Earnings Call Transcript - STE Q2 2020

Operator, Operator

Good morning, and welcome to the Steris plc Second Quarter 2020 Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I’d now like to turn the conference over to Julie Winter, Investor Relations. Please go ahead, ma'am.

Julie Winter, Investor Relations

Thank you, Keith, and good morning, everyone. As usual, on today’s call, we have Walt Rosebrough, our President and CEO; and Mike Tokich, our Senior Vice President and CFO. 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, segment operating income, constant-currency organic revenue growth, and free cash flow, will be used. Additional information regarding these measures, including definitions, is available in today’s release, including reconciliations between GAAP and non-GAAP financial measures. Non-GAAP financial measures are presented during this call with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. With those cautions, I will hand the call over to Mike.

Mike Tokich, CFO

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 growth was 10% driven by volume and 90 basis points of price. We continue to experience strong underlying growth from our customers and success with new products. Gross margin for the quarter increased 150 basis points to 43.6% and was impacted favorably by productivity, price, and currency, somewhat offset by higher labor costs. EBIT margin for the quarter was 20.3% of revenue, an increase of 150 basis points from the second quarter last year. The adjusted effective tax rate in the quarter was 19.1%, somewhat lower than we had anticipated due to favorable discrete items, primarily the benefit of stock compensation expenses. Net income in the quarter grew 21% to $113.1 million and earnings increased to $1.32 per diluted share, benefiting from revenue growth, margin expansion, and a lower effective tax rate. In terms of the balance sheet, we ended September with $225.5 million of cash and $1.2 billion in total debt. During the second quarter, capital expenditures totaled $48.4 million, while depreciation and amortization was $49.6 million. Free cash flow for the first six months declined slightly as anticipated to $162 million due to the planned increase in capital spending. However, we have not invested as much capital as we thought in the first half of the fiscal year, simply due to the timing of projects. As a result, we are decreasing our full-year expectations for capital spending by $20 million to $260 million, and increasing our free cash flow expectations to $320 million. With that, I will turn the call over to Walt for his remarks.

Walt Rosebrough, CEO

Thanks, Mike, and good morning, everyone. As you’ve already heard from Mike, our second quarter continued the trend of outperformance that began in our last fiscal year, with growth meeting or exceeding our expectations in all four segments. The additional volume, higher margin attainment, and a lower effective tax rate combined to drive earnings above our expectations for the quarter. Based on our performance in the first half and our expectations for the rest of the fiscal year, we are once again updating our full-year outlook. Starting with revenue, we now expect constant currency organic revenue growth of 7.5% to 8.5% for fiscal 2020, up 150 basis points from our prior range of 6% to 7%. The increase is due to the outperformance of the underlying business as well as the impact of several small tuck-in acquisitions that we have completed, primarily in healthcare products. While none of the transactions are material on a standalone basis, when combined we expect they will add about $30 million, or 100 basis points to our constant currency organic revenue growth for the full fiscal year. For your modeling purposes, second quarter revenue benefited by about $5 million from these tuck-in acquisitions, with the balance to be spread across the second half of the fiscal year. As a reminder, our fourth quarter has challenging comparisons, which gives us some caution on the growth rate for the second half of the fiscal year. Healthcare Products and AST are the two segments principally driving this increased organic revenue growth. Healthcare Products are seeing improved demand across the segment with steady growth in consumables, improved performance from service, and ongoing strength in capital equipment. AST is delivering strong growth as increased demand from our core medical device customers continues, and the capacity expansions that have come online in the past year or so have allowed us to meet that demand. As you may have read, several ethylene oxide facilities operated by others in the industry have been closed temporarily or permanently due to concerns around the emissions of ethylene oxide gas. The safe and efficient use of ethylene oxide sterilization is required to meet the global need for critical life-saving and life-changing medical devices for patients. For context, approximately 50% of single-use medical devices around the globe that require sterilization are sterilized using ethylene oxide. These devices include items as simple as adhesive bandages and as complex as pacemakers and surgical kits. Through the second quarter of fiscal 2020, we have picked up a modest amount of volume from customers who have been impacted by the closures. However, our U.S. ethylene oxide plants are running full, which will limit our ability to take on significant additional capacity in the second half. Given the strength we’ve seen so far this year across our business segments and the pipeline of business we see for the back half, we now anticipate adjusted earnings per diluted share to be in the range of $5.50 to $5.65, up $0.12 from last quarter’s outlook. The acquisitions discussed earlier are expected to add approximately $0.05 to our outlook in the second half, with the remainder coming from outperformance of the underlying business. The upper end of our earnings outlook range assumes no impact from the medical device excise tax in our fiscal fourth quarter, which is the calendar first quarter. Although we believe the device tax will be delayed or repealed around the first of the calendar year, the lower end of our range should absorb this possible uncertainty, if it is not. We’ve had a strong first half of the year and continue to expect another year of record performance in fiscal 2020. We believe the short-term and long-term future for Steris is bright. We appreciate your ongoing support and appreciate the work of the 12,000 people of Steris, who are making that happen. We’re happy to take any questions you may have for the balance of the meeting. Julie, please open the call for Q&A.

Julie Winter, Investor Relations

Thank you, Mike and Walt for your comments. Keith, would you please give the instructions and we’ll get started on Q&A.

Operator, Operator

Yes, certainly. We will now begin the question-and-answer session. The first question today comes from Dave Turkaly from JMP Securities.

Dave Turkaly, Analyst

Good morning. Walt, thanks for the color on the EO side. I was curious if you might refresh our memory in terms of how many of those plants you guys have. And then when you look at the issues, because I’m sure you’re closer to it than certainly we are. Is it fear out there that’s going to drive the sentiment? Or was there an actual problem that you think you can address? Just I guess, any color on how you stay clear of any of the things that have happened?

Walt Rosebrough, CEO

Yes. Good morning, Dave. First, to answer your question, we have about nine facilities in the U.S. that sterilize using ethylene oxide and about double that worldwide, which makes sense, because this is used globally. For all intents and purposes, it’s the only gas used for this purpose around the world. In response to your second question, I do think this is more around fear than around science. There are conversations going on that, scientifically, don’t make a lot of sense. One of the things that has happened in this process is that we are absolutely adamant about running safe facilities, as safety is the strongest virtue inside of Steris. When we talk about safety, we think about the people that work with us and for us, and also about the community that we live in. So we are absolutely committed to safety. We know that we are at the better end of the industry in terms of how we deploy everything about our facilities, not just how we handle gas. Because we do it so much, we can look across plants and search for best practices across those facilities. We believe we are at the positive end of the spectrum. As we understand it, roughly 100 plants around the country are doing this work, so I’m sure there’s a full spectrum of activity. Most of the conversation has not been handled scientifically. I applaud both the FDA and EPA for working hard to manage this effort and to handle things scientifically.

Dave Turkaly, Analyst

Great, thank you for that. I apologize, I’ve asked you this a number of times, but I’m still trying to get my finger on the pulse of what is happening in terms of surgical procedures. So I mean, another 10% constant currency growth, I know you had maybe a little help from some small deals. But we talked a little bit about baby boomers and the number of procedures. Any anecdotal commentary from your hospital customers regarding what’s driving the strength and how sustainable do you think it is?

Walt Rosebrough, CEO

Yes. I think we’ve talked about this, and this is a broader question. There are variances over time, and when people have the ability to pay for things, they tend to do a little more, and when they have less ability to pay, they do a little less. But since this is healthcare, much of it or most of it is not necessarily something one can decide to or not to do. There are some cosmetic procedures where that’s not the case, but those tend not to be driven by healthcare reimbursement. Broadly speaking, it’s very clear that the number of procedures is rising, and in my view, will continue to rise. Currently, we’re at the middle of the baby boom generation in their mid-60s, and we still have the back half of the baby boom generation to get to their mid-60s. It is in the 60s and 70s where we spend most of our money in healthcare. Therefore, procedures are clearly rising. We’ve discussed that there’s more and more being done in outpatient type facilities, both in hospital systems and outside. The hospitals are still busy, and more complex procedures are being done. For every arthroscopic knee that goes outpatient, there’s another heart or lung transplant staying inpatient, which indicates that the complexity continues to rise in both hospital and outpatient settings. With this in mind, it drives growth in the industry.

Dave Turkaly, Analyst

Thank you.

Operator, Operator

Thank you. And the next question comes from Larry Keusch with Raymond James.

Larry Keusch, Analyst

Thanks. Good morning, everyone.

Walt Rosebrough, CEO

Good morning, Larry.

Larry Keusch, Analyst

I want to come back to the EO comments, and I agree with your thoughts there. But, look, there certainly are communities that are voicing concern about having EO facilities in their backyard. So, what do you think comes out of the Adcom this week? Where do you think the suggestions from the FDA are going to handle the situation?

Walt Rosebrough, CEO

I think the agency is doing a good job of gathering information. The FDA has called in order to discuss potential alternatives to ethylene oxide and other sterilization methods. My personal view is we are presenting there. The FDA chose presenters they thought would be the better ones to discuss this. I think you will see what we largely know, that there are many ways to sterilize things. We know this because we use virtually all of them somewhere. Certain methods of sterilization are better for certain activities. At this moment, and I think for the intermediate to long-term future, ethylene oxide will be a significant portion of that, due to its effectiveness for single-use devices that cannot withstand heat or radiation but can accept gas. Ethylene oxide has been the method of choice by both the agency and medical device manufacturers for decades, and everyone has designed around it. So, we do not see an alternative of scale that will change the ethylene oxide picture for industrial sterilization in the world.

Larry Keusch, Analyst

Okay, very good. Thank you.

Operator, Operator

Thank you. And as there are no more questions at the present time, I would like to return the floor to management for any closing comments.

Julie Winter, Investor Relations

Thank you everyone for joining us again today and for your continued support. We look forward to seeing many of you out on the road in the coming weeks.

Operator, Operator

Thank you. The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect your lines.