STERIS Q3 2022 Earnings Call Transcript

Presentation

[Operator]

Good day and welcome to the STERIS Plc Third Quarter 2022 Earnings Conference Call. [Operator Instructions] Please also note that this event is being recorded.

I would now like to turn the conference over to Julie Winter, Investor Relations. Please go ahead.

[Julie Winter, Vice President, Investor Relations at STERIS]

Thank you, Matt. And good morning, everyone. Speaking on today's call as usual will be Mike Tokich, our Senior Vice President and CFO; and Dan Carestio, our President and CEO. And I do have just 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 express written consent of STERIS is strictly prohibited. Some of the statements made during this review are -- 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.

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 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.

[Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer at STERIS]

Thank you, Julie. And good morning, everyone. It's 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 9%. Growth was driven by organic volume as well as 100 basis points of price. Acquisitions added $333 million to revenue, which is broken down by segment in the press release tables. To assist you with your modeling within the Healthcare segment, of the approximately $210 million in acquired revenue, about 60% is consumable revenue from both Key and Cantel Medical. We passed the first year anniversary of the Key Surgical acquisition in mid-November. So this quarter, Key Surgical's revenue is split between organic and inorganic.

Gross margin for the quarter increased 90 basis points compared with the prior year to 45.1% as favorable productivity, pricing and acquisitions were offset by higher material and labor costs. We continue to face increased material labor costs, which totaled about $10 million in the quarter. As we look at the fourth quarter of the fiscal year, we expect increased pressure on material labor of approximately $20 million, about twice as much as we anticipated just one quarter ago. For the full fiscal year, we anticipate absorbing approximately $45 million in unplanned material labor costs, all while continuing to serve our customers and deliver a record year of performance.

EBIT margin for the quarter was 24% of revenue, an increase of 40 basis points from the third quarter last year. R&D expenses increased. And as anticipated, we are seeing operating expenses such as travel and sales and marketing costs return, somewhat limiting EBIT margin growth.

The adjusted effective tax rate in the quarter was 21%, higher than last year, but in line with our expectations. We now expect the full year tax rate to be approximately 21.5%, reflecting year-to-date actuals at our expectations for the fourth quarter. Net income in the quarter increased to $213.3 million and earnings per diluted share were $2.12.

Our balance sheet continues to be a source of strength for the company. At the end of the quarter, cash totaled $359.1 million. We continue to focus on debt repayment as evidenced by our leverage ratio at the end of the third quarter below 2.6 times. Year-to-date capital expenditures totaled $214.5 million, while depreciation and amortization totaled $319.3 million.

Free cash flow for the first nine months was $300.3 million. As anticipated, this has declined from the prior year due to costs associated with acquisitions and integration of the Cantel Medical acquisition and higher capital spending year-over-year.

I will now turn the call over to Dan for his remarks.

[Daniel Carestio, President and Chief Executive Officer at STERIS]

Thanks, Mike. And thanks again to everyone for taking the time to join us today. Fiscal 2022 is shaping up to be another record year for STERIS. Our year-to-date results have been strong despite headwinds related to supply chain and inflation that are impacting both revenue and profit. In particular, growth in our ASG segment remains very strong, with 21% constant currency organic growth year-to-date.

Healthcare has also rebounded nicely with 13% constant currency organic revenue growth in the first nine months and record backlog of $382 million at the end of the quarter. Life Sciences consumables have stabilized as anticipated and have contributed 5% constant currency organic revenue growth for the segment in the first nine months. The capital equipment backlog in Life Sciences has also continued to grow to a record $117 million. As our backlog in Healthcare and Life Sciences suggests, the underlying demand for our products remains very strong.

Dental revenue was about flat in the quarter, impacted by a slower than expected recovery in patient volumes. We do anticipate that that revenue in the Dental segment will begin to rebound in the fourth quarter. The integration of Cantel is progressing ahead of our expectations as we indicated last quarter. We expect to exceed our cost synergy targets by about $10 million and we are now approximately $35 million in total cost synergies in fiscal 2022.

Reflecting our strong performance to-date, we are increasing our constant currency organic revenue outlook to the high end of our previous range and now anticipate approximately 11% growth for fiscal 2022. We are also increasing our earnings per diluted share outlook and now expect earnings to be in the range of $7.85 to $7.95 or $0.10 above the high end of our prior outlook.

We do have a few known headwinds in the fourth quarter. We completed the divestiture of our renal business, which will reduce both revenue by about $45 million and diluted EPS by $0.05 in the quarter. In addition, we expect supply chain inflation to be incrementally worst by about $10 million sequentially, as Mike discussed.

We do anticipate that we can offset some or all of those headwinds with higher cost synergies from the Cantel integration and continued operational improvements. However, we're leaving some room on the downside of our earnings range to reflect the continued uncertainty.

All said, we are very pleased with where we stand today and the underlying strength of our diversified business. I want to thank all of the associates at STERIS for their hard work and continued dedication to serving our customers. We look forward to updating you all with our progress in the future.

I'll now turn the call back over to Julie to open up for Q&A.

[Julie Winter, Vice President, Investor Relations at STERIS]

Thanks, Mike and Dan. Matt, if you give the instructions, we can get started on Q&A.

Questions and Answers

[Operator]

Thank you. [Operator Instructions] Our first question will come from Matthew Mishan with KeyBanc. Please go ahead.

[Matthew Mishan, Analyst at KeyBanc Capital Markets]

Hey. Good morning and congratulations on a really great year-to-date so far. My first question is on the progression of organic growth. If I'm modeling it correctly, I'm coming in somewhere in the fourth quarter, around 5%, which would be a sequential deceleration. How should we be thinking about that in terms of the procedural environment? And then also, how should we be taking into account your ability to shift on the healthcare capital equipment backlog, given really the massive number you have in orders versus, maybe, difficulty in supply chain and getting those up to customers.

[Daniel Carestio, President and Chief Executive Officer at STERIS]

Yeah. I think the issue on the 5% is that the comps get tougher in terms of what we were looking at Q4 of last year. And we've also baked in what we believe is some slowdown that we saw in January and continuing into some of February in terms of procedures as it relates to Omicron and particularly across the US. So, we believe we've got that appropriately factored into our expectation.

In terms of the capital equipment, I mean, we're -- at this point, we're almost halfway through the quarter. And we have, in our model, forecasts that we're providing an assumption that there's going to be some hold back of equipment that won't go just due to timing. But it's not an issue that we expect from an availability standpoint. It's more of an issue of, to some extent, our customer's appetite to receive that equipment within the quarter.

Nonetheless, I think what we've stated before, there was about somewhere around a $20 million increase in backlog that we would have attributed to deferral or supply chain issues, things of that nature. I don't think, Matt, that we'll flush that out this quarter. And I think it would be unreasonable to expect that in the current environment. But we'll carry that backlog forward into the first quarter of next year.

[Matthew Mishan, Analyst at KeyBanc Capital Markets]

Okay. Excellent. And then, on to the operating margin, I mean, again, record operating margin in a difficult environment. How should we be thinking about the offsets you guys have had to the inflationary impacts?

As I look at the corporate cost, the corporate cost or the other cost, as well as SG&A, did come down significantly from 2Q into 3Q. Are those the Cantel synergies starting to be realized and are they may be coming in a little bit faster than they were previously -- than maybe you had previously thought?

[Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer at STERIS]

Yeah, Matt, this is Mike. So, yeah, we did anticipate that we are going to get more cost synergies and you are exactly right. Those are going to show up first in the corporate side as we have taken the opportunity to reduce the redundancy of the corporate costs, reduce the redundancy of the CEO, CFO. So that's where you're actually seeing those cost energy savings. And as Dan spoke earlier, we anticipate overachieving those cost synergies in this fiscal year by about $10 million.

Some of that has already been reflected through the third quarter. There'll be a couple of single-digit million dollars that will still come through in the fourth quarter. But all in all, that is very favorable to us. The other thing that we're seeing, and I think we're like everybody else, is our operating expenses have been bouncing around, especially around travel. We were anticipating more travel in the third quarter, which didn't happen. So you're seeing that a little bit lower operating expenses in total.

[Matthew Mishan, Analyst at KeyBanc Capital Markets]

Okay. So there was nothing really transitory in those numbers that would necessarily bounce back significantly into the fourth quarter and we're sort of at a good run rate on some of those other costs?

[Daniel Carestio, President and Chief Executive Officer at STERIS]

Yeah. For the most part. I mean, the only variance that I would see being out there is, we are starting -- our fourth quarter is the new year from a calendar year from a benefit standpoint. So you will see some benefits costs that are normally higher. But year-over-year, those should be equal. And then, the other thing is, at the end of the day where does the management bonus occurring if there is an overachievement, obviously you will see that also reflected in the fourth quarter.

[Matthew Mishan, Analyst at KeyBanc Capital Markets]

Okay. Understood. Thank you.

[Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer at STERIS]

Yeah. You're welcome, Matt.

[Operator]

Our next question will come from Chris Cooley with Stephens. Please go ahead.

[Chris Cooley, Analyst at Stephens]

Good morning, everyone. And congrats on a great quarter and what looks to be a great set up going into next fiscal year. I know it's a little bit early for fiscal -- the next fiscal year guide, but just maybe with broad strokes as we look at the business kind of falling on Matt's initial question there, capital in particular in healthcare really has stepped up over the last several years, and you do have a record backlog that you just alluded to won't pull through all the way here in the fiscal 4Q.

Could you just help us think about kind of the end market there? Do we see a step-up in the kind of baseline growth rate for healthcare capital going forward is that a function of replacement, more efficiencies or is this something that we should really think about normalizing kind of reverting back to those historic levels of growth on the healthcare capital side as we get out sometime in mid-year by or at least by mid-year next fiscal year? And I've got a quick follow-up.

[Daniel Carestio, President and Chief Executive Officer at STERIS]

Sure, Chris. This is Dan. So, what I would say is there is, some part of the backlog build that we're seeing now that's pent-up demand on replacement things that just didn't happen for -- at the same rate for six or nine months during the early first year or so of COVID. There is some element of that. However, what I would say is, the capital spending we're seeing from large hospital systems, in particular across the US and as well as surgery centers and things like that nature is unprecedented right now.

And we're well-positioned with a really strong portfolio of capital equipment in Life Sciences and then also in our surgical business and our IPT business. And I think we're probably winning more than our fair share at this point in terms of our performance in the market. But the market's very hot and I don't know that I've ever seen this level of investment from our customers that we're seeing today. And I don't see it slowing in the short term anyways.

[Chris Cooley, Analyst at Stephens]

Thank you. Appreciate that color. And then, just kind of shifting gears to the Life Science segment. I continue to be impressed with the operating margin contribution that we see there, as well as with AST. Can you just speak about thematically where you're seeing both of these portfolios product mix shifting towards? And really what I'm getting at here do we -- is this a stair step where we're kind of flattening out here at these record levels for a little bit? But as the mix continues to shift, you have a chance for another step up in margin? Or do we need to think about the operating margin contribution from here really becoming more a function of volume through the plant expansion at the AST side as we just think about it thematically going forward. Thanks so much.

[Daniel Carestio, President and Chief Executive Officer at STERIS]

Yeah, I think in terms of AST, I would definitely point to volume. And we have a number of legacy older plants that are quite full that tend to contribute at the high end of margin in the portfolio. The newer plants as they come online are somewhat dilutive on a percentage basis, but in aggregate with the total business, it doesn't really have a significant impact because there's been a steady diet of those plants coming on over the last few years. So we would expect -- with the exception of opex coming back, we would we would expect the margin rate in the AST business [Indecipherable] pretty much.

In terms of the Life Science business, the one caveat there is that there is some lumpiness to our capital shipments from quarter-to-quarter. In the capital equipment business, there's generally at a lower margin than our service and our consumables business. So in whole, as we continue to grow consumables at a nice rate, that will have an impact on the overall margin of the business. However, if we keep taking orders in the capital side of the business like we have, I'm not sure that that is going to hold up.

[Chris Cooley, Analyst at Stephens]

Understood. Well, congrats, gentlemen, on a great quarter. Thank you.

[Daniel Carestio, President and Chief Executive Officer at STERIS]

Thank you.

[Julie Winter, Vice President, Investor Relations at STERIS]

Thanks, Chris.

[Operator]

[Operator Instructions] Our next question will come from Mike Matson with Needham & Company. Please go ahead.

[Mike Matson, Analyst at Needham & Company LLC]

Yeah. Thanks. So, I want to ask one about the renal care cell. We had estimated kind of $0.12 to $0.13 of dilution on an annualized basis, but I think you called out about $0.05 in the fourth quarter. Is that $0.05 more like a $0.20 number on an annualized basis? And then, can you just remind me what segment that falls or had fallen under previously, that revenue from that business?

[Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer at STERIS]

Yeah. Mike, this is Mike. The majority of the revenue was falling under the Healthcare side. So if you're going to adjust the model going forward, there was a small piece that was in the Life Sciences business, but nothing really material. And then, as far as -- I've seen a couple of different numbers. Is it $0.03, is it $0.05, some of this is IR math, if you will. But part of the issue is we are anticipating paying down debt in the fourth quarter with the proceeds. We did not get $190 million. A portion of that was held back in escrow. We did not pay down debt on one, two [Phonetic]. It took us a while to clear the maturities that we had. We had some 30-day maturities that we weighted to pay down debt.

So there are some moving pieces here. Again, our best guess is it's around $0.05, so I wouldn't dramatically change for next year. If it's $0.04 or $0.042, who knows? But again, more IR math used here than anything, more directionally didn't give you an indication.

[Mike Matson, Analyst at Needham & Company LLC]

Thank you.

[Julie Winter, Vice President, Investor Relations at STERIS]

[Technical Issues] The business about half capital as you're doing your modeling.

[Mike Matson, Analyst at Needham & Company LLC]

Okay, got it. And then, just the really strong ASP growth, I think it's in the past, you'd had some kind of COVID benefit in there from PPE and things like that. I mean, is that -- was that a factor at all this quarter or is this really just demand from your, kind of, normal medical device customers?

[Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer at STERIS]

Yes. It's demand from our normal medtech customers. The PPE has diminished back to pre-COVID levels or less than right now.

[Mike Matson, Analyst at Needham & Company LLC]

Okay. All right. And then, just finally, just given the strong backlog, great to see that, I guess, increase in backlog. But I'm wondering to what degree is that a function of the really strong orders that you're getting clearly, but is there some role for the supply chain issues there and maybe limiting your ability? Like could you could you meet this -- fulfill those orders more quickly if the supply chain issues were happening right now?

[Daniel Carestio, President and Chief Executive Officer at STERIS]

They would move a little quicker to the plant, but the percentage increase that we have in backlog is unreasonable to expect our factories to turn the same rate that we were six or nine months ago realistically. So, I think we said last quarter, about $20 million of capital shipments were deferred because of supply chain issues either on our end or on the customer's end of things. Like I said, I don't think we're going to flush that through this quarter. It's going to take some time for those things to work themselves out.

And the other thing too is, a lot of these order because a lot of it is long-term capital investment from, particular the healthcare sector, they're not asking for them to be delivered on March 15 necessarily. So there's time to get these built and delivered for customer need when they actually need the equipment in place to get them operational.

[Mike Matson, Analyst at Needham & Company LLC]

Yeah. Okay. Got it. Thank you.

[Operator]

Our next question will come from Dave Turkaly with JMP Securities. Please go ahead.

[David Turkaly, Analyst at JMP Securities]

Hey, good morning. Can you hear me all right?

[Julie Winter, Vice President, Investor Relations at STERIS]

Yeah.

[David Turkaly, Analyst at JMP Securities]

All right. I'm sorry. I'm on a bit of a spot. But, Mike, I think you said leverage was at 2.6 and obviously the last two deals, you did have been very accretive. So I just wanted to get a comment on maybe your appetite here and where that leverage could go or what's your capacity right now to do deals like that?

[Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer at STERIS]

Yeah. So, yeah -- as I mentioned, we have brought leverage down below 2.6 times at the end of Q3. Obviously with the additional payment of about $170 million that we will put forward for the Reno divestiture, obviously leverage will continue to drop lower than that by the end of the fiscal year. So right now, we are and have the ability to more than 1 times from a leverage standpoint to do something from an M&A standpoint. As we've been saying all along, the larger deals are few and far between.

We will start getting back to more, I'll call, tuck-ins. But again, as everybody knows, we've been really more focused on the integration of both T Surgical and Cantel Medical. So, the business development has been slowed at this point in time. But we are getting back towards with leverage being below 2.5 at this point going forward. We are back to looking at opportunities to continue to grow the business, but more from a tuck-in standpoint, as what you've seen in the past.

[David Turkaly, Analyst at JMP Securities]

Thank you for that.

[Operator]

Our next question is a follow up from Matthew Mishan with KeyBanc. Please go ahead.

[Matthew Mishan, Analyst at KeyBanc Capital Markets]

Hey, great. Apologies if I missed it. But I think previously you had reported FY '22 numbers around like $4.6 billion. Is it fair? Just -- is that number still relatively intact or was it $4.2 billion -- are we closer to $4.45 billion or $4.55 billion now with the divestiture?

[Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer at STERIS]

Yeah. I would say Matt, I would still use IR math that round up to $4.6 billion.

[Matthew Mishan, Analyst at KeyBanc Capital Markets]

Okay. And then, on the inflationary impact into the fourth quarter, are you sort of reporting this on a lag basis where you buy inventory at a higher cost a couple of months ago and then it starts coming through in January, February, March or are these the spot prices that you're seeing in the current market that could actually flow through into FY '23?

[Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer at STERIS]

Now this will be the actual amount we anticipate based upon the inventory turns at our various capitalization that we're talking about.

[Matthew Mishan, Analyst at KeyBanc Capital Markets]

Is it something in which is getting better through, at least on a spot basis where you see, going out a couple more months, the prices are starting to come down or should we think about this $20 million level incrementally flowing through into next year?

[Daniel Carestio, President and Chief Executive Officer at STERIS]

Matt, this is Dan. It's too early to say. We have definitely seen spot prices for certain materials come down precipitously. And we've seen other ones where we have vendors not even willing to quote us cost three months' down based on uncertainty on their end. So, our hope is that we see it come down over the next three to six months, but I think we're going to be living with some of these supply chain challenges for a while.

[Matthew Mishan, Analyst at KeyBanc Capital Markets]

All right. Excellent. Thank you.

[Operator]

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

[Julie Winter, Vice President, Investor Relations at STERIS]

Thanks, everybody, for taking the time to join us this morning. We know it's a busy earnings season and look forward to catching up with many of you offline.

[Operator]

[Operator Closing Remarks]

Participants

Corporate Executives

• Julie Winter, Vice President, Investor Relations
• Michael Tokich, Senior Vice President, Chief Financial Officer and Treasurer
• Daniel Carestio, President and Chief Executive Officer

Analysts

• Matthew Mishan, KeyBanc Capital Markets
• Chris Cooley, Stephens
• Mike Matson, Needham & Company LLC
• David Turkaly, JMP Securities