STERIS plc

Good morning and welcome to the Staris PLC third quarter 2020 conference call. All participants will be in listen only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your touch tone phone. To withdraw your question, please press star then two. Please note, this event is being recorded. I would now like to turn the conference over to Julie Winter, Investor Relations. Please go ahead.

Thank you, Gary, and good morning, everyone. As usual, on today's call, we have Walt Rosebrough, our President and CEO, and Mike Tokich, our Senior Vice President and CFO. I do have a few words of caution before we open for comments from management. This webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission, or rebroadcast of this call without the expressed written consent of Staris 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 Staris' 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. Shares of 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, segment operating income, constant currency organic revenue growth, and free cash flow will be used. Additional information regarding these measures, including definitions, is available in today's release, including 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 growth was 12%, driven by volume and 60 basis points of price. We continue to experience strong underlying growth from our customers and success with new products. A total of $13 million, or 180 basis points, is included in constant currency organic revenue growth for the quarter, from the eight tuck-in acquisitions we completed this fiscal year. Gross margin for the quarter increased 40 basis points to 43.1% and was impacted favorably by productivity, price, and NICs, somewhat offset by higher labor costs. EBIT margin for the quarter was 21.1% of revenue, an increase of 30 basis points from the third quarter last year, despite an increase in expenses relating to higher incentive compensation due to our strong performance and a 9% increase in IRD expenses. The adjusted effective tax rate in the quarter was 20%. That income in the quarter grew 16% to $124 million, and earnings increased to $1.45 per diluted share, benefiting from revenue growth and margin expansion. In terms of the balance sheet, We ended December with $199.2 million of cash and $1.1 billion in total debt. During the third quarter, capital expenditures totaled $55.5 million, while depreciation and amortization was $49.6 million. Free cash flow for the first nine months declined, as anticipated, to $238.1 million, primarily due to the planned increase in capital spending. Our capital expenditures have been lowered through the first three quarters of the year due to the timing of capital projects. As a result, we are decreasing our full year expectations for capital spending to $240 million and increasing our free cash flow expectations to $340 million. With that, I will turn the call over to Walt for his remarks.

Thanks, Mike, and good morning, everyone. Pardon me. As you've already heard, our third quarter continued the trend of outperformance we've seen the last several quarters. We experienced solid growth across all of our segments and, in total, delivered double-digit constant currency organic revenue growth for the third consecutive quarter, exceeding our expectations. Our healthcare specialty service segment had a significantly stronger quarter than we anticipated. driven by double-digit growth in the repair business and continued contributions from new outsourced reprocessing centers coming online. Margins in the segment were impacted somewhat by startup costs for outsourced reprocessing centers and personnel costs to support future growth. MyScience also outperformed in the quarter with good growth in consumables and a record level of capital equipment shipments. Even with the strong shipments, our increased capital orders allowed us to end the quarter with record backlog levels in my science. AST continued its outstanding revenue performance this year, growing 15% on a constant currency organic revenue basis for the quarter. We continue to see strong growth from our core medical device customers around the world. And lastly, healthcare products delivered a solid quarter with particular strength in consumables. continue to benefit from our new consumable products as well as recently acquired businesses. Our service maintenance revenue has grown, too, and was augmented by installation revenue due to the strong capital shipments in the first half of the year. Based on our performance year-to-date and expectations for the rest of the fiscal year, we are once again revising our full-year outlook. Starting with revenue, we now expect constant currency organic revenue growth of approximately 9% for fiscal 2020, up from the prior 7.5% to 8.5% range. This increase is due to outperformance in the third quarter. Our expectations for the fourth quarter reflect difficult year-over-year comparisons. Recall that our prior year Q4 constant currency organic revenue growth was 9%. In particular, we expect capital equipment to be roughly flat across the businesses in Q4. In healthcare products, which makes up the bulk of our capital equipment revenue, we have very difficult comparisons against the strong fourth quarter last year. As we've mentioned in the past, we continue our effort to level our capital shipments and avoid fourth quarter spikes. Given the strength we have seen so far this year and our expectations for the fourth quarter, We now anticipate adjusted earnings per diluted share to be at the high end of our $5.50 to $5.65 range. As a result, we continue to expect another year of record performance in 2020. We believe the short-term and long-term future for Steris is bright, and we appreciate your ongoing support. Now, before we open the Q&A, I would like to comment on coronavirus. As you probably know, China is a relatively small piece that stirs its global revenue, so we don't anticipate any material impact to revenue from the coronavirus as a result of China's sales this fiscal year. On the supply chain side, although the situation is fluid, we are in regular communication with our Chinese suppliers. At this time, we believe we should be able to mitigate any issues that may arise so there are no material impacts to revenue due to the supply chain issues this fiscal year as well. We are in contact with our customers to understand how the situation is impacting them and what we can do to help. We're also in contact with our people that are deeply concerned for their health and safety. Our China operations have been closed since the Lunar New Year, except for limited operations to support critical products, and we will continue to follow the guidance of the government and do what is best for our people. Like most businesses, we have restricted travel to and from China across the company. With that, we are happy to take any questions you may have. Julie, can you open the call for Q&A, please?

Thank you, Walt and Mike, for your comments. Gary, if you would please give the instructions, we can get started with Q&A.

We will now begin the question and answer session. To ask a question, you may press star, then 1 on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then 2.

At this time, we will pause momentarily to assemble our roster. Our first question comes from Dave Terkelay with JMP Securities.

Please go ahead.

Good morning. Thank you. Walt, one for you off the bat here. If 1-2 is a hot quarter, I'd love to ask you what you call this quarter.

Pretty darned.

to get into a serious question here, but I guess, you know, there was no one-time impact here, right? There was no extra days or anything like that. You called out the pricing, and I think the M&A side had a little contribution, but overall, no other one-time impacts in the quarter, correct?

I wouldn't characterize any of the impacts of the quarter being abnormal.

Great, and I guess... You know, if we look at those deals that you mentioned, I think you said eight. I guess any color on them, where they fall. You mentioned the contribution, but I guess it might be nice to know, you know, what things you've added, even though they're relatively small, versus your base. Thanks a lot.

Sure, Dave. You know, we're not going to get into the details of that, as we mentioned earlier. The bulk of the revenue this year is coming in in the hospital products business or healthcare products business. It's actually smattered around the various units in that business, none of which are consequential. It does add a point and a half or so of revenue in the quarter. Our best estimate is about a point for the year over time. Again, there's nothing here that's particularly material in the short run. There's a couple of them we think may be for answering in the long run, but we'll hold that until we see how they work out.

Thank you.

The next question is from Chris Cooley with Stevens. Please go ahead.

Good morning, and congratulations on a great quarter.

Morning, Chris.

Hey, good morning. Just two for me. Really solid from top to bottom, both in terms of growth and the leverage. I guess just a couple things. we wanted to get our hands a little bit better around. And specifically, when we look at healthcare products, you had a really strong year-over-year increase in consumables. I'd like to understand a little bit more about what drove that and then why, I guess, the offset to that, why we didn't see more margin expansion with that level of growth and that percentage of contribution in healthcare products. coming from consumables within the broader category there from the segment margin. I've just got one more follow-up after that. Thanks.

Yeah, Chris, it's Mike. In the consumables, a portion of that growth is actually from some of the acquisitions that we just completed. It's about $8 million to $10 million of something of the nature, Julie, right? Yeah, so for the quarter, $8 million to $10 million – of favorable impact, obviously, on the revenue side from some of the acquisitions we just completed.

The other point, Chris, is, as we mentioned, our service had a strong – service is a part of consumables as we look at it, and service profitability is not as strong on an ROS basis as is the chemistry-type products and endoscopy-type products. And so that had more of an averaging effect. It looks more like capital. Obviously, on an ROE basis, it's pretty good because there's very little capital But on an ROS basis, it's not as strong.

Certainly. And then I guess just, you know, lastly for me, as we look ahead, you know, beyond the remainder of this fiscal year, seems to be a hot topic out there right now about capacity at AST. Could you just kind of maybe walk us through where you are in general terms from a capacity perspective and thoughts on incremental CapEx and just how you can see that business growing from a longer-term perspective. Thanks so much.

Sure, Chris. I'll let Mike talk about CapEx, but at a high level, obviously our ethylene oxide plants are pretty full right now, and And, you know, they've had increased pressure, if you will, or fullness. It has moved from the U.S. to overseas as we're now processing some things that would normally have processed in Americas overseas. So they're getting more full. Having said that, we continue to add capacity. And so there's two ways we add. One is by adding facilities or growing the number of chambers inside the facilities that The other is being more efficient with lean approaches inside those facilities. And we're doing both. So although we are more full than normal on the ethylene oxide type facilities, we continue to grow the ability to grow, if you will. By the same token, on the radiation side, we can also continue to grow our ability to grow And there we've talked about a number of plants that are being built or added or opened across our global network. And we're doing so in a very technology neutral approach. That is, we're adding e-vein technology, we're adding x-ray technology, and we're adding capacity in the cobalt facility. So we do see that as the approach. We clearly see greater growth in the e-beam and x-ray type facilities than in any of the others, actually. And so that's where we're placing our money. Mike, I don't know if you want to talk about CapEx.

Yeah, Chris, so at the beginning of the year, our view was we were going to spend about $100 million in growth CapEx in AST alone. Obviously, that number has come down a little bit because of just the timing of projects. And I think we have about eight recent projects that are being worked on that we've announced Our view would be it's just a timing issue, so next year I would look at CapEx being probably at that elevated level once again, and maybe even for the next year or two after that. Obviously, with the growth that we're seeing from our customers from the medical device industry, we need to continue to add capacity to maintain the current growth.

And I would say, as I've talked about a lot, we see the medical device business growing We're in the middle of the baby boom right now, and the baby boomers are largely entering. The biggest part of the baby boom is entering the high health care spending years, and things like orthopedic implants and stents and all those good medical devices to improve our lives get used a lot more when you're 65 and 70 and 75 than when you're 45 and 50 and 55. So we see sustained growth for our customers today. on the unit volume at least for the foreseeable future. And that creates sustained growth for our AST business as well as our hospital business, our healthcare business. But I would add that given our global network, it is, I think, easier and easier for global-type companies to work with someone like us who has broad coverage. We can move from plant A to plant B if they need to for whatever reason. And also, they can count on a single quality system and single regulatory system. So I do think that is helpful for us to grow a bit faster than the market.

Our next question is from Matthew Michan with KeyBank. Please go ahead.

Great. Thank you for taking the questions. Hi, Walt, Mike, Julie. Morning. Morning. You mentioned that results were ahead of expectations. You've had two straight quarters that are consistent like this. I'm just curious, what in particular is surprising you about the sustainability of these trends?

I guess, Matt, I'll answer in four or five years if they sustain. I'll feel even more strongly about the sustainability, but You know, a lot of the things that we have been working on seem to be coming together right now. So, you know, if you walk through them, you know, we talked about the nice growth in the healthcare services business. You know, both the equipment repair business is growing nicely as we've added and continue to add capacity. The outsource solutions, as I mentioned before, we think it's going to look a bit different in the Americas than it looks in the UK, and I think we're getting better at understanding that model and providing what our customers want and need. So that business has a pretty good growth rate, we think. The life science business has continued kind of its long-term growth rate on the chemistry side, maybe slightly off of some of the faster years, but still solid growth in that business. And vaccines and biologics, we think, is a good space to be in, and that's where we are On the AST side, I think I've already talked about that, but we think that is a good grower. And on the healthcare side of the business, again, we continue to add product to our portfolio. We continue to refine our sales approaches. And again, particularly in the I'll call it the industrialized countries, you know, we're facing the middle of the baby boom coming through. And that's going to be like a pig through a python, in my opinion, for the next 10 to 15 years. So, you know, the underlying market demand is good, and we're doing our jobs to pick up at least our fair share of that.

All right. And then how have your conversations, you know, evolved with the major healthcare systems, especially with your scale? I'm just trying to understand how interconnected some of the growth is across businesses like healthcare products and healthcare specialty services. Are they looking at you differently and trying to consolidate more business with you?

Matt, that's an excellent question. The answer to your question is yes, yes. We are clearly seeing more interconnection between the healthcare service business and the healthcare products business. You know, in some respects, one is the customer of the other. And so oftentimes when we're looking at things, we're able to talk to the hospitals about what their needs are, healthcare systems, and what their needs are. And, you know, for one, it might be I add a little more to the CSD that I have. The other one may say, gee, you know, I'll add some more, but can you take over some? Another might say, gee, we'd like you to run our ORC, but we still need to have centers and turn centers in our ambulatory surgery centers. I mean, it is a – they are evolving their business model in this space And having the full spectrum of products and services across that space does put us in a different position to give them what they want independent of what we might think is the best thing. And so it's like most of the things we do. We work hard to be technology neutral, approach neutral, have a broad spectrum of things that we can offer our customer and let them choose which piece of the spectrum they want.

Okay. That's a really helpful color. Could you also give us an update on the ORC model? You're talking about that a little bit more now. I think you previously quoted like $50 million in business on three contracts. Have those at least launched and are running as expected?

You know, again, we don't talk about specific ones. We have now more centers up. I don't know that we're going to give those numbers, but we have more centers up. I know we're not going to give locations to talk about our customers, but we have more centers up. Some of them are more like micro centers. Some of them are more like larger centers. But, you know, the numbers we have quoted for our growth forecast for the ORCs, we continue to exceed those, which is a part of the reason HSS has beaten our expectations.

Okay. And then last question, and it is a multi-part question. So, just warning you in advance. I thought you guys did, at the FDA panel, I thought you did an excellent job. I thought you guys were clearly the, on EO, were clearly the adults in the room. So, I just wanted to ask some follow-up questions on sustainable EO. Like, how long would it take to switch practices from traditional EO to sustainable EO at a facility? You know, what is the incremental cost of implementing that at a medium-sized facility? Does it require new equipment? And, like, what would be the cost savings of using less EO?

I'm going to work backwards on your question, Matt. Okay. It costs nothing in the facilities and does not require any consequential change to equipment, gas, whatever. so that is a non-cost item. It does cost our customers and us working together. We have to revalidate the fact that the process which uses oftentimes half the gas that the traditional processes use, it does, you know, we have to make sure, we know we're using less gas, so we don't have to validate that part of the question. We know there will be less effluent, so we know that's not an issue, but And we also know the FDA pays particular attention to how much residual gas stays in the product. So if it gets implanted into the patient, that's okay. But we know that's better because we're starting out with less gas. So all those things are known. We just need to be absolutely positively sure that we are sterilizing the device when we do that. And that requires validation by the customers and us. We are working with the – and also currently or historically – requires the agency to look at it and approve it. We are working with the agency to lay out templates to make that far simpler for our customers and far less of a regulatory burden for our customers to be able to do that. So I'll call it the switching – the cost of the switching cost is all around validation than any other, I'll call it, material cost. Now, obviously, it uses a little less gas. That cost is largely immaterial in the process, so the delta in the gas usage is relatively immaterial. And, frankly, in most cases, our total cost is immaterial relative to the transportation cost in the process, so this is not a big cost issue. It is a get-it-right issue, and both we and our customers are very serious to make sure that in enhancing what's potentially in the environment that we do not take any risks that the product is not sterile. And, you know, right now we're – I'm going to use the word that's an oxymoron. You know, today in many cases we're over-sterilizing. Now, once you kill all the bugs, you can't kill them again. So we're over-gassing. They're not really over-sterilizing. And to the extent we're over-gassing, we don't need to do that. It takes time, but it's measured in months for any specific customer and any specific product. But there's an awful lot of customers and an awful lot of products out there, so it will take a series of years, we believe. But we do think, and Mr. Crestio, our chief operating officer who grew up in that business, absolutely believes in the set of targets for his team to get down 50% using half the gas we used to use for the same level of requirements and do that inside of five years. And we think we can hit those targets.

All right. Thank you very much for taking the questions, and congratulations to you all for your success. Ethan, Mike.

Thanks, Matt.

No problem. Again, if you have a question, please press star then 1. The next question is from Larry Cush with Raymond James. Please go ahead.

Thanks. Good morning, everyone. Walt, I just wanted to start with you. Obviously, this fiscal year to date has been really outstanding, both in revenue generation and margin expansion. I'm just wondering, you know, as we all start to think about fiscal 21, and I recognize you're not providing guidance, but can you help us just think about any sort of puts and takes that we should be considering for both, you know, as we sort of look at revenues and margins for next year?

You know, Larry, as you have said, we're not giving guidance right now. And, you know, I know in some respects that that can be frustrating for you guys because most companies are calendar year companies and, you know, we're a quarter behind the calendar year. So as a result, we're always a quarter behind. late versus calendar year kind of projections. You know, we have not – we're in our planning processes. We have not concluded those processes. You know, as I mentioned, the Chinese thing, there's a little fluidity there. But, you know, I will say a couple of things to think about. A, we are starting from very nice growth rates, right? I mean, we're approaching double digits for the year, you know, 9%. that gives us tough counts. But the flip side is, you know, last year we started out with uncertainties in device tax, uncertainties in labor rates, uncertainties in trade. And for us, trade is North America more than China. So the trade uncertainties in terms of NAFTA and Brexit. And last year we did have some tough counts in Q4, which, again, we have tough counts this year in Q4. So, you know, if you look all through that, At a high level, you know, we think about this business for the markets we're in to being kind of a 4% to 6% constant currency grower. And hopefully we get a point or so a share. You never know exactly when and how that's going to happen. Hopefully we get a little price. Hopefully we get a couple of acquisitions. And the next thing you know, we're in those high single digits. we're pretty comfortable right now with where we sit that we'll be toward the high end of that 4% to 6% raise in our constant currency growth rates. Again, we haven't done our final analysis. We will obviously talk more about that in three months, but we're feeling pretty good about the high side.

And I would assume, again, similar thoughts around margins. I mean, there's no reason to think that margins wouldn't expand going forward.

As you know, Larry, I'm not the margin expansion guy. I'm the margin growing guy. I like real profit dollars, but I don't have any reason to believe. I am absolutely confident we will be working to improve our cost position. We will choose on what to do in terms of how we handle that in terms of lack of price increase or price increase. We definitely are facing a little headwind on the labor side. Labor rates are clearly going up. But, you know, when we put all that together, we don't see any reason to be off our normal paths.

Okay. One more bigger picture one, and then I'll just add a couple quick ones perhaps for Mike. But, you know, as you think about the next steps within the sterilization regulatory pathway, could you bring us up to speed sort of, What do you think the EPA will ultimately wind up doing if it comes out with its recommendations? And then, you know, look, clearly the states of Georgia and Illinois have been challenging really more from a local government perspective, and I guess that's always the concern. But how do you think about, you know, are there any states where you guys are operating where, local government could start to become more of an issue in the operation of these types of facilities?

You know, Larry, forecasting what governments are going to do is a little like forecasting elections, and I don't really think we have any great knowledge on that. I will say, and I mentioned it last time, we have been impressed with the way the FDA has developed taking this bull by the horns, knowing that there is, you know, 50-some odd percent of the devices are sterilized by ethylene oxide that need to be sterile. And so it's very important to them to keep those supply chains moving. And I think they're doing a superb job of working on that. The EPA, and particularly because the FDA and the Secretary of Health have made it clear that the risks that the country takes on if we cannot sterilize with ethylene oxide in the intermediate term. I think they would have done a nice job, but I think they are taking a nice methodical approach. It would be very easy for them to make a snap judgment, but from what we see, the way they've requested information, the way they're asking all types of players in this space, you those who sterilize, and those who are concerned about those issues in the environment. By the way, we're in two of those. Well, we're all three of those three buckets. We're concerned about the environment. We're concerned about sterilization. We're concerned about a device manufacturer, being a device manufacturer. So it seems to me they're taking a very balanced approach to this process. We do feel, our own opinion is, we feel that we're at the high end of the industry in terms of the way we handle things. You know, our move toward Sustainable EO a couple years ago now certainly led the industry, and we're clearly seeing people being very interested in that approach now. We also know the design of our facilities and the way we handle the gas and the way we remediate the gases at the high end, or I'll call it the good end of the industry. So we're very comfortable that we have been and are safe for our people and our communities. But that doesn't mean we can rest on our laurels. We intend to get safer and safer, which is why we do this 50% reduction. And we're always looking at the way that we handle the gas inside and outside our facilities, and we'll continue to do so. And, by the way, that's not just a comment about the United States. That's a comment about the world. We are not, you know, assuming that the only people that care about it, when I say gas, are Americans. And so, you know, that's our approach. We're comfortable – as comfortable as one can get, I guess, because you can always have something occur. You are correct. In my own view, the bigger risk in the short run, at least, is local and state governments. But, you know, I do think now that it's very clear that both the FDA and the EPA are engaged, that there's more likelihood that people will wait and see what that result is, and then based on that result we'll take appropriate actions.

Okay, very good. And then from Mike, just wanted to think a little bit about the investments within HSS, you know, the operating margin of that business unit has trended down over the past three quarters. I think it's 10.7% discord on an operating margin basis from 14.6 in the fourth quarter of 19. Just again, I want to make sure I'm understanding the investments. It seems pretty straightforward, but just want to make sure we're understanding that. And then what's the right way to think about, you know, again, you know, margins for this business going forward? And then the second question, Mike, is, you know, you talk about 100 basis points or so of growth being added by M&A this quarter of this year. What is the threshold for when you kind of pull that out of organic growth? Because you still characterize it as organic constant currency growth, but there's 100 basis points in there from M&A. So just try to understand what the threshold is.

Thanks. Yeah, certainly, Larry. I'll answer the second question first. Typically what we do is when we do any type of material acquisition, we would separate that out and actually disclose that separately so that we are not in this the boat that we're in today where we're trying to call out cost-currency organic revenue growth and then also note at the same point in time what the acquisitions added. So unfortunately this year, you know, doing eight acquisitions that were all individually immaterial, but if you aggregate them all together, they become material. So that's the reason we chose the way we want to disclose that this year is make sure that everybody understands that the impact is And there's a pretty significant impact in the third quarter, 180 basis points in the quarter for consecrated organic revenue growth, that it is understood and we're being as transparent as possible. We don't like going down that path, obviously. We would prefer to do an acquisition and separate that out and go back to our historical reporting. But this year is an anomaly, hopefully. But, again, with eight acquisitions combined being in the combination of all being relative, We have to do something so that we're, again, truly being transparent. Your first, do you want to say something?

And just to be clear on that, Mike says we don't like that. He's talking the accounting issues, not the businesses. We like those businesses. We love tuck-in businesses. If I can do 10 more next year to look like these eight, we'll do 10 more next year. We'll be talking about this again, I suspect. But it's not that we don't like the businesses. Right. We just don't like the reporting. We don't want to be changing our constant currency growth rate every month because of some small business is really the issue. That's the point.

And then your first question regarding the HSS business. Obviously, as Walt mentioned in his script, that we did have startup costs for the new ORCs. And in addition to that, we are continuing to have people costs. to support the future growth in HSS. I mean, our long-term view of this business is still mid-teens. We haven't come off of that. Obviously, you are seeing the benefit of the revenue, the top-line growth, but it does come with a little bit of startup costs, which we've talked about for two years now in a row. And as we bring facilities online, it probably takes roughly 12, maybe 18 months, depending on the size of the facility, to get the break-even and then start actually adding facilities profit to that business. So it's not unusual and it's not a surprise to us by any means.

Okay. Perfect. Appreciate that. Thank you very much.

You're welcome. This concludes our question and answer session. I would like to turn the conference back over to Julie Winter for any closing remarks.

Thanks, everybody, for joining us again this morning. Hope you have a great day.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.