEC filings are available through the company and on our website. In addition, non-GAAP financial measures will be provided during this call. Additional information regarding these measures, including definitions, is available in today's release. Also, along with reconciliations between GAAP and non-GAAP financial measures. Non-GAAP financial measures are presented during this call with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. With those cautions, I will hand the call over to Mike.

Thank you, Julie, and good morning, everyone. It is once again my pleasure to be with you this morning to review the highlights of our fourth quarter performance. For the quarter, constant currency organic revenue increased 11%. Growth was driven by organic volume, as well as a 120 basis points of price. Acquisitions added approximately $253 million to revenue in the quarter, which is broken down by segment in the press release tables. Gross margin for the quarter increased 120 basis points compared with the prior year to 45.5% as favorable productivity, pricing, and acquisitions were somewhat offset by higher material and labor costs. We continue to face increased material and labor costs, which totaled about $20 million in the quarter as anticipated. EBIT margin for the quarter was 23.6% of revenue, an increase of 130 basis points versus the prior year. This is impressive performance as operating expenses, including R&D, increased, plus the continued headwind from supply chain and inflation. The adjusted tax rate in the quarter was 22.8%. Net income in the quarter was $205.4 million and earnings per diluted share were $2.04. At the end of the fiscal year, cash totaled $348 million. We continue to focus on debt repayment as evidenced by our leverage ratio, being now under 2.4X at the end of the fiscal year. Our focus on debt reduction provides us flexibility to continue making investments in growth capital expenditures and allows us many opportunities to continue to expand our businesses. Year-to-date, capital expenditures totaled $287.6 million while depreciation and amortization totaled $553.1 million. Free cash flow for the year was $399 million. As anticipated, this is a decline from the prior year, due to costs associated with the acquisition and integration of Cantel along with higher capital spending year-over-year. As we look forward to FY2023, we anticipate free cash flow generation of approximately $675 million, as the majority of costs associated with the acquisition and integration of Cantel have occurred. We also expect interest expense to be higher year-over-year, as rates continue to rise. Total non-operating expenses net is anticipated to be about $95 million. In addition, we expect to continue reinvesting in our businesses, with capital expenditures totaling approximately $330 million. With that, I will turn the call over to Dan for his remarks.

Thanks, Mike, and good morning, everyone. Thank you for taking the time to join us to hear more about our fiscal 2022 performance and our outlook for fiscal year 2023. As I look back on the year of fiscal 2022, it was a remarkable year for Steris. Not only did we navigate year two of a global pandemic, but we also completed the acquisition of Cantel, while integrating Key Surgical, and successfully transitioned leadership, all while growing faster than anticipated. I want to start by thanking the people of Steris for all they have done and continue to do to support our customers and each other. Without all of you, we would not be where we are today. We started fiscal 2022 with an expectation of 8% to 9% constant currency organic revenue growth for the year. After increasing our outlook twice this year, we ended the year with 13% constant currency organic revenue growth, well above our increased outlook. This growth was driven by continued out-performance of our AST segment, double-digit growth in healthcare, and solid mid-single-digit growth in the Life Sciences. While Dental is not yet included in the constant currency organic revenue growth, the segment grew 4% year-over-year since the time of acquisition in June. From a profit perspective, we ended the year with operating margins up 100 basis points, despite absorbing about $45 million in unplanned supply chain and inflation costs related to labor. Helping to offset those costs, we were successful in overachieving our fiscal 2022 cost synergies targets for the Cantel acquisition, which added approximately $40 million to our fiscal 2022 results. Adjusted earnings per diluted share of $7.92 increased 28% compared with fiscal 2021 and reflect a new record for Steris. Turning to fiscal 2023, at a high level, we expect another very strong growth year for our business. Our outlook for total revenue calls for approximately 12% growth, which includes two additional months of the Cantel acquisition, offset by the impact of the Renal Care divestiture, as well as approximately $30 million in unfavorable foreign currency. Excluding all that, we anticipate constant currency organic revenue growth of approximately 11%. Importantly, this outlook assumes that the procedure volumes will normalize in the U.S. and that we do not experience any significant wave of disruption from COVID. Our constant currency organic revenue outlook reflects volume growth and includes 200 basis points of favorable pricing. Pricing is essential to help offset the increased costs year-over-year. For FY2023, we expect an incremental $70 million in extraordinary supply chain and labor inflation costs, above the $45 million we incurred in FY2022. This is in addition to our normal low single-digit annual inflation amounts always included in our outlook, which we will work to overcome every year. In addition to the anticipated headwinds from supply chain and inflation, our FY2023 operating expenses will be higher as we get back to spending on travel, sales, and marketing, and other expenses. R&D spending is also anticipated to be higher as we continue to develop and bring new products to our customers. Offsetting those headwinds, to some extent, will be cost synergies from the integration of Cantel, which is expected to be incremental by approximately $50 million from the FY2022 levels. By the end of FY2023, we will be approaching $100 million in total cost synergies achieved. Taking into consideration all of the factors, we expect modest operating margin growth in FY2023. Our full-year earnings per diluted share outlook is anticipated to be in the range of $8.55 to $8.75, or 8% to 10% growth over FY2022. Given all the moving pieces, we are pleased with this bottom-line growth outlook. As usual, the range does provide us some conservatism on the low end. But given all the uncertainty that exists, we believe it is warranted. Overall, fiscal 2023 is expected to be another record year for Steris. Our teams and our portfolios continue to come together to better meet the needs of our customers. And the breadth of our offerings allows us to take advantage of several significant trends in the industry by leveraging our relationships to cross-sell within the business segments. I recently shared with our sales team in our first in-person global meeting in three years that we honestly believe Steris is positioned better today to meet the needs of our customers than ever before in history. That concludes our prepared remarks for the call, and Julie, please give the instructions so we can begin the Q&A.

Thank you, Mike and Dan, for your comments. Chad, if you would give the instructions, we'd be happy to get started.

Good morning. Thank you for answering the questions and congratulations on a fantastic year in fiscal 2022. I have two questions this morning. First, regarding your outlook for the upcoming year, an 11% constant currency growth is significantly higher than your historical performance. Could you highlight where you see strengths and areas needing improvement from an operational and divisional standpoint? This will help us understand the growth drivers and their impact on margins as the year progresses. I also have a quick follow-up. Thank you.

Yes. Thanks, Chris, this is Dan. Thank you for the question. In short, we're seeing a fairly robust recovery in procedure volumes on a quarter-to-quarter basis as we move back into more normalized volume in terms of pre-COVID levels. We're not there yet; we still have quite a way to go. And I think that the real governor on the recovery of those rates is going to be staffing and the challenges that are generally present in the healthcare industry today, particularly in the hospital segment. Having said that as those volumes return, that significantly benefits both our global healthcare business as well as the AST business. We've seen in the last couple of quarters recovery of more and more devices coming through AST in particular that are more highly elective, high-value types of devices. So orthospine and things like that. As those procedures begin to recover and then start working off what's been a couple year backlog of pent-up demand, we're seeing higher growth opportunities than we've seen in the past. In addition to that, we're coming into the year with an all-time record backlog from a Capital Equipment perspective. As we hope to flush that through over the course of the year, that will obviously be a bit of a tailwind for us in terms of our revenue growth.

Appreciate the color. And then just as my follow-up, and I appreciate all the detail here, but a number of puts and takes when you look down to the middle of the P&L, as we go into fiscal '23. Just curious, you're talking about a return to normalcy when I think about SG&A more broadly, higher R&D as well, just directionally; how much of this is a return to normal? How much of this is incremental investment that you're making for the sustainability of the growth of the business? Or was the business maybe under-invested in over the course of the last 18 to 24 months? Just trying to get a better feel for what structurally we should be thinking about longer-term just from an expense rate? Thank you.

Yeah. Chris, this is Mike. I would say that the majority of what we're going to experience, at least in the SG&A side, is more a return to normal. I would not say that we were under-invested by any means, and as Dan said in his prepared remarks, we've had our first sales meeting in three years. So, you can imagine the expense of that compared to the last two years that we didn't have that. So, those are the types of increases we're talking about. Where you're going to see a little bit of a step-wise change though, is in R&D. R&D we anticipate growing by double-digits in fiscal 2023, so we continue to make investments in R&D to bring new products across all of our businesses. So that is, if you look at the two, a step-wise change that we are continuing to invest for the long term. Not that we were under-invested by any means. We just think there's a lot more opportunity that we can bring forth, especially with the acquisition of Cantel.

I appreciate that, Mike. Thanks so much. And again, congratulations on a great year.

Thanks, Chris.

Thanks, Chris.

Thank you for taking my question. I'll begin with the first quarter in 2023. It seems like the organic comparison is going to be a bit tougher. I didn't hear any guidance on expected revenue. Can I assume that you're comfortable with the consensus forecasts? I would assume you're anticipating lower organic growth for the first quarter compared to the rest of the fiscal year.

This is Mike talking to you. We have not made any comments. But to give you a little bit more color to help you with your modeling, we would suggest that from a first-half or second-half, we're about 45% first-half, 55% second-half, which is typical of how we operate. And to your point, I think I would say you are correct. We do have a little bit of a tougher comparison in Q1, but we're not going to give quarterly guidance at this point in time, and nor have we in several years.

And just to clarify, that's earnings.

Yes. You're correct.

Okay. Got it. That's helpful. All right. And then you mentioned that there are some trends that in the industry they're looking towards Steris, I just wonder if you could just talk a little bit more about that. I'd assume one of them is the trend towards ASTs, where the ASTs have to get outfitted with cleaning and sterilization equipment and what not, but maybe just talk about some of those industry-wide trends.

Yes, this is Dan. There is substantial growth occurring in investment, particularly in Acute Care and ASCs across the U.S. We're also beginning to see a recovery in Europe. Our portfolio products, especially in SPD and from an OR perspective, have positioned us well in recent years to meet this need for growth. Additionally, we are experiencing a general procedural recovery, which benefits our consumables, services, and AST business whenever procedure rates increase. Lastly, there is considerable investment in Pharma related to aseptic manufacturing in biopharma and, to some extent, vaccines. We have a significant backlog in Life Sciences that will be addressed this year due to the expansions we've observed in the industry. As these investments come into play, they will create a tailwind for our Consumables Business as they begin to utilize our chemistries and packaging solutions.

And our growth as well.

Okay. Got it.

And obviously, within AST, that's driving biopharma and procedure recovery as a tailwind for our AST business.

I understand. Thank you. Regarding the free cash flow guidance, I'm having difficulty reaching the $1 billion of cash flow from operating activities in my model. I'm projecting higher than that, but the only way I could achieve that figure is by assuming your working capital has increased significantly. Is that a fair assumption? Perhaps you are increasing your inventory in anticipation of supply chain issues, which we've heard from other companies.

Mike, that's exactly right, and we have been doing that for probably the last 18 months to 2 years, where we've continued to carry higher levels of inventory. When we shipped the backlog, obviously the inventory and if supply chain does get a little bit easier, we will actually be able to bring that inventory level down as we go throughout the year. Our philosophy on inventory has gone from just-in-time to just-in-case. So, there's an awful lot of contingencies in supply chain continuity built into our inventory levels right now.

Okay, got it. Thank you.

You're welcome.

Hey, good morning. I thank you for taking the questions. I just want to start first with the Healthcare Capital Equipment, at least versus our model, it looks like it came in a little late in the fourth quarter. Did some of the backlog shift from the fourth quarter into FY 23?

Yeah, Matt, as we've been talking about the last couple of quarters, we have seen roughly $30 million that did not ship that would have been scheduled to ship on a normal course, if you will.

Okay. When considering the potential, if you compare the 11% organic growth for FY23 to a more sustainable level of organic growth, and exclude the Capital Equipment, I think the pricing might not contribute an additional 200 basis points going forward. How do you assess the sustainable level of organic growth in relation to the 11% for '23?

Yeah, I would say Matt, we are still in the mid-to-high single-digit revenue growth on our long-term aspirations. Obviously, we've done better than that over the last several years, but in general, we would still stay with that forecast or that thinking from a long-term perspective.

Okay. And then just Dan, just your longer-term thoughts on Hospital Capital spending as it progresses through the year? I think we've seen a couple of different opinions from some companies on where that's potentially moving.

Yeah, and we've seen those opinions as well. I think some of the differences is the Capital Equipment that Steris is selling is typically $20,000 to $100,000 pieces of equipment; these aren't million dollars, $2 million machines. The other point I would make is everything we sell basically is procedural rate-driven. It's almost like a utility at times for the hospitals; they have to have it in order for them to accommodate an increase in surgical procedures. Whether that's lights and tables or whether that's stuff in the SPD. So generally speaking, given the cost of our equipment and the utility of it in nature, we see continued strong investment. And how long it will last, I don't know. But we don't see it changing anytime in the near future.

Thank you very much.

Good morning. Thank you for taking the questions. One clarification on the response to Mike Matson's question, the 45, 55, Mike Tokich, was that a comment on revenue progression 1H, 2H, or EPS?

Mike, that was on EPS and welcome back Mike. Welcome back to covering us.

There was three Mikes in my first question to you; three Mikes were too many. And maybe on fiscal '23 to level set comments or frameworks like this have been made in the past. I don't think I'm struggling too much, but would you be willing to level set in your $5.1 billion give or take of imputed revenue for fiscal '23? How that splits out across the segments, just so we can work the model a little bit more precisely?

We have not done that Mike, and I think at this point in time, we will not. But I will tell you that for the most part, if you look at growth, Healthcare is going to be exceeding their normalized growth. I would say Life Sciences will be somewhere in maybe a little bit better than the normalized growth. AST will be at its normalized growth. And then obviously, Dental, we still don't have a true comparison at that point in time.

Okay. Dental, what's the early assessment of Dental? I would say this is the one piece of the acquisition that hasn't impressed yet. How do you feel about that business? What is the work-streams and initiatives for fiscal '23 as you continue to integrate and learn that market?

Yeah, it's Dan, Mike. So yeah, we're happy with the business. I would say it is more affected recently, particularly with the surge of Omicron that we saw in the January or February timeframe. Unlike Healthcare, where it had very little effect. Just the broad level of infections across the U.S. in particular ended up postponing or delaying a lot of procedures in the Dental space. If you want to fact-check that, call your dentist today and see if you can get in before July because there's a lot of pent-up demand in terms of lost time in the first couple of months this calendar year. So, we like the business; we think there's a ton of operating opportunities in terms of driving efficiencies, but other than that, it's on a steady track of recovery in terms of demand, barring what we saw in the first couple of months of the calendar year.

And Mike, just to add to that a little bit. We grew 4% since the acquisition, which is a little below to Dan's point because of some of the COVID impacts, which is a little bit below the mid-single-digits anticipation that we would have for that segment, to give you some further clarity.

4%, that's like a pro forma growth rate for the business? Okay.

Yeah.

And if I can do one more, the comments in R&D are interesting. Obviously, Steris is not overly reliant on any single product, and so I don't wish to overstate the importance of any single product category with this question. But I have noticed that you have recently launched, relatively recently, I think this year or late last year, the single-use Ureteroscope, and I saw as a topic that seems to come up from time-to-time. I'd just be curious about your efforts there. And if this launches an appetizer to some more products in that single-use scope category over time. Thank you so much for taking the questions.

Sure, Mike. So yes, we're in a limited market release right now in terms of the new scope. We've received a lot of positive feedback from key opinion leaders, and it's early, early days at this point. We'll see how that goes and how it progresses over time. What I would say is that Steris is uniquely positioned with our IMS business and vast understanding and engineering that we have around scope design from our repair perspective, and that collaboration with the commercial teams has put us in a nice position in the Urology space. As that product begins to go into a more realistic launch, we'll be able to provide some updates and information on it. At this point, it's just too early days for us to discuss it.

Thank you for addressing my questions, most of which are follow-ups. You've mentioned the recovery in volumes, particularly in Healthcare and AST, but could you elaborate on whether the main factors driving those volumes are recovery and demand as you've indicated, how much might be due to market share gains, and any other contributing factors?

In terms of procedure volume, we're currently at about 95% of pre-COVID levels in the U.S. market. Different regions show varying performance, with some hospitals operating at full capacity and others at around 90%. Over time, as staffing levels return to normal and can meet the full demand, I expect to see improvements beyond pre-COVID levels due to significant pent-up demand. However, there's currently a lag in bringing patients back into the system for diagnosis and necessary surgeries, which will take some time to recover. Regarding overall growth, I believe we’re gaining market share across most of our business at Steris. We have discussed this before and have made substantial investments in our Healthcare and Life Sciences portfolio and in capacity expansion for AST. As a result, we are outperforming the market in these areas.

Great, thanks. And follow-up, different topic around capital structure, you mentioned leverage, I think was 2.4 times, mentioned rising interest rates and a big recovery in the coming year in your free cash flow expectations. Maybe just talk about general capital deployment priorities and is getting that how much floating interest rate debt do you have, and is the rising interest rate environment encouraging you to pay off more of that more quickly?

Yes. I would say that in general, as we are anticipating about $675 million in free cash flow, our capital priorities have remained basically the same for the last decade or more. Off the top, we believe in increasing our dividends. We've done this for 16 years in a row. Next would be to continue to invest in ourselves and we're continuing to do that. We're anticipating about $335 million of CapEx, which is almost $50 million higher compared to the prior year. A lot of that CapEx is going to be directed into our AST segment as we continue to expand our facilities and our opportunities in that segment. Third would be looking towards M&A. We've done over 50 transactions in the last 10 years or so. Most of those are tuck-ins in nature, and I would imagine that most of those, in the future, as we continue down the M&A path, will be tuck-ins. Finally, from a share repurchase standpoint, just to offset dilution. We have that built into our plan for this year; we did do about $25 million of share repurchases in Q4. But we had a hiatus in share repurchases for the last 18 months or two years. From a prioritization standpoint, that is how we operate and how we have continued to operate over the last several years.

Thank you.

I think you've asked about that; about a quarter of our debt is floating-rate debt.

Okay. Thanks.

Thanks for taking the follow-up. Just two quick follow-ups for me, if I may. Could you speak to the margin profile in the Dental business? Just trying to get a better sense of we saw a sequential progression downward throughout fiscal '22. How much of that decline in the fourth quarter was volume-related? It does sound like that impacted you from response to a prior question. But just when we should maybe start to expect stabilization there or maybe a lift better. And then it's just a quick follow-up. Bit curious if you could discuss or provide any additional color on when you think about the AST build-out that continues to take place emphasis on different sterilization modalities, in particular x-ray here in the United States and abroad. Thank you so much.

Dan, I'll take the Dental one and I'll give you the AST one; if that's okay?

Yes, sounds good.

On the margin profile of Dental, you are correct that we have observed a decline in our EBIT margins in that area. In the first quarter, Dental was not affected as much as the rest of the business by materials and labor inflation, but that has changed significantly in the latter half of our fiscal year. This is a major negative factor impacting Dental. Additionally, patient volumes have certainly had a negative effect on that business. Overall, we expect Dental to perform above our corporate average as we continue to streamline operations and integrate more deeply into that sector over the long term. However, volume issues and inflation are definitely exerting a greater impact on that segment.

Understood.

We are currently undertaking a significant expansion of our network across various technologies. We are installing several e-beam plants and expanding EEO facilities, alongside numerous x-ray facilities at different stages of construction. The construction process has faced challenges over the past couple of years due to COVID and labor shortages, but the outlook has recently improved. Specifically, in the US, three new facilities are set to open in the next couple of years, with the first expected to be operational very late in this fiscal year, likely in Illinois, followed by either California or Chester, New York.

Thank you.

Thanks everybody for taking the time to join us this morning and look forward to catching up with many of you live in the coming days.