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Good morning, and welcome to the STERIS plc Third Quarter 2020 Conference Call. All participant will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I’d now like to turn the conference over to Julie Winter, Investor Relations. Please go ahead.
Thank you, Gary, 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 from 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' 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.
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 third quarter performance. For the quarter, constant currency organic revenue growth was 12%, driven by volume and 60 basis points of price. We continue to experience strong underlying growth from our customers and success with new products. A total of $13 million or 180 basis points is included in constant currency organic revenue growth for the quarter from the eight tuck-in acquisitions we completed this fiscal year.
Gross margin for the quarter increased 40 basis points to 43.1% and was impacted favorably by productivity, price and mix somewhat offset by higher labor costs. EBIT margin for the quarter was 21.1% of revenue, an increase of 30 basis points from the third quarter last year, despite an increase in expenses relating to higher incentive compensation due to our strong performance and a 9% increase in R&D expenses.
The adjusted effective tax rate in the quarter was 20%. Net income in the quarter grew 16%, to $124 million and earnings increased to $1.45 per diluted share, benefiting from revenue growth and margin expansion. In terms of the balance sheet, we ended December with $199.2 million of cash and $1.1 billion in total debt.
During the third quarter, capital expenditures totaled $55.5 million, while depreciation and amortization was $49.6 million. Free cash flow for the first nine months declined as anticipated to $238.1 million, primarily due to the planned increase in capital spending. Our capital expenditures have been lower through the first three quarters of the year, due to the timing of capital projects. As a result, we are decreasing our full year expectations for capital spending to $240 million and increasing our free cash flow expectations to $340 million.
With that, I'll turn the call over to Walt for his remarks.
Thanks, Mike and good morning, everyone. As you've already heard, our third quarter continued the trend of outperformance we've seen in the last several quarters. We experienced solid growth across all of our segments and in total delivered double-digit constant currency organic revenue growth for the third consecutive quarter exceeding our expectations.
Our healthcare specialty service segment has significantly stronger quarter than we anticipated, driven by double-digit growth in the repair business and continued contributions from new outsourced reprocessing centers coming online. Margins in this segment were impacted somewhat by startup costs for outsource reprocessing centers and personnel cost to support future growth. Lifescience also outperformed in the quarter with good growth in consumables and a record level of capital equipment shipments, even with the strong shipments, our increased capital orders allowed us to end the quarter with record backlog levels in Lifescience.
AST continued its outstanding revenue performance this year, growing 15% on a constant currency organic revenue basis for the quarter. We continue to see strong growth from our core medical device customers around the world. And lastly, Healthcare Products delivered a solid quarter with particular strength in consumables. We continue to benefit from our new consumable products as well as recently acquired businesses. Our service maintenance revenue has grown too and was augmented by installation revenue due to the strong capital shipments in the first half of the year. Based on our performance, year-to-date, and expectations for the rest of the fiscal year, we are once again revising our full year outlook.
Starting with revenue, we now expect constant currency organic revenue growth of approximately 9% for fiscal 2020, up from the prior 7.5% to 8.5% range. This increase is due to outperformance in the third quarter. Our expectations for the fourth quarter reflect difficult year-over-year comparisons. Recall that our prior year Q4 constant currency organic revenue growth was 9%. In particular, we expect capital equipment to be roughly flat across the businesses in Q4. In Healthcare Products, which makes up the bulk of our capital equipment revenue, we have very difficult comparisons against the strong fourth quarter last year. As we've mentioned in the past, we continue our efforts to level our capital shipments and avoid fourth quarter spikes. Given the strength we have seen so far this year and our expectations for the fourth quarter, we now anticipate adjusted earnings per diluted share to be at the high end of our $5.50 to $5.65 range. As a result, we continue to expect another year of record performance in 2020. We believe the short-term and long-term future for STERIS is bright and we appreciate your ongoing support.
Now, before we open to Q&A, I would like to comment on coronavirus. As you probably know, China is a relatively small piece of STERIS' global revenue. So, we don't anticipate any material impact to revenue from the coronavirus as a result of China sales this fiscal year. On the supply chain side, although the situation is fluid, we are in regular communication with our Chinese suppliers. At this time, we believe we should be able to mitigate any issues that may arise, so there are no material impacts to revenue due to the supply chain issues this fiscal year as well.
We are in contact with our customers to understand how the situation is impacting them and what we can do to help. We're also in contact with our people and are deeply concerned for their health and safety. Our China operations have been closed since the Lunar New Year, except for limited operations to support critical products and we will continue to follow the guidance of the Government and do what is best for our people like. Like most businesses, we have restricted travel to and from China across the company.
With that, we are happy to take any questions you may have. Julie, can you open the call for Q&A please?
Thank you, Walt and Mike for your comments. Gary, if you would please give the instructions so we can get started with Q&A.
[Operator Instructions]. Our first question comes from Dave Turkaly with JMP Securities. Please go ahead.
Good morning. Thank you. Walt, one for you off the bat here. If 1Q was a hot quarter, I'd love to ask you, what you call this quarter?
Pretty darned.
So, to get into a serious question here, but again, there was no one-time impact right, there was no extra days or anything like that. You called out the pricing, but, and I think the M&A side had a little contribution. But overall, no other one-time impacts in the quarter, correct?
I wouldn't characterize any of the impacts of the quarter being abnormal.
Great. And I guess, if we look at those deals that you mentioned, I think you said, I think you said eight, I guess any color on them where they fall in? You mentioned the contribution, but I guess it might be nice to know what things you've added even though they're relatively small versus your base? Thanks a lot.
Sure, Dave. We're not going to get into details of that. As we mentioned, the bulk of the revenue this year is coming-in in the Hospital Products business or Healthcare Products business. It's actually smattered around the various units in that business, none of which are consequential. Does add a point and a half or so of revenue in the quarter. And our best estimate is about a point for the year overtime. So again, there's nothing here that's particularly material in the short-run. There's a couple of them we think may be for instance in the long run, but we'll hold that until we see how they work out.
Thank you.
The next question is from Chris Cooley with Stephens. Please go ahead.
Good morning. Just two from me. Really solid from top to bottom, both in terms of growth and the leverage. I guess just a couple things do wanted to get our hands a little bit better around and specifically when we look at Healthcare Products, you had a really strong year-over-year increase in consumables. I'd like to understand a little bit more about what drove that and then why, I guess the offset that, why we didn't see more margin expansion with that level of growth and that percentage contribution in Healthcare Products coming from consumables within the broader category there from the segment margin. I've just got one more follow up after that. Thanks.
Yeah, Chris. It's Mike. In the consumables, a portion of that growth is actually from some of the acquisitions that we just completed.
Okay.
It's about $8 million to $10 billion or something of that nature, Julie, right? Yeah, for the quarter, $8 million to $10 million of impacts, favorable impact obviously on the revenue side from some of the acquisitions we just completed.
The other point, Chris, as we mentioned, our service part of consumables as we look at it and service profitability is not as strong on an ROS basis, as is the chemistry-type products and endoscopy type products. And so, that had more of an averaging effect. It looks more like capitals. Obviously on an ROE base, it's pretty good because of very little capital, but on an ROS basis, it's strong.
Certainly. And then, I guess just lastly for me, as we look ahead beyond the remainder of this fiscal year, it seems to be a hot topic out there right now about capacity AST, could you just kind of maybe walk us through where you are in general terms from a capacity perspective, thoughts on incremental CapEx and just how you can see that business growing from longer-term perspective? Thanks so much.
Sure, Chris. I'll let Mike talk about CapEx. But at a high level, obviously our ethylene oxide plants are pretty full right now and they've had increased pressure if you will of [furnace]. It has moved from U.S. to overseas as we're now processing some things that would normally have processed in Americas, overseas. So, they're giving more full. Having said that, we continued to add capacity. And so, there's two ways we add, one is by adding facilities or growing the number of chambers inside the facilities. The other is, being more efficient lean approaches inside those facilities, and we're doing both. So, although we are, a more full than normal on the ethylene oxide type facilities. We continue to grow the ability to grow, if you will. By the same token on the radiation side, we can also continue to grow our ability to grow, and there we've talked about a number of plants that are being built or added or opened across our global network and we're doing so in a very technology-neutral approach, that is we're adding EBM technology, we're adding x-ray technology, and we're adding capacity in the global facilities. So, we do see that as the approach. We clearly see greater growth in the EBM and x-ray type facilities than any of the others actually. And so, that's where we're placing our money. Mike, why don't you talk about CapEx?
Yeah. Chris, at the beginning of the year, our view was, we were going to spend about a $100 million in gross CapEx AST alone. Obviously that number has come down a little bit because of just the timing of projects. And I think we have about eight recent projects that are being worked on that we've announced. Our view would be, it's just a timing issue. So, next year I would, look at CapEx being probably at that elevated level once again, and maybe even for the next year or two after that. Obviously with the growth that we're seeing from our customers for a medical device industry. We need to continue to add capacity to maintain the current growth.
And I would say, I mean as I've talked about a lot, we seen the medical device business growing. We're in the middle of the baby-boom right now, and the baby-boomers are largely entering, the biggest part of the baby-boomers entering the high healthcare spending years and things like orthopedic implants and stents and all those good medical devices to improve our lives get used a lot more when you're 65 and 70 and 75 than when you're 45 and 50 and 55. So, we see a sustained growth for our customers on the unit volume at least for the foreseeable future, and that creates sustained growth for our AST business as well as our hospital business or healthcare business. But, I would add that, given our global network, it is I think easier and easier for global type companies to work with someone like us who has a broad coverage. We can move from plant A to plant B if they need to for whatever reason. And also, they can count on a single quality system and single regulatory system. So, I do think that is helpful for us to grow a bit faster than the market.
Our next question is from Matthew Mishan with KeyBanc. Please go ahead.
You mentioned that results were ahead of expectations. You've had two straight quarters that are consistent like this. Just curious, what in particular is surprising you about the sustainability of these trends?
Well, I guess, Matt, I'll answer in four or five years if they should stay. I'll feel even more strongly about the sustainability. But, you know, a lot of the things that we have been working on seem to be coming together right now. So, if you walk through and we talked about the nice growth in the Healthcare Services business, both the equipment repair business is growing nicely as we've added and continue to add capacity, the outsource solutions, as I've mentioned before, we think it's going to look at this different kind of the Americas than it looks in UK. And I think we're getting better at understanding that model and providing what our customers want and need. So, that business has a pretty good growth rate. We think, the Lifescience business has continued kind of its long-term growth rate on the chemistry side, maybe slightly off of some of the faster years, but still a solid growth in that business. And vaccines and biologics, we think is a good space to be in and that's where we are. On the AST side, I think I've already talked about that, but we think that is a good grower and on the Healthcare sides of business, again, we continue to add a product to our portfolio. We continue to refine our sales approaches, and again, particularly, I thought the industrialized countries, we're facing, the middle of the baby-boom coming through and that's going to be like a pig through a python in my opinion for the next 10 to 15 years. So, underlying market demand is good and we're doing our jobs to pick up at least our fair share of that.
Alright. And then, how have your conversations evolved with the major healthcare systems, especially with your scale? I'm just trying to understand how interconnected some of the growth is across businesses like Healthcare Products and Healthcare Specialty services. Are they looking at you differently and trying to consolidate more business with you?
Matt, that's an excellent question. The answer to your question is yes, yes. We are clearly seeing more interconnection between the Healthcare Service business and the Healthcare Products business. In some respects, one is the customer of the other, and so, oftentimes, when we're looking at things, we're able to talk to the hospitals about what their needs are in healthcare systems and what their needs are. And, for one, it might be, I'll add a little more to the CST that I have, the other one may say, I'll add some more, but can you take over some, another might say, gee, we'd like you to run our ORC. But we still need to have turn centers in our ambulatory surgery centers. I mean, it is a, they are evolving their business model in this space and having the full spectrum of products and services across that space does put us in a different position to give them what they want independent, what we might think is the best thing.
And so, it's like most of the things we do. We work hard to be technology-neutral, approach-neutral. I have a broad spectrum of things that we can offer our customer and let them choose which pieces of the spectrum they want.
Okay. That's really helpful color. Could you also give us an update on the ORC model? You're talking about that a little bit more now? I think you previously quoted like $50 million on business on three contracts. Have those at least launched and are running as expected?
We don't talk about specific ones. We have now more centers up. I don't know that we're going to give those numbers, but we have more centers. I know we're not going to give locations and talk about our customers, but we have more centers up, some of them are more like micro centers, some of them are more like larger centers. But, the numbers we have quoted for our growth forecast for the ORCs, we continued to exceed those, which is a part of the reason HSS has beaten our expectations.
Okay. And then last question. And it is a multi-part question. So just warning you in advance. I thought you guys did at the FDA panel, I thought you did an excellent job. I thought you did an excellent job. I thought you guys were clearly the adult in the room, because we're asking followup questions on sustainably. Like, how long would it take to switch practices from traditionally-owed to sustainably-owed facility? You know, what is the incremental costs of implementing that at a medium size facility? Does it require new equipment and like what would be the cost savings of using like less EO?
I'm going to work backwards on your question, Matt. It costs nothing in the facilities and does not require any consequential change to equipment, gas, whatever. So, that is a non-cost item. It does cost our customers and us working together. We have to re-validate the fact that the process, which uses oftentimes half the gas, that the traditional processes use, it does, we have to make sure we know we're using less gas so we don't have to validate that part of the question. We know there will be less ethylene, so we know that's not an issue. But, we also know the FDA pays particular attention to how much residual gas stays in the product. So, if it gets implanted into the patient, that's okay, but we know that's better, because we're starting out with less gas. So, all those things are known.
We just need to be absolutely positively sure that we are sterilizing the device, when we do that, and that requires validation by the customers and us. We are working with it. It also currently or historically requires the agency to look at it and approve it. We are working with the agency to lay out templates to make that far simpler for our customers and far less of a regulatory burden for our customers to be able to do that. So, I'll call it the switching cost and switching cost is all around validation, than any other I'll call it material costs. Now obviously it uses a little less gas, that cost is largely immaterial in the process. So, as the Delta in the gas usage is relatively immaterial. And frankly, in most cases, our total cost is immaterial those are the transportation costs in the process. So, this is not a big cost issue. It is a get it right issue, and both we and our customers are very serious to make sure that in enhancing what's potentially the environment that we do not take any risks that the product is not sterile.
Right now, we're, I'm going to use the world an oxymoron today in many cases. We're over sterilizing now. Once you kill all the bugs, you can't kill them again. So, we're over gassing and not really over sterilizing. And to the extent, we're over gassing, we don't need to do. It does, it takes time, but it's not measured in months for any specific customer to name a specific product. But there's a lot of customers and a lot of products up there. So, it will take STERIS years we believe. But, we do think and Mr. Carestio, our Chief Operating Officer who grew up in that business, absolutely believes and set a target for his team to get down 50%, using half the gas we used to use for the same level of requirements and do that inside of 5 years and we think we can hit those targets.
All right. Thank you very much for taking the questions and congratulations to you all for your success, even Mike.
[Operator Instructions]. The next question is from Larry Keusch with Raymond James. Please go ahead.
Thanks. Good morning, everyone. Walt, just wanted to start with you. Obviously, this fiscal year-to-date has been really outstanding both in revenue generation and margin expansion. I'm just wondering, as we all start to think about fiscal '21 and I recognize you're not providing guidance, but can you help us to think about any sort of puts and takes that we should be considering for both as we sort of look at revenues and margins for next year?
Larry, as you have said, we're not giving guidance, right now. And I know in some respects that, that can be frustrating for you guys because most companies are calendar year companies and we're a quarter behind the calendar year. So, as a result we're a quarter late versus calendar year kind of a projections. So we have not, we're in our planning processes. We have not concluded those processes. As I mentioned, the Chinese thing, there is a little fluidity there. But you know, I will say a couple of things to think about, A, we are starting from very nice growth rates, right? We're approaching double-digits for the year, 9%, that gives us a tough comps but the flip side is, last year we started out with uncertainties in device tax, uncertainties in labor rates, uncertainties in trade for us trade is North America more than China. So, the trade uncertainties in terms of NAFTA, and Brexit and last year, we did have some tough comps in Q4 which again, we have tough comps this year in Q4. So, if you, if you look all through that, at a high level, we think about this business for the markets we're in to be in kind of a 4% to 6% constant currency grower, and hopefully we get a our sort of share, and you never know exactly when and how that's going to happen. Hopefully, we get a little price. Hopefully we get, a couple of acquisitions and the next thing you know, we're in those high single-digits. We're pretty comfortable right now with where we sit, that we will be toward the high-end of that 4% to 6% rates in our constant currency growth rates. Again, we haven't done our final analysis. We will obviously talk more about that in three months, but we're feeling pretty good about the high side.
And I would assume, again, some more thoughts around margins and then there's a reason to think that margins wouldn't expand going forward.
As you know, Larry, I'm not the margin expansion guy. I'm the margin growing guy. I like to grow profit dollars, but I don't have any reason to believe. I am absolutely confident, we will be working to improve our cost position. We will choose on what to do in terms of how we handle that in terms of lack of price increase or price increase. We definitely are facing a little headwind on the labor side. The labor rates are clearly going up. But you know, when we put all that together, we don't see any reason to be off our normal paths.
Okay. One more bigger picture and then I just have a couple of quick ones for perhaps for Mike. But, as you think about the next steps within the sterilization regulatory pathway, could you bring us up to speed sort of what you think the EPA will ultimately wind up doing as it comes out with this. Its recommendations and then, you know, clearly the States of Georgia and Illinois have been challenging, really more from a local government perspective, and I guess that's always the concern. But how do you think about, are there any States where you guys are operating where local government could start to become more of an issue in operation in these types of facilities?
You know Larry, forecasting what governments are going to do is a little like forecasting elections. And I don't really think we have any great knowledge on that. I will say, and I mentioned that last time, we have been impressed with the way the FDA has taken this bull by the horns and knowing that there is 50 some odd percent of the devices are sterilized by ethylene oxide, that need to be sterile. And so, it's very important to them to keep those supply chains moving. And I think they're doing a superb job of working on that. The EPA, and particularly because, the FDA and the Secretary of Health have made it clear, the risks the country takes on, we cannot sterilize with ethylene oxide in the intermediate-term. I think they would have done a nice job, but I think they are doing, taking a nice methodical approach. It would be very easy for them to make a snap judgment, but from what we see, the way they've requested information, the way they are asking all types of players in this space, you know, the manufacturers, the devices, those who sterilize and those who are concerned about those issues in the environment. By the way, we're in two of those, well, we're all three of those three buckets. So, we were concerned about the environment. We're concerned about sterilization. We're concerned about a device manufacturing, being a device manufacturer. So it seems to me they're taking a very-balanced approach to this process. We do feel, our own opinion is, we feel that we're at the high-end of the industry in terms of the way we handle things. Our move toward sustainability a couple of years ago now, certainly led the industry and we're clearly seeing people being very interested in that approach now.
We also know about, know the design of our facilities and the way we handle the gas and the way we remediate the gases at the high-end or the, I'll call it the good end of the industry. So, we are very comfortable that we have been in and are safe for our people and our communities. But that doesn't mean, we can rest on our laurels. We intend to get safer and safer, which is why we do this 50% reduction, and we're always looking at the way that we handle the gas inside and outside of the facilities, and we'll continue to do so. And by the way, that's not just a comment about the United States, that's comment about the world. We are not assuming that the only people that care about ethylene oxide gas are Americans.
And so, you know, that that's our approach. We're comfortable, as comfortable one can get, I guess, because you can always have something occur. You are correct. In my own view, the bigger risk in short run at least is the local and state governments. But, I do think now that it's very clear that, both the FDA and the EPA are engaged, there's more likelihood that people will wait and see what that result is. And then based on that result, we'll take appropriate actions.
Okay. Very good. And then, for Mike, just wanted to think a little bit about the investments within HFS. You know, the operating margin of that is trended down over the past three quarters. I think it's 10.7% this quarter, on an operating margin basis from 14.6% in the fourth quarter of '19. So, just again I want to make sure I'm understanding the investments, it seems pretty straightforward, but just to make sure we're understanding that and then what's the right way to think about, again, margins for this business going forward.
And then the second question Mike is, you've talked about a 100 basis points or so of growth being added by M&A this year. What is the threshold for when you kind of pull that out of organic growth? Because, you still characterize it as organic, constant currency growth, but there's a 100 basis points in there from M&A. So, just trying to understand what the threshold is. Thanks.
Yes, certainly Larry. I'll answer the second question first. Typically what we do is when we do any type of, I'll call it material acquisition, we would separate that out and actually disclose that separately so that we are not in this, the boat that we're in today, where we're trying to call out or cuts organic revenue growth, and then also note at the same point in time what the acquisitions added. So, unfortunately this year, doing 8 acquisitions that were all individually immaterial, but if you aggregate them all together, they become material. So, that's the reason we chose the way we want to disclose that this year is make sure that everybody understands that the impact and there's a pretty significant impact on the third quarter, 180 basis points in the quarter for constant currency organic revenue growth, but, it is understood and we're being as transparent as possible. We don't like going down that path, obviously. We would prefer to do an acquisition and separate that out and go back to our historical reporting, but this year is an anomaly hopefully.
But again, with 8 acquisitions combined being in the combination of all being relative we have to do something so that we're again, truly being transparent.
And just to be clear on that, when Mike says we don't like that, but he's talking the accounting issues, not the businesses. We like those businesses. We love tuck-in businesses. If I can do 10 more next year, that look like these eight we will do 10 more next year, we'll be talking about this again, I suspect. But, it's not that we don't like the businesses.
We just don't like the reporting of it.
We don't want to be changing our constant currency growth rate every month, because of some small businesses really the issue, that's the point.
And then your first question regarding the HSS business. Obviously, as Walt mentioned in his script that, we did have a start up costs for the new ORCs and in addition to that, we are continuing to have people cost to support the future growth in HSS. I mean, our long term view of this business is still mid-teens. We haven't come off of that. Obviously, you are seeing the benefit of the revenue, the top-line growth, but it does come with a little bit of startup costs, which we've talked about for two years now in a row, and as we bring facilities online, it probably takes roughly 12, maybe 18 months depending on the size of the facility to get to breakeven, and then start actually adding profit to that business. So, it's not unusual, and it's not a surprise to us by any means.
This concludes our question and answer session. I would like to turn the conference back over to Julie Winter for any closing remarks.
Thanks everybody for joining us again this morning. Hope you have a great day.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.