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Good morning and welcome to the STERIS Plc Second Quarter 2019 Conference Call. Please note this event is being recorded.
I would now like to turn the conference over to Ms. Julie Winter, Senior Director of Investor Relations. Please go ahead.
Thank you, Austin, and good morning, everyone. On today's call, as usual, we have Walt Rosebrough, our President and CEO; and Mike Tokich, our Senior Vice President and CFO.
And I do have just a few words of caution before we open for comments from senior management. 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's 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.
Thank you, Julie, and good morning, everyone. It is 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 9.1%, driven by volume and 70 basis points of price. Gross margin for the quarter decreased 10 basis points to 42.1% and was impacted favorably by price, currency and divestitures, offset by a revenue mix shift towards capital equipment and investments in our outsource reprocessing in the United States. EBIT margin for the quarter was 18.8% of revenue, a slight decline from the prior year primarily due to lower gross margin as well as increases in R&D of about $2 million.
The adjusted effective tax rate in the quarter was 19.5%, somewhat lower than we had anticipated due to favorable discrete item adjustments and the refinement of our estimates based on the IRS clarifying components of the Tax Cuts and Jobs Act. As a result, we now expect the full year effective tax rate to be approximately 20%. Our early thinking for fiscal 2020 is that our annual effective tax rate will remain near the low 20s percent. Net income in the quarter grew 17% to $93.6 million or $1.10 per diluted share, benefiting from both revenue growth and the lower effective tax rate.
In terms of the balance sheet, we ended September with $210 million of cash and $1.27 billion in total debt. Free cash flow for the first half increased to $169.7 million, mainly due to the increase in net income and the timing of capital spending. During the second quarter, capital expenditures totaled $34.8 million, while depreciation and amortization was $46.1 million.
With that, I will turn the call over to Walt for his remarks.
Thank you, Michael, and good morning, all. I hope you've all voted in the midterm elections already this morning and if not, that you will.
As you heard from Mike, we had another good quarter, exceeding our expectations for constant currency organic revenue growth, with strength across all segments of our business. Leading the way, Healthcare Products constant currency organic revenue grew 11% for the quarter, with double-digit growth in capital equipment and 6% growth in service.
Even with these impressive numbers, capital backlog remains strong, ending the quarter $50 million higher than the same time last year. While we continue to be optimistic about the uptick in demand for our capital equipment, we also recognize that capital sales can be lumpy. And that we had relatively easy comparisons with Q2 last year.
We continue to feel good about our expectations of mid-single-digit growth in healthcare capital equipment sales for the year and believe that underlying fundamentals in hospital capital equipment purchases remain stable.
In Healthcare Consumables, year-over-year revenue comparisons continue to be impacted by divestitures. Excluding the impact of the divested businesses, Healthcare Consumables organic revenue increased double-digits. Our operating profit in this segment improved nicely, benefiting from the increased volume and currency, which was somewhat offset by continued investments in R&D as we had planned.
Life Sciences constant currency organic revenue grew 9% in Q2, with growth across the business. As we noted last quarter, we had a timing issue with Life Sciences capital equipment shipments in Q1 which resolved itself nicely in our second quarter with 27% growth in capital equipment revenue.
As a reminder, heading into our second half, our comparisons for capital equipment in this segment get more challenging. We expect our shipments to remain strong, but the year-over-year growth rates will be impacted by last year's success. EBIT margin dipped a bit in Life Sciences this quarter which is expected given the higher mix shift to capital equipment.
Our AST segment had another good quarter with 8% constant currency organic revenue growth stemming from increased demand from our core medical device customers. Our facility expansions continue to pay off and we expect ongoing capacity expansions in the most appropriate places around the globe going forward. EBIT margins improved nicely on the AST volume growth.
And finally, Healthcare Specialty Services constant currency organic revenue grew 7% during the second quarter against difficult comparisons in the prior year. As we discussed at the beginning of our fiscal year, we are working on a number of opportunities for outsourced reprocessing in the U.S. Investments in these new ORC opportunities are reflected in the segment's lower operating income year-over-year as we anticipated.
Even with the planned investments we are making across all of our businesses we were able to grow adjusted earnings per diluted share 17% year-over-year to $1.10 in the second quarter.
Based on our revenue outperformance in the second quarter and our plans for the remainder of the year, we are increasing our full-year outlook for constant currency organic revenue growth to 5% to 6%.
We recognize that our first half growth rate is somewhat higher than that, but the outperformance of our Healthcare Products business in the second quarter is not anticipated to repeat, and we have tough comparisons in Life Sciences and AST in the second half. We have a large backlog of capital equipment to manufacture and ship as well as outsourced reprocessing centers starting up in the U.S. in the second half. So, our revenue forecast recognizes our efforts to run our plants at normalized run rates throughout the year as well as some risk for potential timing issues in capital equipment shipments and outsourced reprocessing center start-up revenue.
A substantial portion of our forecasted overachievement on revenue for the full year has already been achieved with higher capital equipment growth in the second quarter, which caused the natural narrowing of profit margins as we discussed. We also have currency flipping from a favorable impact on profitability in the first half to a neutral impact in the second half as well as the impact of tariffs and labor rates, which we have discussed before, and which we plan to absorb with additional volume and efficiency efforts. As a result, we think that our full-year operating margins will be about as we originally expected.
With all these factors considered, in addition to the lower effective tax rate that Mike has previously discussed, we are increasing our expectations for adjusted earnings per diluted share to be in the range of $4.74 to $4.84, reflecting 14% to 17% growth over fiscal 2018, another record year.
Before we open for questions, I do want to spend a minute on our plan to redomicile to Ireland, which of course depends upon shareholder approval. As you know, we redomiciled to the UK when we closed the Synergy combination, and we put a structure in place that allowed us to benefit from certain European Union tax and other arrangements. Along with most of the world, we certainly did not expect Brexit at that time, and the subsequent uncertainty surrounding Brexit, simply put, significant benefits are at risk if we remain domiciled in a country that is no longer a member of the EU.
As a result, we looked at several alternatives and determined that redomiciling to Ireland is the best path forward for STERIS to preserve the current and future benefits established at the time of the Synergy Health combination. We've provided extensive information regarding this in our S-4 which was filed with the SEC today. So please see our S-4 for additional information.
With that, we are happy to answer your questions. Julie, please open the call for Q&A.
Thank you, Mike and Walt for your comments. Austin, would you please give the instructions and we'll get started.
Absolutely. And our first question comes from Isaac Ro with Goldman Sachs. Please go ahead.
Good morning, guys. Thanks. There have been some changes in the competitive landscape from some of your key players in the U.S. Could you give us a little sense of what you saw this quarter, to the extent there was any interesting behavior there, and really how you're game planning that throughout the rest of the fiscal year.
There hasn't been a great deal of change yet. There have been some changes and some forecast. Obviously, the ASP business of J&J being acquired or we believe being acquired sometime late this year or early next year by Fortive, but again, Fortive has yet to take that business into their management hands. So I don't think we've seen overly significant competitive change there. I can't think of anything else that is a truly significant change in competitive situation or behavior.
Okay. That's helpful. And then just maybe on the margin side. Obviously, all companies are dealing with some degree of FX headwind. As you think about where you've built in a little bit of dry powder, if you will, into the margin plan for this year, are there any levers that you're pulling on a little harder now, as we kind of move into the core of your fiscal year? Or are you kind of steady as she goes and just passing through the FX headwind as is?
Yeah, I mean I would characterize most of our work as being steady as she goes. Having said that, we – kind of there are two operational levers that we naturally work on. One is just general improvement through lean and the other is insourcing components, which is partially a function of lean.
As we get – as we free up capacity in our plants, we can then insource more of our production. Both of those are running. We have accelerated them a little bit. But in truth, we would have accelerated them just as much. So, the – our improvement there is allowing us to cover the headwinds we have in currency. But I wouldn't say that it happened as a result of the currency headwinds.
Understood. Thank you, guys.
And our next question comes from Matthew Mishan with KeyBanc. Please go ahead.
Okay. Great and thank you for taking the questions and congratulations on a nice quarter. I guess I asked the same questions last quarter, but I like them and so, I'm going to ask them again. Any updates to the ORC contracts? How are the launches progressing? And is quoting still active? And is there still a lot of interest?
Yeah, Good morning, Matt. Well I'll reverse the order of the questions, I guess. First of all, yes, we do have – and I'm not sure quoting is exactly the right term, but we do have activity going on in terms of conversations with different entities about ORC potentials. And there's a wide range of those from, I'll call it, relatively smaller peak capacity kind of things where they're at capacity and don't have an ability to add in the short to intermediate term. And so, we have a number of those kind of projects out there as well as the more extensive ones where we would be taking over either in their facility or outside their facility or a combination of the two to run the entire process. So, there are a number of those out there. I wouldn't say the activity has picked up, but it hasn't slowed down. So, we continue to see activity.
In terms of the individual ORCs, we continue to feel the same as we have felt historically. We still feel that that piece of business that we know about and is coming will generate something on the order of $50 million revenue out in the out years.
Of course, as you come in closer to it, as projects get started, some of them start a little later, some of them start a little earlier, how that evens out, we don't have a strong opinion on. But plus or minus we feel that we're in the same ballpark as we suggested earlier in the year.
Okay. Are you planning on giving a running update on annualized contract volume in HSS for that business or was that a one-time thing for you?
Yeah. I would not expect that we would do that. We'll just give forecasts of revenue. There are a number of contracts both in place and moving forward, and some of them as I said, are these smaller kinds of contracts which we really haven't spent a lot of time talking about because most people have been focused on the several larger ones. But it gets harder and harder to put that together in a way that makes sense; and as we get started and they're moving forward, I don't think we'll be doing that. We will obviously talk about what our overall feeling is about growth rates in that space, meaning the ORC space, versus the instrument space because those are two kind of different pieces of the business. But I don't think we'll be – first of all, we don't typically want to give individual customer information out, both for their and our reasons; and secondly, in general, it's going to get messier and messier to do that.
All right. I think that's more than fair. And on the other side of the ocean in that business, any pressures you're seeing in the UK as kind of Brexit talks are progressing on that business? And then I remember you were also talking about bringing instrument repairs and additional service on top of your presence there. How is that going?
You are correct, Matt, that both – part of our general strategy was to do more instrument repair in Europe and more ORC in America. And both of those are in relatively infant phases, but both of them have traction. So – and again, I don't think we'll be getting into details on that on either side of the ocean really. But in general, we are beginning to see that.
The second question is related to Brexit. Really our – I don't think that there's pressure per se as a result of Brexit. We are concerned about the movement of people because obviously there are a number of – a significant number of Europeans in the UK. Our assumption is that both the Europeans and the people in the UK will want to allow that to continue, and I think most parties believe that will continue, but that would be a concern to us going forward if that becomes problematic.
And then, really the only other pressure is the – we have had some cost pressure in that the NHS raised the cost of labor this past year. And I don't remember the exact numbers, but it was well above inflationary rates, instead of 2% or 3%, maybe 5% or 6% percent, something like that. And since that's a – labor's a significant opponent, we are having to offset that with improvements in productivity.
Okay. And then, if I can just squeeze one last one in, and then sorry for the guys behind me. You haven't talked about US Endoscopy in a while, and there seems to be a lot of changes going on in that space. How are they performing and kind of how big are they now as a percentage of your Healthcare Consumables?
Yeah, Matt, they are continuing to do fantastic. They continue to grow in line with our expectations. When we bought them, they were about $70 million and they are more than double that at this point time. So, progressing very well. Probably one of the – I wish I could do 10 of those acquisitions from a US Endoscopy standpoint. But yeah, you don't hear us talk about it because it is doing so well.
All right. Mike, you just do two of them and I'll be happy.
Thanks, Matt (19:12). Oh, he's gone.
And our next question comes from David Stratton with Great Lakes Review. Please go ahead.
Hi. Thanks for taking the question. I was wondering if you could talk just a little bit about what you're seeing on the hospital spending side of the business. What are your trends looking like, and what do you feel like the stage of the cycle we're in, even though it's not very cyclical? I mean, just any color you can give on the future as we're going forward and possibly changing political environments.
Yeah. I've been saying for some time now that hospital capital spending continues to be stable to positive, which in some sense is a little surprising in that there's been a fair amount of uncertainty the last several years what's going on in healthcare reimbursement and all the issues with Obamacare and all those things that are going on. But I think hospitals, when I talk to hospital executives, they are pretty much resigned to the fact that uncertainty is their future. And so I think uncertainty is now less of a concern than it has been in the past.
The second issue I would say is we know in the 2008-2009 time period there was a significant drop in healthcare capital spending. And then there was also a ton of money spent on information systems because the government gave a pretty significant incentive to spend money on information systems and get those systems up. As a result, there probably was a bit of crowding out of other capital spending. So I do think some of this is a gradual – whatever you want to call it, latent demand issue. So that's I think kind of the nature of things as we speak today.
As we look out, we look out at projects 18 to 24 months that you recall that about two-thirds of our business is roughly – two-thirds is I'll call it, routine replacement of capital spending where you just – something gets too old or wears out, they need a new one. And then about a third of our business is where they're managing a large project, either building a new hospital, which is relatively rare, or where they are revamping or remodeling a tower that may include several ORs and the central sterile department. Those projects, we see 18 to 24 months out and the others, we see more near-term, 6 to 12 months out. And both of those pipelines still appear to be quite strong in our view. So, we see them steady to increasing at this point in time. So, we're feeling quite good about capital spending.
The other thing I should mention and this is included in that numbers I've just shared – that description I'd given, is both hospitals and non-hospital entities are building more and more ambulatory surgery centers or things that look like that, micro hospitals or ambulatory surgery centers.
And those all require both operating room type equipment, as well as the central sterile type equipment. So, both of those we see as positive for our piece of capital spending. So, when you put that all together, we're feeling pretty good right now.
Great. Thanks for all the detail. That was it for me.
And this will conclude our question-and-answer session. I would like to turn the conference back over to Julie Winter for any closing remarks.
Thank you, Austin. Thank all of you who did join us for participating. I know it's a busy day with a lot of earnings calls and we do appreciate your time. Happy to take any follow-up calls you got today and look forward to seeing many of you at the Stephens Conference tomorrow.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.