Earnings Call Transcript - STE Q2 2022

Operator, Operator

Good morning and welcome to the STERIS, PLC Second Quarter, 2022 Conference Call. All participants will be in listen-only mode. After today's presentation there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Julie Winter, Investor Relations.

Julie Winter, Investor Relations

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's 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 thinking. 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 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's 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 and 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're 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.

Dan Carestio, President and CEO

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 ASG segment remains 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 a 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 continue 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're also making swift progress implementing Lean and we're 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're 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 foreign exchange, 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 in 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 Winter, Investor Relations

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

Operator, Operator

Sure thing. We will begin the question-and-answer session. Our first question comes from Matthew Mishan with KeyBanc. Please go ahead.

Matthew Mishan, Analyst

Good morning, and congratulations on a strong quarter despite challenging conditions. Dan, I would like to get some clarification on the supply chain comments. Are you currently facing supply chain issues that are affecting your ability to deliver products? Additionally, as you look ahead to the third and fourth quarters, are there areas where you anticipate experiencing supply chain constraints? Will this potentially affect your backlog in capital equipment and your ability to deliver in the third and fourth quarters?

Dan Carestio, President and CEO

Yes, Matt. To date, aside from the rising costs of several precursor materials, we have successfully managed the supply side and have met customer demand. We started the year with some excess precursor inventory as a safety measure. Given the current uncertainty around delivery times for these materials, we might face longer lead times for deliveries. However, we do not anticipate any stockouts. Our goal is to fulfill over $400 million in backlog within the next six months, but if we miss production slots due to supply shortages, it will be challenging to recover. I trust our teams will keep up the excellent work we have been doing so far, but there are challenges ahead.

Matthew Mishan, Analyst

Understood. And then switching over to AST, where your growth 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 the total bioprocess opportunity and where we are with it.

Dan Carestio, President and CEO

Yeah, it is a high-growth area for that business. Currently, it's not a significant portion of the total business. The vast majority of what we do, say over 80%, is what I would categorize as traditional medical type products. 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

Okay. Lastly, regarding raw material inflation, I want to confirm that you anticipate $20 million or more in the second half. Are you noticing any of those costs beginning to peak and decline? What is your worst-case scenario at this point?

Mike Tokich, CFO

Yeah, 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 potentially alleviating, although we have not seen that yet. Obviously, it's impacting us more than we thought just one quarter ago when we revised guidance, so we wanted to make sure you understood exactly what we're anticipating to be the impact as we move forward for the rest of the fiscal year.

Matthew Mishan, Analyst

Okay. Thank you.

Mike Tokich, CFO

You're welcome.

Operator, Operator

Our next question comes from Dave Turkaly with JMP Securities. Please go ahead.

Dave Turkaly, Analyst

Good morning. That material and labor cost, 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? You beat the Street 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.

Dan Carestio, President and CEO

Yeah, 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's just so much uncertainty surrounding the potential impact. Maybe we're being a little conservative at this point. But again, it's the best guess that we have on the potential impact. And again, it's for two quarters in, and we have been surprised in the amount that we've been adversely impacted on the gross margin side for both materials and labor. I would just add, Mike, too that I think we have a fairly decent idea 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 the fourth quarter. So, if we were a quarter out of fiscal year, I think we might have a different position here.

Dave Turkaly, Analyst

Thank you for that. You mentioned exceeding the cost synergy. Can you provide some specifics, like a percentage or figure? Also, have you identified any revenue synergies? I think we haven't discussed those previously. Thanks.

Dan Carestio, President and CEO

Yeah. 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. As we do that, we will 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.

Dave Turkaly, Analyst

Thank you.

Operator, Operator

The next question comes from Chris Cooley with Stephens, please go ahead.

Chris Cooley, Analyst

Good morning and thank you for taking the questions and 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. Specifically, when you look at operating profitability, you are hitting record levels both at AST and also at life sciences. Looking back through my model, I can't find if it's been like this before. I guess in addition to the growth, I would like to better understand what's enabling you to reach these incredibly high levels of operating profitability? And then how sustainable they are? When I think about both the AST and the Life Science segments, is that a revenue mix-specific? Is that something that's structurally changed? I just want to better understand that, and then I'll follow back up on my backlog question.

Dan Carestio, President and CEO

I'll hit on the AST and I'll ask Mike to cover some of the Life Sciences since there's a little more detail there. I think in terms of AST, we still haven't seen OpEx come back to where it was pre-COVID, and we've planned for 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. 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 major implications on the drop-through profitability of the operations. 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.

Mike Tokich, CFO

And then Chris on the Life Sciences side, echoing Dan's comment regarding operating expenses, the same in Life Sciences. We anticipated higher operating expenses throughout the year, and obviously, the COVID impact has slowed some of 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. The other one you alluded to already, Chris, is mix. We continue to see very good growth out of the consumables business. With the addition of Cantel, the consumables business, although it was only up 1% organically, is up almost 11% if you include the Cantel acquisition. We are seeing, as I think you understand, and consumables are higher margins and that is also helping drive the improved profitability margin.

Chris Cooley, Analyst

Thank you for that information. Regarding the backlog, we are experiencing record levels in both the healthcare and life sciences sectors. Could you provide a breakdown of this backlog in terms of new builds? Specifically for healthcare, while I may not have the best perspective, the demand continues to be exceptionally strong. I am trying to understand where you are seeing the highest demand right now and how we should anticipate that moving forward. Is this likely to be in the mid-single-digit or low double-digit range for capital growth in the Life Science sector over the next 12 to 24 months? Thank you very much.

Dan Carestio, President and CEO

Sure, this is Dan. Regarding the healthcare backlog, it is very strong across all product segments right now, including both surgical and IPT. A year ago, we focused mainly on long-term projects, but we've experienced a significant recovery in the replacement business over the last six or seven months, bringing it back to pre-COVID levels for replacement spending. While our backlog is not quite where it would have been proportionally two years ago before the pandemic, the order intake in the last six months has improved significantly. In terms of Life Science capital, there is substantial investment in expanding production for biologics, vaccines, and gene therapies. All these applications necessitate aseptic manufacturing environments, which is STERIS's area of expertise. We benefit from consumables in this regard, and we also see advantages in AST with disposable products for these environments, as well as in Capital Equipment for GMP sterilization. Additionally, since the start of our fiscal year, we have witnessed a recovery in research spending, which was quite slow during the pandemic. A lot of this funding comes from state or federal sources for public institutions, which faced significant declines last year. However, we are now seeing a rebound in the replacement business and lab or research orders, approaching pre-pandemic levels.

Chris Cooley, Analyst

I appreciate all the color and congrats on the quarter.

Dan Carestio, President and CEO

Thank you.

Operator, Operator

Our next question comes from Mike Matson with Needham and Co. Please go ahead.

Mike Matson, Analyst

Good morning. Thank you for taking my questions. I'd like to start with the Dental business. It's great to hear about the 10% growth, but could you provide some insights into what you're observing in that area? Previously, when Cantel was independent, they mentioned an increase in demand for infection prevention products due to the pandemic. Do you think that demand is sustainable? Cantel also indicated that this could evolve into a high single-digit growth business over time. Do you share that view?

Dan Carestio, President and CEO

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 year-to-date anyways with STERIS and we do believe the team over there is doing a great job managing the business and also the recovery coming out of the pandemic. So, at this point, we do believe there's a 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

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

Dan Carestio, President and CEO

What I would say is that we are not solely focused on medical technology. We have significant business in both medical and pharmaceutical manufacturing, and now also in dental. These areas have different structures regarding cost pass-throughs. Historically, STERIS has aimed to pass through enough costs to cover as much inflation as possible. We evaluate how reasonable it is for customers to accept these increases and then focus on improving productivity in our manufacturing environments, where we have been quite successful over the years.

Mike Matson, Analyst

Thanks. I have one more question about hospital capital spending. We've observed very strong capital spending in 2021, much better than I expected. What are you hearing about 2022? Do you think it will continue to be strong next year as well?

Dan Carestio, President and CEO

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

Operator, Operator

Our next question comes from Michael Polark with Baird. Please go ahead.

Michael Polark, Analyst

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 updates? 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 the second half or is it a portion of that because you had a placeholder? Any color here on those numbers and how they relate to the progression of the forecast would be helpful.

Mike Tokich, CFO

Yeah. Certainly, Mike. 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 what we raised last quarter, and also compared to how we exceeded the second quarter results. Hopefully that math ties out and makes sense to you.

Michael Polark, Analyst

Yes, that's very helpful. And just to put a final fine point on it, back to the $5 million and 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?

Mike Tokich, CFO

That is correct.

Michael Polark, Analyst

Yes. Okay. More broadly on supply chain, Dan, could you tell us which raw materials are most significant for STERIS? Are these materials related to your consumables business, your equipment production, or both? I'm interested in more details about the major items you are monitoring and which businesses might be most affected.

Dan Carestio, President and CEO

Our concerns extend to both equipment and consumables, particularly in the chemistry area, where we are closely monitoring to ensure we have enough precursor chemistry to produce our finished products. Regarding other applications, such as components used in manufacturing capital equipment, electronics, steel, or framing, the focus is currently on cost management rather than timing due to observed cost increases. However, we are facing challenges across all areas of manufacturing due to delivery times and overall availability issues.

Michael Polark, Analyst

If I can sneak one more in, I would appreciate an update on the 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 3 to 12 months, or at least your latest expectation on that? And then specifically, there was an update, I'm losing track of time, two to three weeks ago. The EPA, I believe, sent letters to close to 30 EEO 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 on that development. Thank you.

Dan Carestio, President and CEO

This is Dan. We are maintaining close communication with the EPA regarding this issue, and we always respond to their regulatory requests. We are collaborating with them to ensure they have the necessary data from STERIS. We are hopeful that we can expect some kind of proposal to come out in the first quarter of the year. Initially, I had aimed for early January, but that's still to be determined. We remain optimistic that the agency will provide clarity soon, helping us establish a final path. In the meantime, we have made significant investments in anticipation of regulatory changes, and our facilities are on track to complete a few minor enhancements based on expected improvements that may arise from any new operating requirements.

Michael Polark, Analyst

Thank you.

Operator, 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, Investor Relations

Just wanted to take a sec back 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 offline.

Operator, Operator

This conference has now concluded. Thank you for attending today's presentation. You may now disconnect.