Steris Plc (STE) — Q1 2024 Earnings Call Transcript

Thank you, Chuck, 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 press 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 first quarter performance. For the quarter, constant currency organic revenue increased 11%, driven by volume as well as 290 basis points of price. Gross margin for the quarter decreased 30 basis points compared with the prior year to 44.8%. Favorable price was more than offset by continued material and labor inflation as well as lower productivity. EBIT margin decreased 50 basis points to 22.4% of revenue compared with the first quarter last year, which reflects a decline in gross margin as well as the anticipated increase in year-over-year incentive compensation, which is recorded in Corporate and Other. The adjusted effective tax rate in the quarter was 22.6%. Net income in the quarter was $198.2 million, and adjusted earnings were $2 per diluted share. Capital expenditures for the first quarter totaled $66.6 million, while depreciation and amortization totaled $137.9 million. Debt declined slightly in the first quarter and totaled just over $2.9 billion. Total debt to EBITDA was approximately 2.1x gross leverage. Free cash flow for the first quarter of 2024 was $214.5 million as we were able to collect on our strong fourth quarter revenue. Inventory remains elevated as we continue to focus on reducing lead times and meeting customer demand. With that, I will turn the call over to Dan for his remarks.

Thanks, Mike, and good morning, everyone. Thank you for making time to join us to hear more about our first quarter performance and our outlook for the rest of the fiscal year. As you heard from Mike, we had a strong start to our new fiscal year exceeding our plans and STERIS' expectations. Looking at our segments, Healthcare, constant currency organic revenue grew 18% in the quarter. We experienced double-digit growth across capital equipment, consumables, and service. This is driven primarily by procedure volumes in the U.S. continuing to rebound as well as price and market share gains. In addition, the improving supply chain environment, coupled with our ability to reduce lead times, led to a very strong quarter of capital equipment shipments. Hospital capital spending remains robust as evidenced by our healthcare backlog, which totals almost $500 million at the end of the quarter despite the strong shipments. Large projects continue to drive orders representing 40% of first quarter orders. We are increasingly confident in our expectations of a strong year for our Healthcare segment. Turning to AST. Constant currency organic revenue grew 5%. Our performance in the quarter was impacted by two temporary situations: inventory destocking in some categories of med tech and the year-over-year market decline of bioprocessing customer demand. As we said last quarter, FY '24 represents a bit of a reset, and we do not anticipate returning to year-over-year growth in bioprocessing in fiscal 2024. As for the med tech inventory destocking, we would not expect that to continue beyond the first half of the year, and we anticipate customer inventories at that time will align with the procedural growth we are all experiencing. As a result, our expectations are for stronger growth in the second half of the year for AST. Life Sciences revenue declined slightly in the quarter due to the timing of capital shipments which more than offset the growth in service and consumables. Underlying demand for the business remains strong as evidenced by our near-record backlog. Our full-year expectations for the Life Sciences segment continue to be mid-single-digit revenue growth despite the lumpy first quarter start. Our Dental segment’s first quarter revenue declined 4% on a constant currency organic basis as revenue was limited by customer destocking of inventory, in particular, for infection control products. However, we did see patient volumes improve for the first time post-COVID. We are confident that we will achieve low single-digit revenue growth for the fiscal year in Dental. All in, we are pleased with the start to the year. Trends continue to shift in a positive direction and our ability to execute and ship products has greatly improved. There are still pockets of uncertainty, whether that be supply chain, procedure volumes, or inventory management. As mentioned in our press release, we believe that the acquisition of the surgical instrumentation assets from Becton, Dickinson will close much earlier than we originally anticipated. As a result, we have updated our outlook for as-reported revenue, adjusted earnings per share, and free cash flow. We are feeling increasingly optimistic about our constant currency organic performance for the year, yet we are still holding our outlook to 6% to 7% growth. We acknowledge that this is a somewhat conservative approach given our start to the year. That concludes our prepared remarks. Julie, would you please give the instructions, and we can begin Q&A.

Thank you, Mike and Dan, for your comments. Chuck, can you please give the instructions for Q&A and we can get started.

And a really nice quarter to start the year. Dan, I first wanted to start on the capital equipment. As you kind of think about how you had contemplated the phasing of your guidance. Did you pull forward some capital into the first quarter with excess shipments? And also, how are you thinking about the order environment versus the shipments? I'm assuming it's not one for one, and you are thinking about bringing that backlog down in FY '24.

Yes, sure. Thanks. That's correct. What I would say is we overdelivered in terms of what we had anticipated from a manufacturing perspective in Q1. We've been bidding a bit on the supply chain issues over the past year. And so we're trying to do everything possible to manage to our customer demand, where they actually need the product now, and we did a better job on delivery. So that pulled forward some revenue that might otherwise have been in Q2. But generally speaking, our ability to produce and deliver is getting better and our lead times are coming down across all of our capital equipment portfolios. And in terms of the orders intake, yes, there is a point at which you will start to see declining backlog, obviously, as we get back to much more normalized delivery times, with the only caveat being there, some of the large project stuff, Matt, that's got longer lead.

Okay. And then I have two more on the market conditions. And I didn't catch it, but is the phasing 1H-2H still 45-55 from a revenue and EPS perspective? And then secondly, just can you comment a little bit more around the drag from destocking, especially in some categories of med tech? It seems a little bit counterintuitive when you think about the current environment.

Yes. We agree. First off, yes, the phasing remains as originally anticipated. In terms of the destocking that we're seeing in med tech, we really started to see it in Asia Pacific, particularly around some sterile PPE, and some of that was foreseeable given that the national stockpiles have been filled, and all that demand sort of went back to normal levels. What we're a little surprised with is that we're seeing a pullback on our customers' level of inventory. Now having said that, we shouldn't be surprised because they, like everybody else, have too much inventory right now. So as confidence comes back in terms of your ability to produce and your ability to get supplies and the supply chain solidifies, the natural thing one would expect is to whittle down some of that inventory down to levels that are matching demand. I don't think that process is going to take too long. I think it's been going on for a period of months now. And then I think what you'll see is the inventory demand aligning with the procedure rates, which are clearly higher. So, Matt, I agree with you that the two seem in opposite directions in terms of what we're seeing in Healthcare, in particular, our Healthcare Consumables business. And we know that our customers are seeing the same thing. I think they've just got to whittle down some inventory.

Looking at the healthcare numbers related to Capital One, I’d like to ask how you are reducing lead times. You mentioned gaining market share, so are there any new products or highlights that contributed to this performance?

Well, I mean, Dave, we're working off a monster backlog that spilled into this fiscal year, and we had some challenges producing. And as we got parts in, our teams were ready, and we were able to push stuff down the line pretty quickly. And we would expect that to continue in terms of our ability to deliver on that backlog. So I wouldn't highlight any single product or any small group of products in terms of new products or anything like that. It's just generally speaking, I think our portfolio is in a really good spot in terms of how it's positioned, not just on a competitive basis on a product by product, but also as a total portfolio in terms of what we can offer.

And so we think of the market share gains is sort of across the board or is there anything like more specific there that you were kind of calling out in any arena?

Not specifically. I would say we're in a really good position in sterile processing right now within our infection prevention technologies group. Additionally, I believe we are performing well in other areas of healthcare. Currently, IPT is handling a significant portion of the workload.

I just had a couple of questions on the Becton, Dickinson deal. Can you maybe talk about the growth that, that business has had in recent years? And then I know you gave us kind of the EBIT or EBIT margin, but what about the gross margin of that business? How does that compare to your kind of corporate gross margin?

Yes, I would say that on the gross margin side, the growth rates would be similar to what we currently have in our Healthcare segment, which has a long-term view of mid- to high single digits as we integrate our products. Therefore, I don't anticipate much change in margin perspective, both in gross margin and even a slight increase in EBIT margin. However, in the short term, we will face higher interest expenses. Based on some models I've reviewed, it seems that not everyone realized we would utilize our entire revolving credit facility for the $540 million, resulting in about $25 million in interest expense this year. Consequently, there might be a slower ramp due to this expense. Once we manage to reduce some of that expense, we can expect to return to what I would describe as normalized Healthcare margins.

Okay. That's helpful. And then I didn't hear you quantify the inflation impact. I know last fiscal year, you were kind of giving that every quarter. And then just related to that, you also called out lower productivity in terms of your gross margin. So I don't know if you can comment on either of those things or quantify them.

Yes. So we originally anticipated this fiscal year that we would have about $30 million, and we've been using the term excess material labor inflation. We incurred $10 million of that $30 million in the first quarter.

Okay. And the productivity, lower productivity that you called out, can you talk about that? Or...

Yes, we really haven't quantified that, but we are having the same issue that we've had in the past, right? So we are touching our products multiple times as we're waiting on the parts. So that productivity should improve throughout the year, which will help not only our gross margin but also get more of our EBIT margin back to flattish, which is where our original guidance was for FY '24.

This is Mac on for Jacob. Just a couple of quick questions for me. Despite a sequential revenue decline, Dental margins increased sequentially. What is the outlook for margins in this segment?

I'm sorry, what was the question?

Dental margin.

Yes. Long term, we said they should rise to near the corporate average. And you are seeing that they are getting much more operationally efficient, which is really helping drive that EBIT margin improvement. There's still a way to go, but we are more than happy with the progress that they are making within that segment.

Sorry if you can't hear me, just let me know, I'll repeat the question. But Healthcare operating margins they're the highest it's been in some time, and two solid quarters in a row. Are there any one-time bits? Or is this a good run rate going forward?

Volume is currently the primary factor driving our results. We have observed a continued increase in operating margins within our Healthcare segment. While we may not be ready to declare it as a new high yet, we are very satisfied with our current position. As we process more volume, particularly on the consumables side, if that trend continues throughout the year, there remains potential for further improvement in those margins.

Amazing. I'll keep it to two, and I'll just ask them both upfront here. I guess the first one, obviously, everyone is talking about the big capital equipment number. I'm just curious how the conversation with your customers has gone? I appreciate that some of this is working through the backlog and lead times on your end, but presumably, it seems like the customers are in a pretty healthy place if they're willing to be investing on the capital equipment side to that degree. And then I guess the second one is essentially related to that, which is, in some ways, the more important component of that capital equipment side is the follow-on consumables componentry for the rest of the year. Is it fair to take a look at that strong conversion from the backlog and think about the consumable pull-through and the growth on that side, whether it's for the rest of this year or going into next year?

Thank you, Patrick. This is Dan. What I would like to point out is that discussions with our customers have highlighted the financial strain the Healthcare system is experiencing, particularly in the U.S. Labor costs have increased by 20% in many areas, and they are already working with narrow profit margins, which makes cash flow a challenge. However, everyone agrees that procedure volumes are returning, recovering, and increasing, resulting in pent-up demand. STERIS equipment is regarded as essential rather than a luxury because they require the capacity to process instruments and surgeries through sterile processing. Fortunately, our order intake has remained strong. Overall, the outlook for continued demand is positive for the foreseeable future. As we place these units and utilize space in the sterile processing department, it is crucial that we ensure the availability of chemistries and consumables that accompany steam sterilizers, washers, or any other relevant equipment. The demand for these follow-on consumables has been consistently robust, and we have a dedicated team within the Healthcare organization focused on this area.

I must say first, I counted 8 minutes of prepared remarks, including the disclaimer. So kudos there, that might be an all-time conference call record. My first question may be a few parts to it is on AST. With the fresh call-out of med tech related destock, internally is your full year revenue expectation for ASP different than it was before?

No. I think what I would say is that it may be weighted more negative in the front half of the year than we anticipated, and we expect to recover some of that in the second half. I mean, Mike, if not for bioprocessing and the destocking that we're seeing right now, I can say confidently we'd be somewhere in the, I don't know, pick a number between 9% and 12% kind of range is what we would have expected. And I think that those two issues sort themselves out by year-end. And I think that the healthcare destocking probably sorts it out sooner than year-end.

So two follow-ups there on bioprocess and medtech. So on bioprocess, I think this is the third quarter you've called it out year-on-year. So it's definitely been in the run rate sequentially for at least two quarters. My question is June quarter versus March quarter, did it deteriorate incrementally? Or is it kind of consistent Q-over-Q in terms of overall order pattern from those customers?

It was flattish to the Q4. The reason why it sticks out a little more is the comp in Q1 and also in Q2 are the two highest, the two toughest comps for us.

Yes. And then on device customers, I heard the national stockpile call-out. I appreciate that. In kind of interventional medicine, let's say, the neuro and cardio and ortho. Any categories there that you see as kind of especially noteworthy in terms of reducing inventory levels? Or would you call it broad-based ex the PPE stockpiling?

I would say it's widespread. Additionally, some areas are still experiencing growth and increasing inventory, particularly in orthopedics, spine, and pain management. However, this does not constitute a significant portion of the overall volume processed at our facilities.

I wanted to start a little bit with the guidance rationale. You beat consensus by almost $0.15, really strong free cash flow quarter revenue, obviously, as we've all talked about, was really strong, but you elected not to make any updates to full year guidance. I know we're only one quarter into the fiscal year. It sounds like there's some maybe early year fiscal year conservatism, but can you talk about the pushes and pulls that went into the decision to update or, I guess, in this case, not update core guidance the way you did?

Yes. In summary, I believe we had an excellent performance in our Healthcare business this quarter, and we feel very positive about its prospects for the year. Regarding Life Sciences and AST, we have some timing issues to resolve with certain events. We feel confident we understand the market dynamics, and while we have strong data suggesting how things will unfold, there are no guarantees or perfect predictions. Thus, we are adopting a cautious approach. If everything continues to progress well, we will revisit this discussion in the future.

Okay. All right. Makes sense. And then I wanted to come back to the Dental business as well here. The core growth has been flat to down for, I think, four consecutive quarters now. So the commentary obviously getting easier here going forward. But maybe looking backwards first, are there actions you're taking or you have taken in exiting unprofitable areas or shutting down certain SKUs? And I really asked just because the performance we've seen so far does seem like it's running a little bit below market. So I'm trying to figure out if there's maybe some self-inflicted pain here that has a positive ROI? Or if you see any other factors that's contributing to the weakness for that segment, again, relative to maybe the market or your peers? And then just as a follow-up here on a two-parter. What contributes to the optimism of getting that business back to low single-digit growth given where it's been trending here?

Yes, a couple of things. I would say I think that we have a little more exposure than some of our peers per se because of the amount of PPE and infection control that is almost half of the business, the STERIS Dental business. And that type of stuff got way overbought and overstocked and it needed to get burned down. And also the comparisons of how much was being used a few years ago versus now, it's a different time and a different world as it relates to that type of stuff. What I would say is on the instrument side, the Hu-Friedy brand stuff is doing really well in terms of growth, and we would expect that to continue. We would expect to see innovation from a product perspective and also cost management from a manufacturing and delivery perspective. And the team in the Dental Group has done a really nice job managing the OpEx until we see the market recover as well and making sure that we're not overspending.

I just wanted to talk about longer-term GI procedures. One of the larger hospital systems was saying that they're realizing pent-up demand, seeing a lot of strong growth for GI and endoscopy. And one of the factors they're starting to see is like a change in guidelines, reducing the age for, I think, colon cancer screening down to 45 and 50 and that's starting to play through. I was just hoping you could talk a little bit about your endoscopy business, some of the Cantel doctors and kind of how you're looking at that over the next year or two?

Yes. What I would say is that the drivers in terms of the 45 age recommendation has helped. I mean it does open up for a lot more screening. The sort of the governor on that for the past, I don't know, up until about a quarter ago or six months ago was really Healthcare staffing and the ability to get colonoscopy scheduled. I know that I personally tried to schedule one in December, and they told me as soon as I could get in was the end of February. So I think a lot of that has been sorted. So it does have an impact, and that is reflected, in particular, in both our capital equipment with all the AERs that we sell, but it also is a major contributor to why we had strong delivery in Healthcare consumables in the first quarter.

And then a follow-up on the Corporate and Other, I believe you mentioned that it was an incentive comp and kind of a reset incentive comp that drive that. Is that type of year-over-year increase from a dollar perspective, something we should be modeling in over the next several quarters as well?

Yes, Matt, if you recall, we called out last quarter that we will have a $40 million hole, if you will, that we have to fill from an incentive comp expense year-over-year. So that is a big driver of that increase in corporate expense. A couple of the other drivers in there. We also opened a new distribution center in Indianapolis, Indiana. So that is also an additive cost. And then one of the other things that we're seeing is our usage of our employee health care benefits is on the rise. So we're also incurring slightly more expense there. So those are the three main components that we saw in the first quarter. But for sure, that $40 million we called out last quarter.

Thank you, everybody, for taking the time to join us this morning, and we look forward to seeing many of you out on the road this fall.