Steris Plc (STE) — Q3 2023 Earnings Call Transcript

Thank you, Jamie, and good morning, everyone. As usual, speaking on our call today 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, 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. 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. In addition, on today's call, non-GAAP financial measures, including adjusted earnings per diluted share, adjusted operating income, constant currency organic revenue growth, and free cash flow will be used. Additional information regarding these measures, including definitions, is available in our release, as well as 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 third quarter performance. For the quarter, constant currency organic revenue increased 7%, driven by volume as well as 300 basis points of price. As anticipated, the divestiture of the Renal Care business impacted our revenue comparisons to the prior year by about $47 million, which is detailed in the press release tables. This is the last quarter of a year-over-year impact for the Renal Care business as we divested it in January of last year. The integration of Cantel Medical continues to go well. We achieved approximately $10 million of cost synergies in the third quarter, bringing our year-to-date total to about $45 million. We are well on track to achieve our stated goal of approximately $50 million in fiscal year 2023. As anticipated, gross margin for the quarter decreased 200 basis points, compared with the prior year, to 43.1%, as pricing, currency, and the favorable impact from the divestiture of Renal Care were more than offset by lower productivity, unfavorable mix, and higher material labor costs. Sequentially, the impact of material labor costs has improved and totaled about $15 million in the quarter, compared to the prior year. This puts us at about $75 million year-to-date, with our outlook of $90 million for the year remaining unchanged. EBIT margin declined 10 basis points to 23.9% of revenue, compared with the third quarter last year, which reflects the gross margin pressures mentioned earlier, which were partially offset by lower SG&A expenses. The adjusted effective tax rate in the quarter was 23.4% higher than the prior year, due primarily to geographic mix and favorable discrete items that occurred in last year's third quarter. Net income in the quarter was $202.4 million, and earnings were $2.02 per diluted share, reflecting the lower anticipated value. Capital expenditures for the first nine months totaled $290.5 million, while depreciation and amortization totaled $410.7 million. Year-to-date, our capital expenditure spending has been higher than anticipated, primarily due to the timing of our investments within the AST segment. We still expect our full year capital expenditures to be approximately $330 million. Total debt increased slightly in the third quarter to just over $3 billion, reflecting borrowings to fund a few small acquisitions and share repurchases. Total debt to EBITDA is slightly over 2.3 times gross leverage. Free cash flow in the first nine months of the year was $263 million. Free cash flow was limited by higher-than-planned capital spending, mainly due to timing, and higher levels of inventory. With continued pressure on working capital, particularly inventory and accounts receivables, we now anticipate the free cash flow for the full year will be about $500 million or a reduction of about $100 million, based on our last guidance. 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 participate in our third quarter call. I will cover a few highlights from the quarter and then address our revised outlook for the fiscal year. Starting with Healthcare, the segment grew 10% on a constant currency organic basis in the quarter. This was driven by high-teens growth in capital equipment. In particular, improved shipments in our IPT business were driven by operational and supply chain improvements in core washing and steam products. In addition, we saw double-digit revenue growth in our surgical products. Our main supply chain issue continues to be with electronic components. We are working hard to resolve these issues. As we have discussed, we are working with existing and new suppliers where possible to ensure the availability of parts in order to meet customer demand. The Healthcare services business delivered double-digit constant currency organic revenue growth, driven by increased demand and improved pricing. We also saw sequential improvement in consumables. Consumables constant currency organic revenue grew low-single digits compared with the third quarter of last year. Supporting that growth, U.S. procedure volumes improved in the quarter, with recovery outside of the U.S. still lagging. The underlying dynamics of our Healthcare segment remain very favorable. Hospital capital spending remains stable, as evidenced by our Healthcare backlog, which totaled over $500 million at the end of the quarter. Orders for the quarter remained at approximately a 60-40 split for replacement and large projects, and we are not seeing any order cancellations at this time. Although we still have some delays, our capital shipments have improved dramatically from prior quarters. Approximately $30 million in capital equipment shipments were delayed into the fourth quarter. Overall, our third quarter Healthcare performance showed nice improvement. Opportunities remain from a supply chain perspective, which we anticipate will take some time to fully work through. Our expectations for the fourth quarter reflect a conservative outlook on how quickly we can recover from these challenges and difficult comparisons in AST and Life Sciences. Our AST segment grew 7% on a constant currency organic basis despite a reduction in demand for bioprocessing disposables and delayed shipments from Mevex, our capital equipment business. On the bioprocessing side, our second quarter this year was a peak level for biopharma within AST. We are hearing from customers that they are resetting their expectations due to a reduction in vaccine production. Importantly, we are not seeing declines in total revenue at this time, but rather a flattening of growth. Positively, we anticipate that our core medical device customers will benefit from improvement in procedures, which we expect will help AST continue to perform at historic levels. Regarding Mevex, a large E-Beam capital equipment order of approximately $10 million was delayed into Q4 as our customer was not ready to receive the unit. Turning to Life Sciences, constant currency organic revenue was down about 1% for the quarter, with declines in capital equipment and consumables, somewhat offset by growth in service. The same factors impacting the bioprocessing demand in AST are also impacting our Life Sciences consumables volume. In addition, we have difficult comparisons with strong consumables growth in the third quarter of last year. That said, we do anticipate that this is a matter of timing as cell and gene therapies continue to increase in demand, which should help offset the reduction in vaccine production. We remain confident in the long-term growth drivers within the customer base for both AST and the Life Sciences segments. In addition, Life Sciences had an unanticipated shipping challenge out of Europe that limited capital equipment growth in the quarter by about $10 million. Positively, backlog remains at near historic levels at over $100 million. Dental increased 1% on a constant currency organic revenue basis in the quarter. Procedure volumes remain at approximately 95% of pre-COVID levels due to the broader economic pressures impacting consumer spending. Based on market data, STERIS is performing better than the market and benefiting from pricing and modest share gains. As you heard from Mike, gross margins remained under pressure as anticipated. Despite the impact of lower gross margins and increased pressure from foreign currency, we held EBIT margins about flat in the quarter, as SG&A was lower than planned, largely driven by lower incentive compensation. With added pressure on interest rates and taxes, our adjusted earnings per diluted share for the quarter came in at $2.02. As a result of our performance to date and our expectations for the fourth quarter, we are revising our full year guidance. As reported revenue is now anticipated to grow 6%, compared with prior expectations of 8% growth. Based on foreign currency forward rates through March 31, 2023, currency is now anticipated to negatively impact revenue by approximately $110 million this fiscal year, a decline from expectations of approximately $150 million. Constant currency organic revenue is now anticipated to grow approximately 7%, compared with prior expectations of 10%. With one quarter left, this revision in outlook implies the challenges, which limit our performance in the third quarter, do continue. Reflecting on the lower revenue, adjusted earnings per diluted share are now anticipated to be in the range of $8.00 to $8.10. Our long-term expectations for the business remain unchanged. We continue to be very confident and believe that STERIS is capable of generating mid-to-high single-digit constant currency organic revenue growth and double-digit earnings growth into the future. With that, I will turn the call back over to Julie to open up for Q&A.

Thanks, Dan and Mike, for your comments. Jamie, if you'll give the instructions, we can open up for Q&A.

Great. Thanks. Hi, I wanted to confirm something, Dan. You mentioned $30 million in delayed capital shipments in Healthcare, $10 million from AST, and $10 million from Life Sciences. Adding those up gives us $50 million, which seems to align with what you were short of the Street. Are we understanding that correctly?

Yes, sure, Dave. That's correct.

Dave, I would also add in there. The reduction in bioprocessing was another $10 million roughly, and that was split about evenly between AST and Life Sciences, just so that we're all on the same page.

No, I appreciate that. And I have a question for Dan as well. The good news is this is not a frequent situation for your team. However, if we analyze this, it was mentioned that there was growth in bioprocessing customers, but you clarified that the vaccine was the primary factor. What is the lead time in this regard? How does it potentially arise unexpectedly, as we were not aware of this last quarter, and now we are?

Yes. Let me provide some context. Our customers, particularly in AST where we experienced the most significant impact, are mainly manufacturers of single-use sterile technologies used in aseptic manufacturing for vaccines and biopharmaceuticals. Over the last couple of years, we've seen high double-digit year-over-year growth in that sector within AST. It has been a key growth area for us, contributing between 1.5% and 2.5% growth on top of our normal increases in AST, peaking in Q2 at the end of summer and early fall, which aligns with the high production season for vaccines. Our customers built up considerable inventory, and due to either vaccine hesitancy or general production slowdowns, they were left with excess inventory. As a result, our volumes in Q3 significantly decreased. We began noticing this at the start of Q3, and unfortunately, there was little we could do to adjust during that time. We believe this issue will resolve itself as the inventories are used up, and the fundamental growth drivers for single-use technologies in bioprocessing remain intact. We will be addressing the tough comparisons stemming from the anticipated spike in vaccine production.

Thank you.

Hi, good morning, Dan, Mike, Julie. I want to take a step back, Dan. Can you provide your perspective on what you expect the normalized growth profile for STERIS to be over the next several years? I assume you don't believe it's a 10% or 11% grower, and what you're projecting for this year likely aligns with your longer-term view of the business.

Yes. I mean, our stated objective is to grow high-single digits on the topline and low-double digits on the bottom line. And we believe with a high degree of confidence that's something we can continue to do even in the current market conditions over the long haul.

And then as you think about going out to next year versus that high-single digits, what looks, I guess, better or worse as you think about next year?

Matt, we need to get through the fourth quarter right now, so we're not providing guidance for the next fiscal year. I want to say that while this is preliminary, it's encouraging to hear that some of our peers in the medtech industry are optimistic about a recovery in procedures during the second half of the calendar year. We think there has been a recovery back to pre-COVID levels in healthcare, particularly in the U.S., starting in the third quarter, although it still lags significantly outside the U.S. If this trend holds and improves in the second half of the year, it would be beneficial for us since we are primarily a procedure-driven company.

And Matt, I would just also add that our backlog in Healthcare remains at record levels and within Life Sciences, it is near record levels. We are overcoming some of the supply chain constraints and have shipped more sequentially. The $30 million of capital deferral in Healthcare was $60 million last quarter, indicating progress. This gives us greater confidence as we look ahead to next year.

Okay. And I guess, just the last one, just on the order environment. I mean, your backlog did go up sequentially. It typically does on a seasonal basis. But as you're shipping out more from supply chain improving, how should we think about the order environment and your ability to replenish those?

It has remained very strong at this point, which contrasts with what you might read about the financial performance of many hospital systems these days. However, they appear to be willing to invest significantly in future capacity needs. For procedures, it is important to remember that much of what we offer in terms of capital to hospital systems functions as infrastructure. To operate at a higher volume, they need more sterilizers, washers, OR tables, and lights. Therefore, our equipment is not a luxury; it serves as a utility in many ways.

I'll jump back in the queue. Thanks, guys.

Hi, thanks. Good morning. I have a couple of questions regarding the bioprocessing market. First, Mike, if I understood you correctly, you mentioned a $10 million headwind in the third quarter. Is that an accurate way to approach the fourth quarter? Additionally, as I've been listening to what your customers are discussing, they are experiencing some immediate challenges due to COVID and inventory issues, but they seem optimistic about the latter half of this calendar year when things are expected to return to normal. Is that a reasonable way to interpret the situation for your company, or is there a delay between what they are observing and the demand that ultimately reaches you?

I think what you're going to see as it relates to bioprocessing is you're going to see pretty tough comps leading up to Q2 of this past year, the year that we're currently in. So, I think as we burn those down and get back to what is the normalized growth rate for bioprocessing, which is still in the mid-to-higher double digits, but it's going to take some time to burn through the inventory and to burn through what was a spike in vaccine production demands.

Okay. Thanks for that, Dan. And then my follow-up, which you may have answered, but I'll check is, just on the AST side of things, did the slowdown due to COVID impact any of your kind of capital allocation plans, especially as I think about X-ray capacity?

No, we're looking at our capital spending and adjusting when we will build and expand our infrastructure. The market and the difficulties with supply chains and construction have allowed us to postpone some capital expenditures, as it has been a tough time to undertake construction projects. However, our plans remain mostly unchanged, with possibly different priorities for what comes online first. Otherwise, the projects are still active, and we are very confident about them.

Got it. I'll leave it there. Thanks.

Good morning. Thank you for taking my questions. I would like to inquire about the backlog in Healthcare. While I understand you are not ready to provide guidance for 2024, it seems that you anticipated above-normal growth this year due to the backlog, which hasn’t materialized primarily because of the supply chain issues. Is there still a possibility that as you address the backlog, you could achieve above-normal growth in the Healthcare business at some point?

At some point, we expect to see sequential improvement in our capital shipments as we progress through the current quarter. Looking ahead to next fiscal year, we believe things are improving, which suggests that we may deliver a significant portion of the capital in our backlog during the first half of the year. However, we have not yet modeled this or completed our planning.

No, I understand. As for pricing, it's encouraging to see the 300 basis points. I'm curious about the sustainability of those higher price increases. Given your contracting and everything in place, do you think this trend can continue for a while, or is it more likely to be a temporary bump that returns to normal levels?

I think that largely is determined by what happens or continues to happen with inflationary pressures. To the extent that we need to push through pricing and it makes sense to do so in order to protect our margins and still remain competitive in the marketplace, that's something that we'll do and we have always done consistently at STERIS.

Okay, understood. My final question is about the AST business. Considering what has occurred with your main competitor and the ongoing EO litigation, I wanted to know if you have observed any shift away from them or any effects on your business as a result of their situation.

No, I wouldn't say so. I mean, the current situation in the industry is the capacity is pretty tight, especially as it relates to ethylene oxide here in the U.S. So, we have strong partners across medtech, and we're always striving to take a little more share of wallet wherever we can do that.

Okay, got it. Thank you.

Hi, good morning. Thanks for taking our questions. First one, I'll follow up on Matt Mishan's question earlier, but maybe take a different stab at this. I wanted to come back to some questions around guidance. A lot of things that are understandably outside your control, we've seen that here this year. But guidance is in your control, and this is the second time in three quarters where we've seen guidance lowered. So, since we're sitting just a few months away from fiscal '24 guidance, I guess, what learnings can you say that you've taken from this year that can help inform how you set your outlook for fiscal '24? And then I know a few others have asked, but I guess, just any early puts and takes we should be considering as we work through our models for next year, particularly on the equipment side?

Yes, Jason, I'll make one comment, and then I'll let Mike add a few remarks as well. We entered the year with a substantial backlog, and we believed we had managed COVID effectively in terms of supply chain. However, we faced significant challenges in Q1 that revealed vulnerabilities in our supply chains across our manufacturing network. I can say we are much more resilient now, with better oversight and a more strategic focus on managing those supply chains. I believe this resilience will continue into next year. However, just because we start the year with a large backlog, we need to be cautiously optimistic and have realistic expectations regarding how quickly that backlog will change.

Yes. I think surgical procedure volume was the other thing that we anticipated was going to be much higher this year. And obviously, everybody knows how that is playing out, although from a favorability standpoint, we have seen some improvement in Q3 in the U.S. in particular. But again, there are just so many moving pieces here. And to Dan's point, I think conservatism at the end of the day is the norm for us, and we have put out a outlook for the fourth quarter that we believe is conservative in nature, based upon the facts that we continue to work with throughout the year.

All right. Very helpful, and that's good to hear. Okay. Then maybe one on free cash flow. I mean, we saw the pretty sizable reduction. I know we're talking, I think, some round numbers here, $500 million versus $600 million. But that is a much bigger drop than what's implied just from the EPS cut. I think, Mike, you mentioned some comments there around inventory running higher, receivable collections running lower. Maybe could you bucket those two? And does that reverse as we start thinking towards free cash flow then for next year, does working capital work lower?

Yes. I would say that if we go back to the beginning of the year, we anticipated about $675 million in free cash flow. And obviously, we're down to $500 million. And I would bucket though, that inventory and receivables two-thirds, one-third. Inventory is remaining elevated. Obviously, as we have not been able to ship at the rates we anticipated, we are carrying more inventory, as we've talked many times in the last couple of quarters. We continue to fill our manufacturing slots. So we're building, building, building, waiting for that golden screw. But that golden screw doesn't come, that product remains in inventory until we ship it. So, inventory has continued to be elevated. And then on the receivables side, it's not our inability to collect. It's just the timing of collections. We have about just under a 60-day DSO that we have collection. So, originally, we anticipated shipping earlier or more product in the third quarter. That has shifted to the fourth quarter, which pushes collections into the first quarter. So, free cash flow isn't lost. It's just more of a timing issue.

Okay. All right. Makes sense. I'll hop back in queue. Thanks so much.

Hi, good morning. Thank you. I want to follow up on bioprocess and AST and try to put together some math that you mentioned earlier in the Q&A. At one point, not long ago, it was contributing 1.5 to 2 points of growth to the segment. I also heard that it's been growing at a high double-digit rate, which I would interpret as 15% to 20%. So, if I combine those two pieces of information, bioprocess makes up about 10% of the total and AST. Is that a reasonable estimate?

Yes, ballpark. Maybe slightly less, but you're in the range.

The follow-up relates to AST and the recent $10 million slippage from Mevex. This acquisition has shown variability from quarter to quarter. Last year, Mevex contributed $10 million in revenue for the same quarter. Now, with this $10 million slippage reported, it appears that Mevex’s contribution was close to zero during this quarter. What I would like to understand is the year-on-year revenue headwind from this equipment line in AST.

Yes. Your math is about right. And in total, we're somewhere between $25 million and $30 million for the full year for Mevex. But yes, you're exactly right, Mike. It was near zero. So, that full $10 million is flipped from one quarter, third quarter to the fourth quarter. And again, it's the timing. It is lumpy, unfortunately. I know that AST has in the past been much more predictable for us, but Mevex has hurt us twice now with shipping issues. But if you add the Mevex shipping issues, you take the biopharma processing, you're back to somewhere in the low-teens growth for AST. So, the trajectory hasn't changed dramatically, but it's the timing that is the concern, I think, from everybody's standpoint.

Yes. Just to add to that, Mike, those systems for Mevex can be anywhere from $5 million or $6 million to $12 million, and they're large build systems with lots of conveyance and complicated electronics and control systems. And we rely on our customers to have the infrastructure in place before we can come install. And sometimes there's a change in scope, and sometimes there's just delays in construction. So, it's as much as we try to stay on top of it and help project manage. Ultimately, it's in the hands of our customer as to when we can deliver.

I have a couple of questions. I would like to get back in line and ask a few more, but I may just wait and return. Thank you.

You're welcome.

Michael, could you provide your thoughts on the consumables and the low-single digit growth we’ve observed? It seems to have been flat or even declining in some previous quarters. What is your perspective on the hospital inventory of your consumables? Is the issue purely related to volume, or is there also some destocking occurring?

I think it's purely procedural volume-driven. They don't hold a lot of this, because it's heavy, it's bulky. It takes up a lot of space. So, it's not something that would carry a lot of excess inventory of.

And is it across the board from core STERIS, Cantel, Key Surgical, or is there a little bit of mixed change in pieces of the business that may be lagging versus others?

You can get into a really complex stratification of this. But in the end, it's not really any one particular piece that's driving it one way or another. So, I wouldn't say it's a mix issue. It's truly procedure-driven demand.

Matt, you guys know we are heavy U.S., right, compared to a lot of other healthcare companies. We're 80% U.S. in what we do. So, the trends here have the biggest impact on our performance.

And then back to AST, does this open some capacity for AST with some slower growth in bioprocessing? I think you could fill that fairly quickly because there's a shortage throughout the industry.

Yes. Well, keep in mind, all single-use technologies for bioprocessing only run in radiation, so not ethylene oxide, where there's real significant shortage. And really, the phenomena is, if we're running with a lot of product backlog, especially as we come up to the holiday seasons, in a typical year in AST, we would starve out our plants. So, we'd shut down a day or two, and you either do it the Christmas week or you end up starving out, because it takes customers a longer time to start up production, because they've shut down factories before you see their supply chain start to flow in early January. In the case of the last couple of years, we've been sitting on so much backlog demand in bioprocessing that we ran at a number of our plants straight through the holidays, 24/7, 365. So, not doing that in this year's case; it's basically straight drop-through because of the high fixed cost model at AST.

Okay. And then, Mike, if I'm looking at the balance sheet right, it seems that the debt has increased. You've generated cash flow throughout the year, even with the working capital build. Why has the debt balance gone up? And why not reduce some of that to lower interest expenses?

Yes, the debt balance increased mainly for two reasons. First, we made some minor acquisitions, paying cash for them during the quarter. Second, we continued to offset dilution from our share repurchases and took advantage of opportunities for share buybacks due to the situation with the EO. In total, we spent approximately $88 million on share repurchases and another $50 million to $75 million on acquisitions during the quarter. These were the two key factors that altered our debt profile. Our leverage ratio remains comfortable, just over 2.3 times. We also paid off a $91 million private placement note that was due during the quarter. This resulted in a slight increase in our interest rate since it was fixed rather than floating. Currently, our average interest rate is just under 4%.

And then how much is left on your authorization for share repurchase?

About $160 million remains under the current authorization.

Okay. Thank you very much.

You're welcome, Matt.

Thanks, everybody, for taking the time to join us this morning. If anyone would still like to chat, please let me know, and I'll be happy to do my best to accommodate you. Take care.