STERIS Q2 2022 Earnings Call Transcript

Participants

Corporate Executives

• Julie Winter, Vice President of Investor Relations & Corporate Communications
• Michael J. Tokich, Senior Vice President & Chief Finance Officer
• Daniel A. Carestio, President, Chief Executive Officer & Director

Analysts

• Matthew Mishan, KeyBanc
• Dave Turkaly, JMP Securities
• Chris Cooley, Stephens
• Mike Matson, Needham & Co.
• Michael Polark, Robert W. Baird

Presentation

[Operator]

Good morning, and welcome to the STERIS plc Second Quarter 2022 Conference Call. [Operator Instructions]

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

[Julie Winter, Vice President of Investor Relations & Corporate Communications at STERIS]

Thank you, Grant, and good morning, everyone. As usual, speaking on today's call will be Mike Tokich, our Senior Vice President and CFO; as well as Dan Carestio, our President and CEO. I do have 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 expressed written consent of STERIS is strictly prohibited. Some of the statements made during this review are or may be considered forward-looking statements. Many important factors could cause actual results to differ materially from those in the forward-looking statements, including, without limitation, those risk factors described in STERIS' securities filings.

The company does not undertake to update or revise any forward-looking statements as a result of new information or future events or developments. 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 as well as 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 J. Tokich, Senior Vice President & Chief Finance Officer at STERIS]

Thank you, Julie, and good morning, everyone. It is once again my pleasure to be with you this morning to review the highlights of our second quarter performance. For the quarter, constant currency organic revenue increased 12%, with growth across all segments. Growth was driven by organic volume as well as 130 basis points of price. Acquisitions total added $346 million to revenue in the second quarter, which is broken down by segment in the press release tables. To assist you with your modeling, I will share some color on the acquisition revenue contribution within the Healthcare segment. Of the approximately $220 million in acquired revenue, about 65% is consumable revenue from both Key and Cantel Medical, about 20% of the balance is capital equipment revenue, with the last 15% being service revenue. We will not be breaking that down any further as it is already difficult to differentiate some product lines as we are integrating the businesses quickly, and that challenge will only increase with each passing quarter.

Gross margin for the quarter increased 120 basis points compared to the prior year to 46.2%, as favorable productivity, pricing and acquisitions were somewhat offset by higher material and labor costs. Combined, material and labor costs were about $10 million in the quarter, significantly higher than we were expecting. As we look at the second half of the fiscal year, we anticipate that higher material labor costs will continue to impact gross margin by approximately $20 million or more. EBIT margin for the quarter was 23.3% of revenue, an increase of 80 basis points from the second quarter of last year. As anticipated, we are starting to see some 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 22%, higher than last year, but in line with our expectations for the full fiscal year.

Net income in the quarter increased to $200.3 million and earnings per share were $1.99. Our balance sheet continues to be a source of strength for the company. Our leverage ratio at the end of the second quarter is now below 2.8 times. As a reminder, we cash settled all of Cantel's convertible notes during the second quarter. The total cash settlement value was approximately $371.4 million. At the end of the quarter, cash totaled $383.5 million. During the first half, capital expenditures totaled $133.4 million, while depreciation and amortization was $201.7 million, reflecting recent acquisitions. Free cash flow for the first half was $135.8 million. As anticipated, this is a decline from last year due to costs associated with the acquisition and integration of Cantel Medical and slightly higher capital spending year-over-year. With that, I will now turn the call over to Dan for his remarks.

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Thanks, Mike, and thanks again to everyone for taking the time to join us today. Our fiscal 2022 is shaping up to be another record year for STERIS. Our first half turned out to be stronger than we anticipated, with constant currency organic growth across the business. In particular, growth in our AST segment remained strong, with 23% constant currency organic growth year-to-date despite some tough comparisons in the second quarter of last year. Healthcare has also rebounded nicely, with 17% constant currency organic growth in the first half and record backlog of $311 million at the end of the quarter for the legacy STERIS products. Life Sciences consumables have stabilized, contributing 3% constant currency organic growth in the first half. And our capital equipment business backlog has grown to a record $98 million. Lastly, our newest segment, Dental, reported 10% growth for the quarter, in line with our expectations. Underlying our performance, procedure volumes in the U.S. have held steady as hospitals have learned how to manage through the pandemic.

While we continue to see pockets of the world that are more limited in procedure volume due to COVID outbreaks, overall, we believe procedure volume is moving closer to pre-pandemic levels. We are cautiously optimistic about the coming months as COVID cases appear to have peaked and are now once again receding. Despite the more difficult comparisons, we expect revenue to stay strong in our second half as we continue to benefit from these trends. We also continued to make progress on the integration of Cantel in the quarter. The majority of our staffing changes have been made, aligning STERIS to better serve customers, positioning us for growth going forward and contributing to cost synergies. We are also making swift progress implementing Lean, and we are very pleased with how receptive our new colleagues are to our passion for continuous improvement. All said, we would expect to exceed our synergy cost targets for the year and also in total.

Looking at the full year, while we are increasingly confident in our ability to achieve our improved outlook provided last quarter, we are not increasing guidance further at this time. While we overachieved earnings in the second quarter, we have a few offsets that will likely impact the back half of the year. On the revenue side, our comparisons do get a bit more challenging. And we do expect some headwinds from FX, in particular, from the euro and the pound. In addition, while our teams have done outstanding work to mitigate the supply chain challenges so far this year, it is difficult to predict the unknown implications the current environment may have on the second half of the fiscal year. All said, we are pleased with where we stand today and the underlying strength of our diversified business, and remain optimistic that if it were not for supply chain and inflation uncertainties, we would be at the high end or above our adjusted EPS guidance range for the full year. We look forward to continuing to update all of you on our progress. Thank you. And I will now turn the call back over to Julie to open up for Q&A. Julie?

[Julie Winter, Vice President of Investor Relations & Corporate Communications at STERIS]

Thank you, Mike and Dan, for your comments. Grant, would you please give the instructions and we can get started on Q&A?

Questions and Answers

[Operator]

[Operator Instructions] Our first question comes from Matthew Mishan with KeyBanc.

[Matthew Mishan, Analyst at KeyBanc]

Good morning. Congrats on a nice quarter in a difficult environment. Dan, I just want to clarify the supply chain comments. First, are you seeing supply chain issues right now that are impacting your ability to deliver on product? And kind of -- and I'm -- and I guess what I'm asking is, as you go out to your third and your fourth quarter, where are you potentially looking at having supply chain constraints? Does it impacts you potentially with your backlog and capital equipment and being able to deliver in 3Q and 4Q?

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Yes. Sure, Matt. So what I would say is, to date, other than the cost escalation of many of our precursor materials, we've been able to navigate the supply side of it and make sure that we have been able to keep up and meet customer demand. And we had a little bit of excess sort of precursor inventories coming into the year as well as some safety. In the current environment, with the uncertainty around delivery time of these materials, it may -- it could potentially result in sort of extended lead times for deliveries. We don't see a scenario where stock out would happen or anything like that. But the ability to deliver on what now is over $400 million in backlog in the next six months just from a -- if we miss production slots, it's going to be hard to get them back if we miss them because of supply shortages. So I believe our teams will continue to do the outstanding work that we've been doing thus far, but there are challenges.

[Matthew Mishan, Analyst at KeyBanc]

Understood. And then switching over to AST, where your growth is still -- has been exceptional. I typically view this business as more tied to medical devices. But I guess, how should we think about biopharma now as a percentage of sales and opportunities moving forward? I'm just trying to understand like the total bioprocess opportunity and where we are with it.

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Yes. It is a high-growth area for that business. Currently, it's not a significant portion of the total business. And the vast majority of what we do, say, over 80%, is what I would categorize as sort of traditional medical type product. But nonetheless, it's growing very fast. And we have a very good position with the companies and our customers that are accelerating growth and making a lot of investment for their capacity.

[Matthew Mishan, Analyst at KeyBanc]

Okay. And just lastly, on the raw material inflation with the impacting, I just want to clarify that you expect $20 million or more and then -- in the back half. So that's in the next two quarters. And whether or not you're seeing some of those costs kind of peak out and start to decline, where that would be sort of a worst case scenario for you at this point.

[Michael J. Tokich, Senior Vice President & Chief Finance Officer at STERIS]

Yes, Matt. So we experienced about $5 million of material labor costs in Q1. That doubled in Q2. And what we anticipate for the second half is $20 million or more for that combined third and fourth quarter. How that lays out by quarter? It's anyone's guess at this point in time. You read a lot in the papers about supply chain is potentially alleviating. Although we have not seen that yet, obviously, it's impacting us more than we had just thought one quarter ago when we revised guidance. So we wanted to make sure that we -- you guys understood exactly what we're anticipating to be the impact as we move forward for the rest of the fiscal year.

[Operator]

Our next question comes from Dave Turkaly with JMP Securities.

[Dave Turkaly, Analyst at JMP Securities]

Hi, good morning. That material and labor, the $10 million, is that split pretty evenly? And I guess the question I'd like to hit as well is, if it's $10 million in the next two quarters, I mean, you beat discrete significantly this quarter. So I'm just curious as to why we might not see that happen again maybe even along with the synergy comment you made looking at the back half of the year.

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Yes, Dave, the split is more like 60% materials, 40% labor, just to give you an understanding of that breakdown of $10 million. And I think, Dave, from our standpoint, there is just so much uncertainty surrounding the potential impact. Maybe we're being a little bit conservative at this point. But again, it's the best guess that we have as to the potential impact. And again, it's -- for two quarters in, we have been surprised in the amount that we've been impacted negatively on the gross margin side for both materials and labor.

[Michael J. Tokich, Senior Vice President & Chief Finance Officer at STERIS]

Yes. And I would just add, Mike, to that. I think we have a fairly decent idea clearly of what's going to happen relative to materials and labor cost escalation going into the third quarter. I don't know that we can say that with a high degree of confidence when we talk about fourth quarter. So if we were a quarter out of fiscal year, I think we might have a different position here.

[Dave Turkaly, Analyst at JMP Securities]

Got it. And then you mentioned exceeding the cost synergy, I'd love you to put a parameter around that. I don't know if there's a percent or any kind of number you could give. But -- and also, have you identified -- are there any revenue synergies, because I think we hadn't spoken about those in the past?

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Yes. I would say that we're very confident on exceeding the $25 million target. Much of that is what we would say is in the bag because a lot of it has to do with executive compensation and public company costs and a number of things that are already in the run rate. We still have some things to go get between now and the end of the year. And as we do that, we'll get more and more confident on what the actual number will be. But we do know that it's going to be north of the $25 million.

[Operator]

Our next question comes from Chris Cooley with Stephens.

[Chris Cooley, Analyst at Stephens]

Congrats on another solid quarter. Maybe just two quick ones for me. I was hoping you could address profitability and maybe the composition of the backlog. And specifically, when you look at operating profitability, you're hitting record levels, both at AST and also at Life Sciences. Looking back through my model, I can't find it when it's been like this before. So I guess in addition to the growth, I'd like to better understand what's enabling you to reach these incredibly high levels of operating profitability? And how sustainable they are when I think about both the AST and the Life Science segments? Is that revenue mix specific? Is that something that structurally that's changed? I just want to better understand that. And then I'll follow back up on my backlog question.

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

I'll hit on the AST and I'll ask Mike to cover some of the Life Sciences because there's a little more detail there. I think in terms of AST, we still haven't seen opex has come back -- opex come back to where it was pre-COVID. And we planned it to be back sooner than later. The other thing I would say is that we have a number of facilities that are operating at extremely high utilization levels right now. And the nature of the business is such that there's a very high fixed cost on each one of these individual plants. And the difference of running at 80% utilization versus 97% or something like that has got major implications on the drop-through profitability of the operations. So as we've talked about a number of times, we're in the process of building out a number of expansions in that business. And then as those come online, we're not going to see any significant drop in profitability percentages. But we do believe going forward, it will stabilize in the ranges of where it is today.

[Michael J. Tokich, Senior Vice President & Chief Finance Officer at STERIS]

And then, Chris, on the Life Sciences side, echoing Dan's comment regarding the operating expenses. Same in Life Sciences, we anticipated higher operating expenses throughout the year. And obviously, the COVID impact has slowed some of that, the travel and marketing and sales expenses, although we are starting to see those come back, but that is one factor that is definitely adding to the increased operating profit. And the other one, you alluded to already, Chris, is mixed. We continue to see very good growth out of the consumables business. And with the addition of Cantel, the consumables business, although it was only up 1% organically, it is up almost 11% if you include the Cantel acquisition. So we are seeing, as I think you understand, consumables are higher margins -- tend to be higher margins for us. So that is also helping drive the improved profitability margin.

[Chris Cooley, Analyst at Stephens]

Super. That really helps. And then just on the backlog. When I look at in total or just core STERIS record backlog that you're seeing there, both in Healthcare as well as in the Life Science sector, could you split out for us just kind of the composition of that backlog in terms of new build, etc? When we think about the Healthcare piece. And on the Life Science side, I continued to be on the wrong side of this equation, but it just remains extremely strong. And I'm trying to grapple a little bit with where you're seeing the greatest level of demand right now and how we should think about that going forward? Is this kind of again a mid-single-digit or low double-digit type capital growth when we think about the Life Science component going forward over the next kind of 12 to 24 months?

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Sure. This is Dan. What I would say on the Healthcare backlog, it's really strong across all product segments at this point, whether that's surgical or IPT. And then in terms of project versus sort of short-term work, a year ago, we were almost exclusively long-term projects and builds and things like that. And we've seen a significant recovery in the replacement business in the last six, seven months, I would say, to where it's kind of back to pre-COVID levels in terms of replacement type spending. So we've got a -- our backlog still not maybe what it would have looked like proportionately two years ago before the pandemic. But the last sort of six months or so of order intake definitely is. In terms of the Life Science capital, there's a lot of money being spent expanding production in terms of biologics, vaccines and gene therapies, all these different type of applications that require aseptic manufacturing environments.

And as we've discussed before, that's really STERIS' sweet spot. We tend to benefit on the consumables side of that. We tend to benefit in AST, on the disposable side going into those manufacturing environments. And then we also tend to benefit on the capital equipment side for GMP type equipment for sterilization into those type environments as well. The other thing I would mention is, we have seen since the beginning of our fiscal year recovery in sort of research type spending, which was really slow during the pandemic. Much of that is state or federal funded public institutional spending, and that dried up pretty bad last year. And we have seen our replacement business and -- what we would categorize more as lab or research come back, at least on an order input, to what it would look like pre -- close to what it would look like pre-pandemic.

[Operator]

Our next question comes from Mike Matson with Needham & Co.

[Mike Matson, Analyst at Needham & Co.]

Good morning. Thanks for taking my question. I guess I'll start with the Dental business. I heard the 10% growth. So that's good to hear. But maybe talk about what you're seeing in that business. I think prior -- when Cantel was still separate, they were talking about seeing kind of increased demand for infection prevention products because of the pandemic. Is that sustainable? And I think Cantel talked about this being sort of a high single-digit growth business over time. Do you kind of agree with that?

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

I think it's early days for us at this point to put out any long-term projections on Dental. Frankly, we're still learning the business. We like the performance sort of year-to-date anyways with STERIS. And we do believe the team over there is doing a really nice job managing the business and also sort of the recovery coming out of the pandemic. So at this point, we do believe there's connection in terms of the infection control value piece. To be able to quantify that to you at this time, I just don't think we're in a position to do that yet.

[Mike Matson, Analyst at Needham & Co.]

Okay. No, that's fine. And then you're one of a handful of med tech companies that has positive pricing. So is there any ability to maybe raise the prices a little more to offset some of the inflationary pressures or even like freight surcharges or anything like that?

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Yes. I mean what I would say is we're not a pure-play med tech. I mean, if you think about it, we've got an awful lot of business that deals with medical manufacturing and also pharmaceutical manufacturing, and now actually dental as well. So -- and those have a little different structure around what can and can't be done in terms of past cost throughs. What we've consistently done historically at STERIS is tried to pass through enough to basically cover as much of inflation as we can where reasonable and where the customers will accept it. And then we try to get the rest out of productivity gains within our manufacturing environment, which we've been pretty successful at over the years as well.

[Mike Matson, Analyst at Needham & Co.]

Okay. And if I could just squeeze one more in on hospital capital spending. So we've seen very -- it seems to be very strong capital spending in '21. Much better than I would have expected. What are you hearing about calendar '22? Does it look like that it's going to continue to be strong into '22 as well?

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

I do not see a changing in the foreseeable future based on what we've seen consistently in terms of order intake and also new projects that are still out there for opportunities for STERIS going forward.

[Operator]

[Operator Instructions] Our next question comes from Michael Polark with Baird.

[Michael Polark, Analyst at Robert W. Baird]

Hi, good morning. I want to go back to Mike's comments on these material and labor costs. And I'm trying to understand what had previously been considered in guidance and what is incremental today that's limiting the guidance update. So I heard $5 million in the first quarter, $10 million in the second quarter. You raised the earnings guidance after the first quarter. Presumably, that raise included the $5 million in the quarter and probably considered the number for 2Q. Is that fair? And what of that amount is incremental in the forecast today? Is it the full $20 million for 2H? Or is it a portion of that? And because you had a placeholder in for -- so any color here on those numbers and how they relate to the progression of the forecast would be helpful.

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Yes, certainly, Mike. So as you're right, we did incur $5 million in Q1. And when we did increase guidance, we anticipated an additional $10 million for the remaining three quarters. We incurred $10 million in Q2. So the $20 million plus is all incremental to our revised outlook at this point in time, which is one of the reasons why we're holding our outlook steady compared to where we raised last quarter and also compared to how we exceeded the second quarter results. So hopefully, that math ties out and makes sense to you.

[Mike Matson, Analyst at Needham & Co.]

Yes. That's very helpful. And just to put a final fine point on it. Back to the $5 million in the progression and the build of these numbers. This is all incremental to the initial outlook that you put out before the fiscal year, correct?

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

That is correct, Mike.

[Michael Polark, Analyst at Robert W. Baird]

Yes. Okay. Just more broadly, on supply chain. Dan, you mentioned -- what are the raw materials that matter for STERIS most? And is this stuff for your consumables business, for your equipment production, both? Just curious for a bit more detailed color on what's -- what are the major items that you're watching and which businesses are potentially most impacted.

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

I mean it's -- our concerns are across equipment and also consumables, especially on the chemistry side. And that's the one that we're really watching, to make sure that we always have adequate amount of precursor chemistry to continue to make our finished products. In terms of the other applications, whether it's components that go into manufacturing and capital equipment, whether it's electronics or steel or framing or whatever, that's more of cost management at this point as opposed to timing because we are seeing cost escalation there. But it's -- trust me, there are issues across every aspect of manufacturing environments right now in light of delivery times and just general availability and things of that nature.

[Michael Polark, Analyst at Robert W. Baird]

If I can sneak one more in. I would appreciate an update on EPA's progress on these potentially updated ethylene oxide emission standards. Where we are in that rule-making cycle? What milestones may be ahead here in the next three to 12 months or at least your latest expectation on that? And then, specifically, there was an update of -- I'm losing track of time, two to three weeks ago. EPA, believe, sent letters to close to 30 EO facilities in the U.S., asking for those facilities to report emissions data starting in '23. Historically, this was voluntary. STERIS had some facilities on that list. So I'd also be specifically curious for your feedback to that development.

[Daniel A. Carestio, President, Chief Executive Officer & Director at STERIS]

Yes. Sure. This is Dan. So what I would say is, I mean we are in close communication with the EPA on this issue. And we always fulfill any request that they have from a regulatory perspective. So we're working with them to make sure they have the appropriate data from STERIS. In addition, we're optimistic that we do see some sort of a proposed role sometime in the first calendar quarter. We had originally -- I personally had originally hoped for early January. That's TBD. But hopefully, we'll see something sooner than later out of the agency that gets us to a final path. And in the interim, we've made some significant investments ahead of any regulation in anticipation of any change, where our facilities are -- now are down to just tying off a few minor things in terms of what we think are enhanced improvements ahead of any regulatory NESHAP rule that might change the requirements to operate.

[Operator]

Ladies and gentlemen, this will conclude our question-and-answer session. I'd like to turn the conference back over to Julie Winter, Investor Relations for any closing remarks.

[Julie Winter, Vice President of Investor Relations & Corporate Communications at STERIS]

Just wanted to take a sec to thank everybody for joining us. I know it's a busy earnings season time. And we look forward to catching up with many of you off-line.

[Operator]

[Operator Closing Remarks]