STERIS plc (STE) Earnings Call Transcript & Summary

Okay. Good morning, everyone. Thank you so much for being here. Patrick Wood. I run the U.S. Medtech team. I'm very excited to have Dan Carestio here, CEO of STERIS. Before we start, some disclaimers. There's usually a little a board here, so I'm going to ask about memory, morganstanley.com/researchdisclosures. Pretty sure that's the one. I'm sure you're all be going there. Or you can reach out to your Morgan Stanley sales rep either way. It should be good. Dan, thank you so much for joining us. I really appreciate it.

Maybe just to jump right into it, last quarter had some very strong capital equipment trends for you guys. Obviously, you came into it with quite a big backlog, but there's still quite a big backlog. Maybe you could just speak to sort of where you're seeing some of the strength, the type of demand, products, the durability, any comments around that?

I think we've been especially strong in sterile processing equipment, although we've done well on surgical lights and tables as well. A couple of things, Patrick, there's a lot of pent-up demand, a lot of maintenance CapEx that wasn't spent during the pandemic, a lot of healthcare systems that are now seeing a path back to profitability and positive cash flow, whereas a year ago today, they were hemorrhaging cash. So although we remain pretty strong even during sort of back end of the pandemic in terms of order rates and I think that's largely because of the equipment we sell is more of a utility that's procedural-driven or procedure enabling in terms of making sure you have to have capacity to sterilize and reprocess instruments. So the order rates remained high, and there seems to be pretty good durability to it. Now I say that, but I'll also tell you there's always cyclicality in capital equipment purchasing. There always has been in the 26 years I've been at STERIS. We've seen that trend. So it's not something I would bank on 5 years into the future necessarily. But I think with our portfolio, I think we've probably picked up a little share. And the outlook is pretty positive right now, and we've gotten a lot better in terms of supply chain easing in our ability to manufacture and ship, whereas a year ago today, we were really having some challenges on some critical supplies, especially electronics. That's largely not an issue anymore, and we're back to normal operations in terms of output.

Do you get a sense from the hospitals like how many projects are proportionately being like expansionary in nature, if you like, versus the maintenancy side? Like how is that ratio looking?

It's a higher percentage now than it historically has been on expansion. And I think part of that is because you see a lot of consolidation of hospital systems and movement of hospital systems. There's a definite trend to going out into the communities and sort of getting away from the huge acute care facility downtown and being more community-based care. So as a result, you're seeing smaller hospitals pop up. Other hospitals are obsolete, going away and movement going around. So I think that's fueled some of our growth on the capital side that we've seen.

The -- obviously, the trend towards ASCs and outpatient care has been something that's kind of been growing for a while. What are the differences for you in servicing that kind of a customer versus a large inpatient facility?

The big thing on equipment is footprint. They're challenged with space. And then the other big thing is utility. The utilities generally aren't as good. So our equipment has to accommodate the utilities in terms of water pressure and air and all that type of stuff. And then also simplifying the equipment, so it's easy to use because you have fewer staff, higher turnover. And so we have to do a lot more education with our clinicals to make sure that we keep them running. But other than that, it's important to have a different -- sort of a good, better, best price tier model of options for them. Certain ASCs have a lot of cash and are willing to buy the upper echelon of equipment. Others might want to buy a certified preowned equipment.

Do you notice the difference in terms of which surgeries that ASC is supporting, i.e., higher margin surgeries, I don't know for certain conditions, outpatient [ better ] pricing?

Yes. The ortho clinics tend to spend the most money, ortho and spine. That's where a lot of the money is and a lot of those procedures have moved out of acute care into ASCs. And they tend to build out the [ nicest ORs ].

Makes sense. And then there was also -- the medtech procedure volume has been very strong, certainly in the first half of the year. There was a little bit of destocking from your end in terms of -- it seems like supply chains have got better, so people are willing to run with lower inventory. Have we seen a sort of an end to that? How do you see that playing out for the rest of the year?

We talked about it in last quarter's earnings call. And my belief is that by third quarter, I think we'll see demand meet inventory. Everybody got bloated on inventory during the pandemic, ourselves included, basically as a cautionary effort to make sure we didn't have stock outs and things like that when there was uncertainty around supply chains. And now as we see our customers start -- they're starting to bleed that down. I think the crossover happens this fall because the procedure rates are up, and the volumes that we're seeing like through AST in Q1 didn't necessarily reflect that because of the destocking. Now having said that, I've seen this play before, and there's always a -- the inventories go down, there start to be issues, there's an overreaction on production, demand goes through the roof, and then it takes a while to modulate. So I think that we'll see that trend play out in the future.

So an unfair question because it's more of an industry-wide comment. But you guys get a good exposure and a good ability to see general procedure volume trends across kind of everything, more than a lot of other companies. So I guess, there's been some worries in the market overall within medtech as some of the procedure volumes might have slowed during the summer. I think it's tied, docs take longer holidays and stuff like that. There's always seasonality there, but more so than usual. Is there anything you could give any guidance in terms of what you guys have seen?

I would say in the U.S., we've seen consistent trends of procedure growth and very robust volumes and intake has improved so much in patient intake. In the early Q1, things like that, we still have seen struggling recovery in Europe. Asia Pacific started to show better improvement and is moving towards the path it's -- they're 6, 9 months behind us. There's a number of countries that just came out of COVID shutdowns last spring. So -- but -- so we're seeing improvement in APAC. But generally speaking, I don't see any summer seasonality necessarily. In Europe, you have the strikes that occur and all these issues with NHS and everything else. But I think that will modulate itself going into the fall.

Yes. I'm pretty glad I live in the U.S. now. The -- maybe you could remind some of the audience about the bioprocessing business, the kind of trends you're seeing there. We hear a lot from [ Sartorius ] and the others. Just kind of anything you're seeing that be curious.

Yes. So major destocking that happened last year, really Q4 started to happen in Q3, where their customers had overbought and they had overbuilt in anticipation of that continued demand and it slowed down significantly. Now what I would say is there's 1.5 decades trend of sterile single-use disposables that we've seen on a constant double-digit growth rate since it started showing up in the back of a station wagon 20 years ago, literally. Now it's a huge business. And I would expect it to resume that growth once it sort of resets. And we believe that will resume for us anyway, we'll see positive growth next fiscal year. It may cross over to positive in our fourth quarter, which is first calendar quarter.

And you recently did a reasonably sizable acquisition of the surgical instrumentation business from BDX. Just curious how you -- for the audience who are less familiar with that, how you feel that asset fits to STERIS? What was it that made it attractive for you?

Yes. A couple of things. So there are 2 primary products that are sort of durable stainless steel medical instruments used in surgery and sterilization containers. And almost 100% of what we process going through sterile processing departments is durable stainless steel instruments. So whether it's our sinks or our chemistries or ultrasonics and they have to go through our washers and our steam sterilizers or hydroperoxide sterilizers. And then all the associated products that goes into that process, that's all around processing stainless steel largely in the hospital. So for us -- and also our tracking systems that we track all the instruments through. So for us, it was a very logical step. And it also gives us an opportunity in the future to position the instruments with the front-end CapEx as opposed to waiting until 3 months before the hospital opens and then looking for instruments. And with all the data we have through processing and our ability to help customers, hospitals build more efficient steps and kits, we think we can drive some value there with our customers.

I know it's early days, always difficult to comment, but how are you feeling integration is going? Is it culturally and business-wise kind of what you thought it might be?

Yes, it is. It's going as we would expect. The culture seems good. They seem happy to be part of STERIS. It's a good fit for the [ newer ] assets. And we've got to set up as an own individual business unit within our Healthcare group, under procedural. And I think things are going quite well so far. It's been a month, but too early to say.

Yes. I guess the other sort of move in the industry is some of the EO regulation on that side of things and how that's going. Maybe for the audience who are less familiar, just a quick overview of what's happened there and how you view that sort of changing dynamics of the industry or not?

It will change. I would say -- it goes back for those who don't know 3 years ago, a competitor plant in Illinois was shut down basically by public opinion not by regulators. And it's become a real issue with EPA to redoing the rule for both application, which is the FIFRA and NESHAP, which is the sterilizer operating rule. And the challenge is that 50% of single-use sterile medical devices go through ethylene oxide. And many of those have 0 alternative in terms of how they're processed because they're either not heat stable or radiation stable or whatever it may be, which is most plastics. So having said that, there's going to be significant increased regulation. We fully expect that. We, at STERIS, have been working -- has made significant investments over our long history in our EO facilities to keep them at the highest level of technology. Going back 3 years ago, we deployed basically scrubbing equipment on all of our warehouses, which is going to be part of the rule, we believe, interestingly. And I think that we're happy to operate in highly regulated environments. We know how to do it. And I think that our technology team and engineering team in the AST group as it relates to ethylene oxide have got us very well positioned to meet whatever the requirements are when the rule comes out, which is anticipated to be first calendar quarter, probably March of next year.

Do you think the AST and that side of things, do you think a more complicated regulatory landscape might encourage some of the medtech businesses that haven't yet outsourced the sterilization step to partner up with STERIS given it's just more than you ask, quite frankly, for them to do it themselves?

Yes, it's not for the [indiscernible] checkbook, and there is regulatory risk involved in it, I mean to build an ethylene oxide facility of any scale at $60 million to $70 million. So I think we have the expertise. I think we're well positioned. We have a great history with quality and regulatory. And in addition to that, I think you'll also see med tech go upstream into R&D and look at their manufacturing and materials and determine whether or not this really needs to go to ethylene oxide. What currently happens today is, they engineer a product and it gets to the end point and then they come to us or they come to their engineers and say how do we sterilize this? But if you haven't made decisions way up in the process, you end up picking materials that aren't radiation stable and you're on the alternative of ethylene oxide. So I do think that you're going to see innovation in the design that's going to allow things to move into radiation over time or maybe also into hydrogen peroxide.

Do you have a work with any of the CMOs? Or are they just doing all their own stuff in-house?

We do work with the CMOs on the pharma side specifically. Absolutely, we do. And mostly with our GMP equipment and chemistries for Life Sciences, a lot of critical environment equipment for maintaining their clean rooms, VHP, hydrogen peroxide for their isolators for doing aseptic fill and all those different things. So we're heavily involved both in direct pharma as well as CMOs.

And then you obviously called out some of the excess cost inflation on that side of things. I think some of that from memory is catch-up of employees who didn't get paid super well. The prior year getting made whole, I guess. But how are you seeing the cost inflation environment maybe outside of labor because it's kind of sticky like the other?

We're starting to see improvement. A year ago, this summer, we were paying $70 for chips that we used to pay $3 for. I mean it was from some kid in the basement somewhere in Arizona, right? That has subsided. We have very good continuity of supply at reasonable prices for our electronics as have come back down. As we burn through that higher inventory, you're going to see that somewhat normalized. That will be somewhat offset with labor inflation. I would say, especially at the manufacturing area that it's been a local challenge depending on what market you're in, in terms of rates, and we've found that we've had to be both proactive and reactive in terms of make sure we have people coming into our factories every day to work and keeping them staffed has been a challenge, but we continue to manage that. In terms of materials, I think we're in pretty good shape in terms of what we anticipate from an inflation standpoint. And hopefully, they come down a bit more.

I know you've always been trying your best not to pass pricing on to your customers. But I suppose in some instances, like you said, $67 million to set up a plant and then you're integrated with that network, when needed under higher cost inflation environment, how do you feel about your ability to keep passing pricing through?

We have to. It's inevitable. It's a strike of balance type of thing. It's not something we necessarily do to try to increase or improve margin, but rather to maintain. And in an environment where labor is going up, pick a number, 15%, 20%, in some cases in the last 2.5, 3 years. It's just something that can't be avoided given the cost that the component of that cost being so critical to both services as well as manufacturing.

I mean the labor cost inflation side is obviously 2 components, right? You've got the actual cost inflation environment and therefore, labor is kind of looking to catch up. But there's also a supply component on labor itself. Have you -- like has that got a little less tight? Are you able to find the people you need? Or is it still pretty tough?

It's still pretty tough, but we offset that with culture and wage and also with -- we talked about this. We're a leading manufacturing operation, and we do everything we can to eliminate waste, make the jobs better for the employees as well as streamline them so we can do more with less labor, wherever possible. So our continuous improvement efforts, along with the culture and wage, I think, have helped us quite a bit in terms of making sure that we keep our labor where we need it to be.

I have to -- I don't think it has much impact, but I also have inevitable [ GLP-1 ] related question. And if you see it having an effect on the industry?

Yes, I don't know. What I would say is we are a beneficiary of any type of aseptically manufactured drug. Most of the equipment that we sell out of our Life Sciences group and the chemistries are used in those processes. I would say that -- but also I would tell you the GLP-1s are this much of total aseptic manufacturing in the world today. So I don't think it has a huge commercial drive in terms of STERIS. The other question that everybody inevitably ask us what's the long-term impact on Healthcare, given the impact that you've seen on bariatric surgeries and things like that. And the short answer is I don't know. I've heard everything from it's going to be enormously impactful to it's a drop in the bucket because there are so many other causes of disease that aren't necessarily obesity driven. So I'm not going to try to answer that question, specifically on the long-term impacts on Healthcare anyway.

No one has done a good job there anyway. So it's not possible. You actually have a decently sized endoscopy business. Now how are things going there? How do you see the competitive environment? How do you feel about that?

We went through the full integration over the last 2 years with Cantel's endoscopy business and our endoscopy business. It went really well. We've got 2 sister factories that we've really been able to leverage sort of centers of excellence for different manufacturing environments. The field consolidation went very well in terms of customers. We were challenged last year, a separate division, but highly associated with the endoscopic reprocessing business. And so just now as we've gotten through our manufacturing issues, we're able to really pull that effort together with devices and with AERs. And so we're really excited about that, and it's done really well for us in the last couple of quarters. So I would say, all in all, it's gone incredibly well. We've got a strong position in terms of the portfolio in the space. And there's some good competitors in the space, too, as you well know, as there is in many of the spaces we operate. But I think we're positioned to do incredibly well. And it's a good growth market anyways, in terms of [ GI ].

I know you're agnostic between them, its either AST or its Healthcare. But are you surprised in some ways to how slow some of the conversion to single-use has been? Or is that just -- that was too much hype?

I think it's too much hype. I mean the reality is, my personal opinion and our opinion is a company who has a $0.5 billion scope repair business as well is that for very small diameter, high brake fix scopes like ureteroscopes or cystoscopes or things like that, it can make sense if you get the cost point right on it, I think, in terms -- in my view, in terms of large diameter colonoscopes and things like that, it would take a technology leap to get those to where they could have a cost that was meaningful and also there's a sustainability challenge as well in terms of the amount of plastics and things should be thrown away after every single use of a 6.5-foot long, 7-foot long scope.

You've obviously got a bit of surgical instrumentation and then the endoscopy side, where you're kind of involved in the sterilization and the device in a way. Are there other areas that you've thought about where your -- that sort of marriage could make sense?

We're always looking, but we're also very committed to staying in our narrow fairway, I think, and it's something that has proved us -- it's been very good for STERIS for a very long time as it needs to either have a direct association with procedural [ NGI ] and/or sterilization, disinfection across different markets of Healthcare. And I say of Healthcare, I mean whether that's pharma, whether that's med tech, whether it's whatever. We're not -- we have not looked at, nor do we anticipate looking on taking that out of -- into other consumer or industrial markets, we just don't think that makes sense. Our focus is Healthcare.

Do you think that could be a more systematized way to get involved with hospital sterilization outside of the core areas, like in the broader facility? I'm just thinking about things like [ AMR ] and like the microbial resistance, all that sort of thing and some of the regulators changing payment rates for patients who end up with surgical infections and things like that. Is that a broader business there?

I think it's with surgical infections, it's seldom if ever from the instrument. It's usually from exposure in the OR suite or post-op wound treatment. So I don't necessarily -- I don't think so. I think what we can do is by having smart equipment and basically feeding the people doing the work and sterile processing, the instructions for use for the instrument they're holding electronically and doing everything we can to make sure they're processing from sync to sterilizer correctly and ensuring that compliance with an hourly worker that's getting paid $22 an hour, keep in mind, making sure they have full compliance on that to ensure that the instruments are safe and sterile every time and making that process easier for our customers.

Maybe could you speak to the competitive environment overall? One of your peers arguably might be a little distracted with some issues they've got. I don't know if you see any impact from that?

I don't really ever address our competitive position. We just continue to try to improve our position in our portfolio. And what I would say is across our businesses, in particular, in our Healthcare SPD. I think it's really tough to beat STERIS right now with the portfolio of products that we have. I also think AST is in a really strong position with our global footprint. And with all the investments we've made in X-ray technology that have started to come online and will come online over the next couple of years, I think we're in a really good spot to continue to grow at market plus maybe a little bit above our weight in terms of share.

And for those who are maybe less familiar with the sort of growth [indiscernible] further growth algorithm, essentially like midterm, maybe you could paint the expectations for the kind of consistent growth that you feel STERIS could do?

I mean our long-term stated objectives have always been 7 and 11, 7 on top, 11 on the bottom. And that's something that we feel that we can consistently deliver on. You may have a year where that gets out of cycle here or there because of inflation or whatever or may be higher than that because of acquisitions. But over the long haul, that's been our mantra, and we believe that's something we've done consistently and we'll continue to do as a company.

I guess you've got 4 sort of main stores for the business. And some of, I guess, the investment is customer-led, as much as they approach you in some ways. But presumably at the start of the year, you're also sat down thinking like where are we going to spend a disproportionate amount or our time and money. How does that process work internally?

Yes. So we have what we call our Senior Executive Board, which is top 6 executives, including myself. And so those proposals come to our Board, our internal Board. And we discuss them. And if the risk and the internal rate of return balance is right, we'll make those investments. Fortunately, for the last few years, we haven't had to push a lot of them back if they were good investments because our cash flow is good and our outlook for cash long term is very good. And in the absence of any major acquisitions, there are a number of things we can do to grow our business internally, whether that's AST expansions or building outsource for processing centers for hospitals or whether that's investment in our R&D and new product development or a number of other things that we do. But that's how this is going forward, and we manage that CapEx.

You obviously have a global presence, but you're a little more U.S. weighted maybe than some of the customers that you serve. Is there any opportunity to maybe bulk up on the U.S. side of the business?

Yes. One of our biggest opportunities, I think, is Healthcare Europe. And before when it was key in Cantel and STERIS as separate companies, nobody really had the breadth of the portfolio. They were good at their little areas. But now we've got a lot more scale in terms of channel that we can be a lot more efficient as well as manufacturing operations in Europe as well as a much better portfolio, most importantly, from a customer perspective. So we've made good progress. Europe has been slow to recover in terms of procedures, as everybody knows. But I think that it's been a -- it's been positive for us, but I think there's a lot more runway to improve over there.

And that's obviously engaging a lot of times with sort of the large National Health Services, not just in the U.K. then in Germany and France, things like that. Would you envisage that looking at sort of they try out a couple of contracts to see how it goes and then you scale from there? Is that how you would see that looking?

I think we'll probably go in with product penetration first, where we have strength, where we have real strength, so hydrogen peroxide, peracetic acid, endoscopic sterilization, those type of things and then pull in steam and washing with that afterwards.

And then one area that we obviously don't end up talk about as much as Dental. So I'm just curious how you feel about that as an end market? I know it's kind of a cash cow for you guys.

It is a cash cow. It's a slower growth market, and it's been slow to recover post-pandemic and still has had challenges in terms of just volume. Now what we have seen is good improvement in terms of overall margin of the business despite the volumes being down and a lot of that is because of the continuous improvement in lean work that we've worked with, with our dental folks. So I think as the volume comes back, they're going to be well positioned to do a little better on margin. But it's not a 10% grower. It doesn't make it a bad business. It's a great business, but it's not going to -- it's not at the same high level growth that we've seen in the other businesses with STERIS.

Is that something that you would want to keep it in the group or something that if it became too much of a distraction, you consider selling?

It's a workable asset right now, and I think it's a wait and see in terms of what the market does long term with Dental.

And it feels like you probably have all the puzzle pieces in terms of your core market from Healthcare, AST and the Life Sciences side. But are there any other like jigsaw pieces you feel that you might be able to add on?

I don't think so right now. I think what -- within Healthcare, we have a procedural group where we have our GI devices, and we have a number of other sort of safety devices that are used in the OR. There is an opportunity to build that out further over time. But right now, our core focus is really operating the business as we have it today and focus.

And most of the medtech companies you've spoken to and you have seen it obviously so far this year backlog come through in a bit of a bolus of procedures. But actually, most seem to still think that next year is going to be a kind of normal year. You're not going to get a difficult comp effect or something like that. How do you feel about that?

I think there's more backlog that's going to -- I mean -- and it depends on where you are. Europe, there's a couple of years of backlog. Now some of that's just not going to happen. But orthopedics and things like that, there's a lot of backlog. In terms of U.S., I think it's going to be quite a while before it clears out, at least a year, in terms of -- because they just started -- really the big healthcare systems just started getting positive intake of patients over the spring. And so for those who matriculate towards ultimately having a procedure or being treated for a long-term disease, it's going to take some time. So I think that bolus may last a little longer than people anticipate. And as I speak to hospital system CEOs, that sort of resonates.

And the capital equipment strength we saw at the start of the year, and we'll see how long that goes for, of course. But the -- how should we think about the real money in some ways the chemistry isn't because that does a follow-on? How do we think about that impact later?

Well, yes, we're placing a lot of washers and a lot of AERs and those do push a lot of chemistries. And most of that's proprietary chemistries, in fact, regulated under 510(k). So assuming the procedure rates stay up, and those -- we win on the procedural volume in terms of chemistries, which is generally higher margin products for us.

Is that like one of the key sort of internal KPIs you look at, is like the installed base shifting forward? Is that...

It is. It's something we look at all time. And if you look back at our history, it wasn't that long ago, 15, 12 years ago, we were 80% capital equipment company and 20% reoccurring, and now we're 80% reoccurring, 20% capital. And we've grown our capital business significantly. It's just we've made significant effort and focus on the consumables and chemistries and devices as well.

Obviously, you do plan at these meetings, you have a lot of calls with investors and stuff like that, but then you have your actual job internally. And where do you find like disconnect is too strong a word, but there'll be stuff internally, it takes up an enormous amount of your time, but no one asks about externally or vice versa, things people are asking a lot about externally. It's not really a debate internally. Can you think of the topics in that area?

Yes. Maybe not really. I'll give you some -- maybe a couple of interesting facts on STERIS, if that helps, because there's not a lot that you guys are pretty perceptive that we don't get asked about, to be honest with you. But I would tell you this, if you look at the 4 business units of STERIS as well as myself, as well as our CFO as well as our [ GC ], we're all 20-plus years with the company, which is not the norm in a lot of industry. The other thing I'd tell you is we've had 4 CEOs at STERIS and 50% of them have had Zoology degrees.

I'm just trying to think how I'm going to fit that into the note. Dan, thank you so much. Perfect, on time as well. Thank you.

Thanks for the opportunity.