STERIS plc (STE) Earnings Call Transcript & Summary

All right. We're going to get started here. First of all, welcome to Dan from STERIS. Thanks again for joining us. We're excited to unpack parts of the story. Before we get into it, there is a disclaimer on the Morgan Stanley website, so I suggest everybody go check that out. Dan -- I just learned it was Dan's 29th anniversary year at STERIS, but importantly, also 5 years as CEO. So congratulations on that. Maybe to start us off, you can reflect a bit about what you learned in the last 5 years about STERIS and that as a CEO that you didn't appreciate when you first took the role on and maybe what you think investors still underappreciate about the story?

Yes. Thank you, and thank you for having me. I think the one thing that I would really point to is how resilient and how durable the demand is for our products and services, in particular, in the health care space. In a time where our customers are definitely under some financial crunch, STERIS has emerged as really a provider that will work with them to help enable them to have better outcomes. And what do I mean by that? I mean, as hospitals need to generate more revenue, they need to turn surgeries. They can't ever have an OR shutdown because of lack of sterile product. And running a sterile processing department in the basement of the hospital is not very sexy, but it is absolutely essential, and it enables the hospital to turn those procedures. It enables them to have compliant, safe outcomes and ensure that everything operates as intended. So we've had different conversations over the last year with the C-suite level of major health care systems. And as -- while it's tightened, I guess, on capital spending from time to time, we just haven't seen an impact because of the value we're delivering.

Great. And I do think that your role and relationship within the hospital is actually a very unique one compared to some of the other medical devices out there. As we saw in the last earnings quarter, there was a lot of questions around hospital utilization rates and procedure volumes and quite a variance in views. Given your role and STERIS' role, can you share perspectives on what you're seeing from your customers and what you can kind of glean on the volumes?

What I can do is provide a lot of data that we have and -- or some anecdotal data and then let people draw their own conclusions of what's going on in the market. And as a point of reference, we touch the space in many different ways. First, on the industrial side, we're a major supplier of industrial sterilization across the globe, largest industrial sterilization company in the world. And so we see roughly 1/3 of the world's single-use medical devices come through one of our plants. What we have seen over the last, I don't know, a year or so has been destocking in terms of volume, which is counter to what we're seeing in terms of procedure volume. So we'll just put that data aside for a second. And then if we talk about the data that we have on the hospital side of things, we run in-house and outsourced sterile processing departments for many large health care systems as well as we have embedded data in the equipment in the sterile processing departments that track consumption of instruments and trays. And so we see that across a broad network in particular here in the U.S. and generally speaking, we've seen -- we continue to see some modest level of procedure volume growth across both acute cares and also the ASC market. Generally speaking, I've always said that in a good year, a really good year, we tend to see procedure growth at the high end of the range at, like, 4%. And in a not so good year, it tends to be at the lower end of the range. I'd say we're definitely at the lower end of the range but growth nonetheless. There are some bright pockets though. And not that that's not good because it is growth, but there are some bright pockets, in particular, we see in endoscopy, where we have a lot of exposure because we have a sterilization system that's specifically geared to reprocessing of endoscopes and also larger repair operation and a device business. But endoscopy, just as a market in terms of procedures, is up somewhere between 7% and 8.5% and due to some factors with screening age coming down and also the unfortunate, what seems like an increased occurrence of colon cancer in much younger people than previously seen. So anyway, but the procedure rates, we have all this data suggest that we are seeing growth in the North American market and broadly around the world as well.

Okay. That's very helpful as a framework. Just focusing on the P&L for you all. Consistently, you've talked about mid- to high single-digit organic top line growth, leveraging that to have double-digit bottom line growth. What gives you confidence in the sustainability of this algorithm over near term, midterm, long term?

Yes. So let me start by saying 10, 12 years ago, STERIS was -- approximately 80% of our revenue was from capital equipment, 20% was from recurring revenue streams. Today, it's inverted. So 80% of our business is recurring revenue, which comes out of our chemistries franchise that goes through all of our washers and some of the low-temp sterilization machines that's in Healthcare as well as our Life Sciences products that go into aseptic cleaning and aseptic environments that are disposable or chemistries. And then a huge portion of that is now services. So when you have 80% of your revenue that's largely procedure-driven in a necessary environment, it's pretty easy to have that outlook because you have data of past months and years of trend analysis. So as long as we're headed in the right direction, we tend to stay that way. The only thing that can fluctuate a little bit from time to time is some of the capital purchases, in particular, on the Life Science side. Generally speaking, Healthcare has been very consistent for us over the long term.

Okay. Great. I do want to go a level deeper on that top line growth. And maybe, if you could just share a little bit of how do we break that down, the sources of that top line growth between procedure growth, market share gain, pricing, new products, any sense of relative contribution and which one of the 4 you think has the most runway in the near term?

Well, it's pretty simple math for us. I mean, it starts with price. It's not exciting, but it is important. We get a couple of hundred basis points of price. So that's 2, right? And then you layer in procedure volume, which is material in terms of all of our recurring revenue businesses in health care as well as AST, our industrial sterilization business and then somewhat related to our customers in pharma that are manufacturing the aseptic drugs. If you go back to what I was saying earlier, somewhere between 2% and 4%. So you stack that up, right? So you're at somewhere between 4% and 6%. And then you look at a little share gain. And then maybe we do a little small bolt-on M&A here and there, something like that, that gets us up to a number that looks like mid- to higher single digits. And then through that revenue scale through our own internal initiatives on continuous improvement and cost savings and things like that, we generally able to get meaningful margin out of that 7%.

Okay. And if we spend a little bit of time on the Healthcare segment specifically because it's now at $4 billion of annual revenue. So by law of large numbers and math, as the business gets larger, that growth rate, delivering that mid- to high single-digit growth rate becomes harder and harder. How do you think about delivering that top line growth versus converging to the procedure growth that we just talked about?

There's still a lot of market share out there to be had, both in North America and especially in Europe, where we have a much smaller presence in Healthcare. So I'm confident long term that our commercial teams have shown their ability to consistently win share. I think the model that we've developed in the U.S. market and the Canadian market, in particular, as we deploy that to Europe, we're going to be very successful there. It gives us a lot of room for growth. And there's also still a number of things that we can bring into the portfolio over the long term through our own R&D initiatives and things like that. We have a very good channel. We have very good technologies, and it's a matter of just expanding that for our customers.

Okay. I mean if we pivot towards Healthcare services, I mean that has been a phenomenal growth driver and one of your strongest growth categories. What's structurally been driving that outperformance? And again, what does that outlook look like in the mid- to long term?

Yes. So that's -- you can really break that down into a couple of businesses. One is about half of our revenue is our traditional maintenance business, repair business on our equipment, so the wrench turning business. And that continues to do very well because we deliver a lot of value in terms of uptime for our customers in sterile processing in particular. And also, we get -- we are able to get some -- a little bit of price there. But it's really the trust that they put in us to keep those machines running because they're critical. We've also placed a lot of capital equipment over the last couple of years, and that's helping drive the growth there as well as those service warranties turn into contracts. In terms of the rest of our Healthcare services business, that's largely third-party repair of -- a lot of it is endoscopes or rigid scopes or some power tools used in orthopedic surgery. And we create value for the customer by extending the life of those devices through basically replacing glasses or sensors or things like that. I mean a high-end scope can be $60,000 to $80,000. And if we can repair that and keep it running for another 5 years, it's really super value as our customers are looking to sweat some of the assets as long as they can keep them delivered.

Yes. Okay. Makes sense. I mean I think one of the crown jewels of the portfolio is the AST business, right? It's quite a differentiated asset. I'm sure you get a ton of questions from investors around it. What do you think are the biggest structural drivers of growth for that AST business over the mid- to long term?

That one gets clearly to procedure volume. And then also some to the mix of the product that we have. And that is as some devices get generally more sophisticated, more expensive, they require a more specialized approach to sterilization, which often allows us to price things at a much higher price based on the unique abilities of our plants to develop and design and deliver a very tight dose or a very specific cycle. So I think that long term, our global footprint with well over 60 plants, I think it's touching 70 now in Asia, Europe and North America, Costa Rica, Dominican Republic, it just puts us in a place where customers who need resilient supply chains, who need to have flexibility, we're just in a great position to service that.

Sounds great. And I do think post-COVID, there's been an increasing focus around supply chain surety and how do you make sure that inventory is being kind of managed appropriately. If you could talk a little about within AST, how much visibility do you have on the underlying end market demand versus some of those short-term bursts that are more inventory movements within med tech customers? And do you have -- what indicators tell you about destocking or inventory management being normalized now?

We start with the conversation with our customers, right? And generally speaking, that gives us a guide. Now there's some bias in it sometimes because they want to say they're going to utilize as much capacity so there's never an issue of us having not enough capacity for them. So we try to temper that, right? Beyond that, because we see a lot of the competitive landscape for a certain product offering, we're able to sort of put it all together in our minds and look at growth and make some assumptions. Another thing that we see is we do a lot of the precursor materials for orthopedics that have to be cross-linked during the radiation process. So a lot of times, we'll see that as maybe a precursor to what is going to be either an increase or slowdown in orthopedics demand because it typically takes a couple of months for that to work its way through the manufacturing process. There's a number of different variables. But it's hard to say there's any one thing in particular. What I can say, though, is that we saw a lot of med tech get fat on inventory post pandemic. We had the supply chain crisis, the golden screw, all that kind of stuff. And I mean, STERIS itself, I think 1.5 years ago, we've taken out $100 million of inventory of our own because everybody was keeping inventory for just-in-case, not just-in-time. So it's been about a year now. We've seen this pull down amongst our large customer segment, which has slowed -- caused a slowdown -- a little bit of slowdown in the growth rate of AST. We fully expect that corrects itself in Q3, and our Q3 starts October, just to confuse everybody. And -- but that's when we get past an anniversary of 10% growth for 2 quarters in the prior period. And we think we'll finally worked it out, and we'll see normalized inventory levels resume.

Okay. That's very helpful. I mean Life Sciences, pivot to the last business, Life Sciences has returned to stronger growth as customer capital spend has recovered. Can you give a little flavor for how we should think about the normalized growth rate for that business?