Steris Plc (STE) — Q2 2024 Earnings Call Transcript

Thank you, Jamie, 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. And 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 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 second quarter performance. For the quarter, constant currency organic revenue increased 8% driven by volume as well as 330 basis points of price. Gross margin for the quarter decreased 50 basis points compared with the prior year to 44.3%. The favorable price was more than offset by lower productivity and continued material and labor inflation. EBIT margin decreased 130 basis points to 22.5% of revenue, compared with the second quarter last year, which reflects the decline in gross margin as well as the anticipated increase in year-over-year incentive compensation expense. The adjusted effective tax rate in the quarter was 23.7%. Net income in the quarter was $202.2 million and adjusted earnings were $2.03 per diluted share. Capital expenditures for the first half of fiscal 2024 totaled $149.9 million, while depreciation and amortization totaled $290.2 million. We are adjusting our capital spending outlook for fiscal 2024, down from $375 million to $310 million. This change reflects the timing of projects for our AST business. This change will allow us to offset higher-than-planned inventory levels, keeping free cash flow outlook for fiscal 2024 at approximately $685 million. Debt increased to $3.4 billion in the second quarter, reflecting borrowings to fund the acquisition of the BD assets. Total debt-to-EBITDA at quarter end was approximately 2.3x gross leverage. Free cash flow for the first half of fiscal 2024 was $284.7 million as we benefited from lower capital spending and a decline in cash used for tax and compensation-related payments. Inventory remains elevated as we continue to focus on reducing lead times and meeting customer demand. With that, I'll turn the call over to Dan for his remarks.

Thanks, Mike, and good morning, everyone. Thank you for making the time to join us to hear more about our second quarter performance and our outlook for the rest of the fiscal year. As you heard from Mike, our second quarter continued the momentum we have experienced in our Healthcare segment for the past few quarters. Overall, we are very pleased with our performance in the Healthcare segment and it is anticipated to outperform our original expectations for the fiscal year, offsetting the macro challenges impacting demand in our other segments. Looking at our segments, Healthcare constant currency organic revenue grew 14% in the quarter. We experienced double-digit growth across capital equipment, consumables, and service again this quarter. This is driven primarily by procedure volume rebound in the U.S. as well as price and market share gains. As anticipated, our backlog has reduced as we were able to ship at a faster pace than new orders are coming in as we get back to normal lead times for our customers. During the first half, we saw strength in replacement orders, representing 65% of our total orders in Healthcare. We are increasingly confident in our expectations of a strong year for our Healthcare segment. Growth will, however, decelerate in the second half as we face very challenging comparisons in the fourth quarter. Turning to AST, constant currency organic revenue declined 1%. While our services business grew 5%, our capital equipment business declined due to the timing of large shipments. In addition, our performance in the quarter continued to be impacted by two short-term situations; inventory destocking in the Medtech space and the year-over-year market decline of the bioprocessing customer demand. We do see very positive signs of recovery in the Medtech demand. We saw good growth in the U.S. during the quarter, reflecting the improving procedure environment and the burn down of customer inventory. We continue to see weakness, however, in the European markets where procedure recovery is taking a bit longer to take hold. From a bioprocessing perspective, as we have said, 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 we head into the second half, our comps ease as it was the third quarter of fiscal 2023 when we first witnessed declines in bioprocessing. Based on these factors, our outlook continues to reflect very strong growth in the second half of the fiscal year for our AST segment as compared to the first half. Life Sciences revenue grew 5% in the quarter on a constant currency organic basis as the delayed capital shipments from the first quarter were recognized contributing to 18% growth in capital equipment. Consumables grew 4% and service was flat. As you are hearing from many others in the space, the short-term demand remains a bit murky. We continue, however, to be very optimistic about the long-term trends driving demand for aseptic manufacturing in biopharma. Our Dental segment, second quarter revenue declined 6% on a constant currency organic basis as revenue was limited by customer destocking of inventory, in particular, for infection control products. Despite these challenges, we are impressed with the ability of the business to sequentially improve margins, delivering EBIT margins above total company in the quarter. All in, we are pleased with the first half of the fiscal year. U.S. procedure trends continue to shift in a positive direction, supply chain challenges have largely abated and our ability to execute and ship capital products to our delivery times has greatly improved. That said, there are still pockets of uncertainty, which remain outside of our Healthcare segment. We are maintaining our expectations of 6% to 7% constant currency organic revenue growth for fiscal 2024 as we expect a strong third quarter followed by very tough fourth quarter comparisons, which will limit our total growth in the second half. In addition, from an earnings perspective, we now have an additional headwind from currency of about $0.05, which we are absorbing in our current outlook of $8.60 to $8.80. That concludes our prepared remarks for the call. Julie, would you please give the instructions, and we can start the Q&A.

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

Hey, good morning. Thanks for taking my questions. Maybe Dan or Mike following up on kind of the last comments and the 2024 outlook. It seems like some of the year is playing out as expected, and I appreciate the comps, but it also seems like Healthcare is going better than expected. Can you just talk about the other three segments and where things have changed the most? I think reading the material, Dan, maybe it seems like Life Sciences is the biggest delta since the beginning of the year, but just curious kind of how those other three segments are playing out this year versus original expectations?

Yes, we still expect to have a strong year in Life Sciences, though there is ongoing destocking in the sector. This trend is evident across all companies that provide tools or disposables to the biopharma and pharma industries. Recently, Pfizer announced a $3.5 billion cut, and other pharmaceutical companies are following their lead. When we see these actions, it typically leads to a short-term contraction in the industry. However, the long-term outlook for biopharma and aseptic manufacturing, which is our key area, remains very positive. We have an excellent portfolio and anticipate good results. Regarding the AST business, we've observed a positive trend in the U.S., with procedures surpassing the previous excess inventory from the last quarter. Our Medtech customers are showing strong growth. In Europe, recovery has been slower due to numerous strikes and labor shortages that have hindered healthcare delivery compared to the U.S. However, this will eventually improve, and even if it takes longer, they will need to deplete the existing inventories they have. We initially expected this to occur in the fall, and while it may extend into winter, it should only take weeks or a few months, not quarters. As for bioprocessing, we reached our peak in Q2 of last year, then saw a slowdown in Q3, which bottomed out around the beginning of our fiscal year. Therefore, the comparisons will become easier in the second half of the year, especially into Q4 and the next fiscal year.

Got it. Thanks for all that. Just I guess, my follow-up. Just on backlog, both Healthcare and Life Sciences down sequentially. Is it fair to say healthcare is more about kind of execution and you catching up on lead times and maybe Life Sciences a little bit at the macro or anything else you'd share on that?

Yes, no, I would say both are just getting products out the door. We had a lot of stuff that was supposed to move out in the prior quarter in Life Sciences, in particular, that slipped till the end of the quarter and didn't get recognized until this quarter. So that's just purely a timing issue, and orders remain pretty strong. And we've just been able to get a lot more stuff out of our factories as we bring our lead times down pretty significantly. So we just had a great delivery quarter for capital and general cross-post businesses.

Got it. Thanks for taking my questions.

Sure, thanks.

Hey, good morning. I just wanted to ask one follow-up on the AST side. It seems like we have some companies that are saying demand is super high. They're actually like experiencing bottlenecks to get devices sterilized, and you mentioned the timing of projects for AST. I'm just curious, is there a shift going on between some of the modalities there? Or what exactly the Medtech customer inventory that you're highlighting are you seeing?

We have observed a significant rebound in demand within the U.S. market over the past quarter, returning to what I would describe as more typical growth rates compared to the previous two or three quarters. The recovery outside of the U.S. has taken a little longer. Our facilities in North America are operating at full capacity, while those outside the U.S. are not as busy. However, we anticipate this situation will improve in the next quarter.

And Dave, the shortages, I think, have been more tied to EO sterilization.

Yes.

That makes sense. I have a follow-up for Julie or the team that managed the pilot program. I'm curious about your thoughts on its implications. I believe you mentioned that STERIS is first, but I'm unsure how to interpret that or what it will mean for you moving forward.

Yes, it really provides our customers with the opportunity to significantly enhance and create more resilient supply chains. Specifically, it enables them to transition between different sterilization methods, such as EO to X-ray or gamma to X-ray, or even e-beam to gamma, and switch within our network of facilities or technologies without needing to undergo a substantial refile from a regulatory standpoint. Products that fall under 510(k) would not need a refile; they would participate in our master file program. During their subsequent routine audits by the agency, they would review their records to ensure everything is in order. This approach reduces a considerable regulatory obstacle, allowing customers to establish greater resilience and switch between technologies.

Great. Thank you.

Hey, good morning. AST question for the back half. It obviously, the segment has the Mevex in it and you break it out, so that's helpful. Not a lot of Mevex in the front half. Can you help level set how much Mevex you expect in the back half?

In the second half, it will be less than $15 million of total revenue versus the first half, which was about $3 million. Again, not material, but unfortunately, year-over-year, the percentages are large, but the dollars are not.

Yes. Understood. No, that's helpful. And then on the AST services phasing, look, I hear all the destock comments, and it sounds like light at end of tunnel, especially in U.S. devices and bioprocess worst of it annualized in now. I'm looking at AST services in the front half, up 5% year-on-year. What's kind of a good either sequential growth rate or year-on-year growth rate to plan for in the back half?

Yes, in the second half, we expect low double-digit growth rates getting back to more normalized.

In the AST services line?

AST services line, exactly.

I appreciate the information. Regarding the equipment in healthcare, although it's not a metric you provide, I've done some calculations for the book-to-bill ratio in healthcare equipment. It was around 1.0 last quarter and dipped below 0.9 this quarter. My question ties into the order environment; you have a significant backlog and have been working diligently to convert it, with noticeable improvement in conversion rates. However, I wonder about your readiness to replenish the backlog. Are you currently less focused on pursuing new business given the existing backlog? This presents an interesting dynamic. Additionally, as we approach calendar year 2024, I'm interested in your insights on hospital capital spending and whether you're observing any stresses or strains without any tangible impact. Any thoughts you could share would be greatly appreciated. Thank you.

Yes. I have a few comments. Our orders continue to be strong, and there is a lot of activity happening in the field regarding our portfolio right now. One positive sign I've noticed is the significant increase in the replacement business over the last quarter compared to previous periods. This indicates that our customers have confidence in us, as well as our field team, to deliver within normal lead times. They are also willing to invest in necessary maintenance capital expenditures that hospital systems have deferred. While healthcare providers may not be thriving financially at the moment, many are on a path to profitability and have improved cash flow compared to a year ago. Furthermore, our capital equipment is essential for operations; these are not luxury items. You cannot perform procedures without adequate lighting and tables, nor can you operate without sufficient capacity in the sterile processing department. That is our role, and while it may not be glamorous, it is indispensable.

Thank you.

Yes, thanks. I guess I'll start with the Dental business. It was down again. It looks like you're starting to lap some of the declines that you've been seeing. So, is that, I guess, just what's the outlook there? Is it just really boil down to kind of the economic headwinds or something else, maybe?

Yes. I mean short term, we expect it to be about flat this fiscal year. And we would attribute that entirely to the economic downturn and the ability of people to spend cash right now on elective type dental procedures, and it's just generally impacting the entire industry, and others have spoken on that topic prior to us, I'm sure, in the last couple of weeks. Long-term, we think it's a solid mid-single-digit grower. But some of these challenges facing discretionary spending, in particular, the U.S. economy you've got to get sorted out in order for it to get back to those type of numbers.

Yes. Okay. It seems you are addressing the backlog in the Healthcare business. I wanted to inquire about hospital staffing related to equipment installation. I know this has been a concern for some companies in the past. Have you noticed any improvement in this area? Is it still a limitation on your ability to generate revenue there?

No. We've seen that. I mean, there's more coordination today than there used to be maybe in terms of getting stuff received at the docks and getting shipments married up, so we do install. But keep in mind, we've got well over 1,000 techs in the U.S. that do this work for us, that are full-time STERIS employees, that are ready to go to help shepherd the process to get our stuff into the doors and also get it installed properly.

Okay. Got it. And then I know you may have addressed this in the prepared remarks, if I got on the call a little late. So I just wanted to ask about the gross margin. It did look like it was down a little bit sequentially. And you had a nice improvement, I guess, last quarter sequentially from the fourth quarter, but just any kind of commentary there would be helpful.

Yes, Mike, we mentioned in our prepared remarks that while gross margin decreased by 50 basis points, we had favorable pricing. However, this was more than offset by lower productivity and ongoing material and labor inflation. Currently, our efficiency in moving items through the facility is not at our typical level, and this reduced productivity is negatively impacting us in the short term.

Yes. Got it.

AST volumes declined sequentially don't help margin.

Yes. Okay. Thank you.

Hey, good morning. Thanks for taking the questions here. I want to start on, I think, the topic of the day here with AST, but maybe first on the CapEx side with AST. Just the decision to postpone some of those projects that's influencing the CapEx outlook for the year. I appreciate you wanting to protect free cash flow. But is there a risk at all here that you're foregoing future growth in AST, just been not adding capacity? And should we be thinking about this CapEx spend shifting out of fiscal '24 into '25 and just next year being an above-normal year of CapEx spend?

Yes, Jason, this is Dan. Thank you for the question. To be clear, we are not delaying these shipments. The delays are due to the natural building process and the current environment regarding installations and permitting. We haven't intentionally slowed anything down; it's just that things have naturally taken longer. We do anticipate that some of these will extend into the next fiscal year from a capital expenditure perspective. We haven't canceled any specific projects.

Okay. Dan, you're talking about the CapEx spend, not the equipment that you're recognizing as revenue, just to be clear?

Correct. Yes. I'm talking about CapEx spend.

Okay. Okay. So it was like $65 million of spend that's shifting out of this year into next year?

Yes.

The bulk of that is AST. It's not 100% in AST, but the bulk of that $65 million is directly related to the AST segment.

Got it. Okay. All right. Thank you. And then we've had some questions here on backlog. It sits down $100 million from peak levels. I know we were running well above normal for a long period of time. What do you see as the baseline? Where do you think backlog settles in a normal environment? How much more backlog work down do you think we need to see before we're kind of at that again, that normal level?

Yes, we think normal is somewhere around 350, but we're happy to keep it higher if we keep pulling in orders. It was artificially high in the past because of our ability to manufacture and deliver. And as we've sort of solved those issues from a supply chain perspective, it's now really coming down at an accelerated pace.

Although I would say that our lead times continue to be longer than we would like them to be.

Okay. All right. Thanks. And then last one for me. I don't think I heard it, but if I did, I apologize. Are you able to bifurcate what you're seeing with your U.S. AST services business and contrast that against what you're seeing in Europe? How much the growth rate delta are you seeing across those two markets? It seems like the opportunity for improvement here is more dependent on the European market improving. So just wondering what kind of visibility you have on procedures in that geography recovering and if you're seeing anything or hearing anything from your partners, that would be an encouraging leading indicator?

We do monitor the situation closely. We have numerous data points from our time in hospitals and our direct interactions with customers who provide insights on market trends. There is also a wealth of public information available from NHS and other public health authorities in Europe. I believe conditions will improve. Even if the rate of procedures doesn't rise, the reduction of excess inventory will eventually lead to a return to normal stock levels for our customers. Many have significantly increased their inventory over the past couple of years and are now working to reduce it. We've heard reports from some customers indicating reductions of 40% to 50%, which will take a considerable amount of time. We’ve already seen this shift in the U.S., and we anticipate reaching a similar point in the coming weeks or months in Europe, rather than quarters, particularly regarding Medtech. Additionally, as we move into the latter half of the year, the comparison figures for bioprocessing and single-use disposables will become less challenging, which has been a significant obstacle during the first half of the year.

Okay. All right. Thank you.

Thank you, everybody, for taking the time to join us. I know you have a busy week. We do look forward to seeing many of you out on the road over the next few weeks of several conferences.