STERIS plc (STE) Earnings Call Transcript & Summary

Okay. Good morning, everyone. Welcome to the Annual Raymond James Institutional Investors Conference. We're excited to have with us this morning, kicking off the meeting this year, STERIS. STERIS has really seen some terrific growth over the last year and change. They have really seen all parts of their businesses firing on all cylinders, driving margin expansion and deploying capital effectively, so extremely well positioned. With us today to give an update on the story is Mike Tokich. Mike is the Senior Vice President and Chief Financial Officer at STERIS; and in the audience is Julie Winter, who is the Director of Investor Relations and Corporate Communications. So with that, Mike, I'll turn it over to you.

Great. Thank you, Larry. Good morning, everybody. It's my pleasure to be here to talk about one of my favorite subjects, STERIS. As Larry said, we've had a fantastic year. Our year does end in less than 30 days from now, we are a March 31 year-end company. But throughout the fiscal year, at least through the third quarter, we've had double-digit top line growth and double-digit bottom line growth for our fiscal year 2020. As we typically do, we give guidance in May, so we are not prepared to give any guidance at this point in time. The presentation I have, for those of you who know STERIS, this will be very familiar to you. It's the presentation, our standard presentation. We're going to talk about who we are, what we do, who our customers are and look at over some trends as to how our performance has been over the last 5 years. And then after this, we have a breakout session downstairs, so more than welcome to join us there for Q&A. So as I begin, who we are. Our motto at STERIS is we help our customers create a healthier and safer world by providing innovative health care and Life Sciences product, service solutions around the globe. So we're about a $3 billion top line company. We have a very nice balanced revenue stream. 75% of our business is recurring revenue. The remaining 25% is capital equipment, and the capital equipment is found in 2 of our 4 segments, and the recurring revenue is actually in all 4 of our segments, just split out differently. We have about 12,000 people worldwide. But more importantly, we have 3,000 customer-facing service and sales folks in the field. We just crossed the $14 billion market cap and just joined the S&P 500, about 3 months ago. And then from a revenue standpoint, about 70% of our revenue is in the U.S. We have a very wide definition of health care and we report in 4 primary segments and you could see the segments, health care products and health care specialty services. The focus there is really the hospital customer themselves. So we focus on several areas of the hospital. The sterile processing department, which is in the basement of the hospital, where instruments from the surgery, the operating room come down to be washed, decontaminated and sterilized on a daily basis. We also are found in the operating room where we have surgical tables, surgical lights. And then we're also found in the GI space of a hospital. And it doesn't necessarily have to be a 4-wall hospital. It could be an ambulatory surgery center or a micro-hospital, anywhere surgical procedures take place is what we're after in these 2 segments. Our next segment is Applied Sterilization Technologies, which is a technology-neutral contract sterilization business. Also we provide some lab services to our customer. So this is where we sterilize primarily medical device customers, so take the hips, knees, stents, anything that needs to be sterilized prior to entering the body will go through 1 of our 60 facilities across the globe. And then finally, Life Sciences. We saw a combination of capital consumables and also service in this business, and this is focused on primarily our pharmaceutical production customers. So think of biologics, that's the customer we're going after. So combined, 4 segments is our reporting structure. Just going to go a little bit more detail with the segments themselves. So this is health care products. This is our largest revenue-generating segment. And you can see we have a very nice balance between consumables, 30% of our business; service, 30% of our business and service, to us, in this business is the maintenance, the installation and the parts for our capital equipment. And then we have 2 main business units within health care -- or sorry, within health care products, which focuses on the basement of the hospital: Infection prevention capital, so this is where we sell large steam sterilizers, vaporized hydrogen peroxide, washers, disinfectors, again, for decontamination, sterilization of those medical device instruments that are coming from the surgical suite, and that's where you'll see our procedural capital. So this is again where we sell surgical tables, surgical lights, ceiling management systems, integrated OR, and this is also where you'll find a smaller piece of our business, the GI space. We put all that together as procedural capital. This business has been growing very nicely during the fiscal year, about 8% constant currency organic revenue growth, which is a little bit faster than typically what we've seen in this business. We've really focused this year on new products, especially in the infection prevention area. And last year, we focused on new products in the consumable area of this segment. So we've started to see that traction come through, so we're doing very well in this segment. Our next segment is our Healthcare Specialty Services segment. This segment is actually growing above our expectations. This is 10%, 11% growth for the year, constant currency organic revenue growth. Very good growth. We're actually seeing some very good traction here. The main portion of this business is actually instrument repair, so 75% of the business is instrument repair. So we're either going to the hospital on location and doing instrument repair with 100-plus trucks or hospitals are sending us their instruments, their power tools or their endoscopes, and we're actually doing that off-site in one of our many facilities that we have. And we just use FedEx to bring those pieces of equipment back and forth. And then we also provide other services. Those who know us, you hear us talk about outsource reprocessing. This is actually where we are doing the reprocessing that's typically found in the basement of a hospital, in the 4 walls of a hospital off-site. So the hospital is actually sending us their dirty instruments, and we're actually doing it in a larger format, and we can do many hospitals at the same time. Very nascent business for us and will continue to be a very nascent business for us for quite some time. We've got a handful of outsourced reprocessing centers, either open or just about ready to be open. The growth in this, as I talked about, is nice double-digit growth for us, but we are experiencing some start-up costs, especially around these outsourced reprocessing service. That is costing us several million dollars this year as we -- as start-up costs associated with those. So as we work through and those outsourced reprocessing centers gain traction and that we get all the kinks out, we get the necessary volumes to run that. We typically run roughly about a year unprofitable. And then after that, you'll definitely see a stepwise change. We believe this is a mid-teens margin business in total. Applied Sterilization Technologies is -- the next segment is also the most profitable segment that we have. So remember, the customers here are primarily medical device manufacturers. We have several modalities of radiation. And we are, from our standpoint, we are technology neutral. So we don't dictate to what sterilization modality customers use. We basically use their recipe and sterilize those pieces of equipment. So we have 2 main functions, radiation and gas. And then we also as I said earlier, we also have some labs and testing of products for our customers. About 70% of our billable, 75% of our business is medical device providers. So again, a large portion of our business for this segment. And then finally, Life Sciences, again, similar to health care products, a nice mix of capital consumables service. The consumables here are a big portion of this segment at 45% of revenue. And this is really looking at surface disinfectants, barrier product solutions that we purchased a couple of years ago. It's all surrounding, again, the pharmaceutical manufacturers' service here. Just as in health care products, same thing. It's maintenance, installation and parts, and then from a capital equipment standpoint, steam sterilizers, washers, vaporized hydrogen peroxide machines, typically more highly customized machines, larger machines, less standard as we have in our health care products business. This business has also been growing ahead of our expectations for the year from a top line standpoint. If you just step back and look at the last 5 years, so we looked at several different areas from revenue, adjusted EBIT, adjusted operating margin, adjusted EPS, we are growing very nicely. Top line growth over those 5 years compounded is 11%. So doing very nice and this is a combination of organic growth and acquisitions. Over the last 8 years, we've done 40-plus acquisitions, so we've been very busy, and that has definitely helped drive our top line growth. It's also helped to drive our EBIT -- adjusted EBIT growth, also growing 17%. So what we try to do is get all the efficiencies, operating efficiencies, margin improvement, get some pricing benefits through the P&L. And you could see that has done a nice job returning 17% from an EBIT standpoint over the last 5 years. Typically, we look at annualized basis to expand EBIT margin somewhere in the neighborhood of 50 to 75 basis points on top of the revenue growth. And then you could see adjusted margin, 460 basis points. Again, that's where we're actually getting a lot more benefit on an annualized basis as we're being -- using operational efficiencies, lean manufacturing techniques, new product introductions helped the margins. So we've definitely done a nice job of looking and running this business for the long term. And then EPS growing 15% on top of that. From a cash flow standpoint, we've done a really nice job of improving our free cash flow over the last 5 years, topping out at $355 million although this year, fiscal year 2020 we're going to be about $340 million, a little bit less than last year, but primarily because we are spending a lot of money on capital expenditures this year. We're projected to spend about $240 million this fiscal year, which is causing free cash flow to be a little bit lower year-over-year. But again, we're investing for the future, particularly in our AST segment and our Healthcare Specialty Services segment. In order to keep up with the growth that's out there, we need to continue to invest in those 2 areas. As Larry did say earlier, our priorities for capital have been very disciplined over the last 10 years. We have a philosophy that we want to maintain and grow our dividend off the top. We have grown our dividend 14 years in a row. And we try and grow dividend in line with our earnings growth, so double-digit growth over the last 14 years from a dividend standpoint. Next, we believe we want to reinvest in the business. We have a lot of opportunities for growth in what we already have. And like I said earlier, we are spending $240 million in capital this year, which is about almost $80 million more than we spent last year. And again, it's focused in the AST business and the HSS business as we're seeing good growth in those 2 businesses. Mergers and acquisitions, I mentioned earlier, over the last 8 years, we've done 40-plus acquisitions, so we're using our funds to grow the business. And then finally, share repurchase. We use share repurchase only for offsetting dilution on an annualized basis. But again, we've been very, very disciplined over the last decade with these prioritizations for capital. If we look out and look at what our long-term objectives are is to grow our revenue, mid- to high single digits, and you saw the 5-year CAGR is actually a little bit beyond that. But again, we want to focus and make sure that we are -- we're in a space that is very mature. And we've got to do everything we possibly can to continue to grow in this space. And that, again, is through nice organic growth through some acquisitions, through new product development and really, working closely with our customers. And then not only are we going to grow revenue mid- to high single digits, but we're going to translate that down to double-digit adjusted EPS growth over the long period. So again, as you've seen in the last 5 years, that's what we are projecting to continue to do. And again, this year, this fiscal year, we are set to do both top -- a record top line growth and a record bottom line growth in fiscal 2020, which ends in less than 30 days. So here's just our outlook. We are looking for 9% constant currency organic revenue growth for the year. We do have very tough comps in our fourth quarter, which we are going through now. Last year, our capital equipment really did well. This year, we project that we'll have about flat growth, both in Life Sciences and health care. But we still have a very nice backlog entering into the next fiscal year. We did make a comment on our last conference call, beginning of February, that we typically grow 4% to 6% organic revenue growth. We believe that going into next year, fiscal '21, we will be at that top end of that 4% to 6%. So we believe that there is still momentum. We believe that we still have a very nice traction as we enter the new fiscal year. You can see I talked about free cash flow, I talked about capital spending. And then our guidance for earnings $5.50 to $5.65, and we believe we'll be at the higher end of that range as we wrap up the fiscal year and have our conference call for the fiscal year sometime in May. Why STERIS? Well, we think we are very well positioned to continue to grow. We have a solid history of double-digit EPS growth and mid- to high single-digit revenue growth. And again, I've mentioned, we run the company for the long term. I mean that is our main focus is invest now, but obviously, get the returns now and even into the future. We offer a very comprehensive sterilization and disinfectant solution with a broad customer base. We are really the only company like us. One of the unique things about us is we don't have a one-for-one competitor, so it's a little bit hard to compare us. You've got to look across the industry, but that's actually good and actually bad. For us, we enjoy that because it does allow us to be as flexible as possible and continue to invest in the business. We do see competitors at times, but nobody that looks one-for-one like us. We will continue to grow, not only organically, but we believe M&A is definitely an opportunity for us. As we said, we've done 40 acquisitions, and we believe the pipeline is strong. We are -- also have dry powder to continue to grow. Our leverage is about 1.5x. So we definitely have some opportunity there to continue the growth. And then finally, one of the things we're very proud of is our strong balance sheet and the ability to provide and generate free cash flow that allows us that capacity for growth. So that's all I have for prepared remarks. I don't know, Larry, if you want to do a little bit of Q&A here or just go to the breakout?

No, we have about 10 minutes, so we can do some Q&A in the room. Mike, let me start off because, obviously, this will come up throughout the day, which is the situation with coronavirus. Obviously, clearly, remains dynamic. But maybe you can remind investors about the exposure for STERIS from both a revenue and supply chain perspective, I guess, focusing in on the Asia Pacific area. So that's sort of the question, and then I have another one after that.

Yes, certainly. So for STERIS, our revenue base in -- well, China, particularly, even in Asia Pacific. It is not really material. It's not large for us. So we do not think that as of right now we would have any material impact from the coronavirus. Obviously, that's on a top line standpoint. Supply chain is the only concern that we would have. But for us, we have all the inventory we need to finish this fiscal year, so it would actually be into next fiscal year, depending on how long this issue lasts, we would more comment on that in May time frame. But for this fiscal year, I think, again, we would not -- we do not expect to see a material impact through the rest of this month to finish our fiscal year.

Okay. And then I guess, just following up on that. So is it fair to say that China is around 5% of revenue? Is it less?

Oh, it's less. It's probably low single digits, China itself. So what we do in China, we have a, I'll call it cherry picking strategy. We use dealers or distributors. We do not have feet on the ground for our own sales force. And we are targeting the Tier 1 or private hospitals in China, who want to look more like the U.S. So very nascent for us from a top line standpoint.

Okay. And just to finish up on this topic. If the virus sees an increasing spread into Europe and the U.S. and elective surgical procedures are curtailed, I would assume that the hospital sterilization business could see some impact. Maybe AST is a little bit more insulated and less companies start to reduce manufacturing. Is that fair?

Yes, I would say, I would agree with you. So I mean if you look at the largest part of our business, it's all about surgical procedures. So any time there is a slowdown in surgical procedures, obviously, we would potentially be at risk on that point. I would say that the AST business probably is a little more insulated, as with Life Sciences. Obviously, if there's vaccines or something of that nature for the virus and that could actually help us on the back end.

Okay, terrific. Switching gears, another topic that's come up a lot over the last 6 months or so has been the issues around ethylene oxide sterilization. Luckily, you guys have not had any issues. It's really been associated with competitors. But to the extent that emission standards tighten, let's call it, a 99.9% capture rate. It's my sense that in some states, you're already operating at levels close to that. But I guess the question is, if we go there, how big capital commitment would that have to be to get your facilities into that range? I guess the good news is, there is technology to get there. So that's not the problem.

No there definitely is technology to get there. And I would say you probably wouldn't even notice the additional capital CapEx that we would need to spend because we are in compliance or exceed compliance in most of our -- we have 9 facilities, 9 EO facilities in the United States. And we're not just looking at the United States either, we're looking across the globe. So if we're going to make changes and improve, we're going to improve across our network. And over time, again, you would not even notice, and we probably wouldn't even point out because we've already started that process and we're trying to get ahead of that. But we feel that we started out much further than some of our competitors have. So we believe we're in a much better position, obviously, for those of you who followed this issue, we are working closely with both the FDA and the EPA on this issue to make sure that capacity constraints are limited. We've talked about AST as growing 14%, 15% constant currency organic revenue growth, which is fantastic. About 200 basis points or so of that is due to this step-up of our capacity or using our capacity, fulfilling and using all of our capacity from some competitors that have been down. So we've actually had the ability to bring that capacity in, which is helping our growth. We believe that we can maintain that capacity over time. But one of the things we're very concerned about is any time you run your facilities at close to 100% there's very little downtime for maintenance and the like without interrupting customers. So that's something that we have to be very concerned about and we have to work closely with our customers.

Where Mike, if you were to fast forward over the next, let's call it, 10 years. Where do you think the industry ultimately goes? Is it ultimately going to be required to have an alternative to ethylene oxide gas? I mean ethylene oxide gas has a lot of incredibly positive characteristics to it when it comes down to sterilizing medical device products. But obviously, again, it's a known carcinogen. And so it's a tricky situation. But I guess, maybe speak to whether you think there will be alternatives that ultimately have to emerge?

Yes. So as I spoke earlier, we are working closely with the FDA, and the FDA has put out a challenge to companies like ours to say how can we replace ethylene oxide. Just to give you some perspective, over half of medical device products are sterilized with ethylene oxide. So it's very hard to replace that. So after several days, they actually called it, what is it? The challenge...

Innovation Challenge.

Innovation Challenge that the FDA. So one of the things we brought to the table, we already started this. It's not like it's new to us. We have something that we've tagline Sustainable EO. So our view was a couple of years ago even thinking forward to reduce the amount of ethylene oxide that is used for the kill of bugs in medical device products. What we typically -- what we are beginning to see is ethylene oxide gas is fairly inexpensive, and customers would use sometimes up to 2x the amount required to get the kill. They just were doing it more for belt-and-suspenders. And we said we challenged our customers, can we reduce that by half and we're actually working through that process. We believe that we can reduce the use of ethylene oxide by 50% in a 5-year period of time, and we're probably in year 2 of that. So we brought that to the table with the FDA and the FDA really liked that idea, and we're working with them right now on how to implement that, how to make it very easy for the customers to actually go and transition without having to file a brand-new 510(k) for less ethylene oxide, but we will prove that the kill happens, and we're looking for the FDA to give us that ability to work with our customers. But during that Innovation Challenge, one of the things that was discovered is that ethylene oxide, there is not a replacement to date, is going to take up to probably a decade to get there and transition all of those products to something else. So lots to come, but again, from our standpoint, we believe that from a safety standpoint, we want to not only protect our employees, not only protect the customers and the patients they serve, but also protect the communities that we have our facilities in.

Okay, very good. We just have about a minute left. Is there anything from the audience?

Do you do anything in veterinary industry or [indiscernible]

So the question is, do we do anything in the veterinary industry. We have a couple of small businesses within our Healthcare Specialty Services business that we actually target, especially on an instrument standpoint, so think of endoscopes. But it is -- it's not a focus of ours, by any means. Part of the problem is, unlike hospitals, there are a lot of vet places and to chase each one of those and knock on everybody's door it's very difficult. It's just, from our standpoint, nothing that we focused on over the last several years. So...

Okay, very good. We will conclude here. Management will be available downstairs in the Amarante 1 Room. Thank you, Mike.

Great. Thank you, everybody.