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Steris Corp  (NYSE:STE)
Q2 2019 Earnings Conference Call
Nov. 06, 2018, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning and welcome to the STERIS plc Second Quarter 2019 Conference Call. All participants will be in 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 would now like to turn the conference over to Julie Winter, Senior Director of Investor Relations. Please go ahead.

Julie Winter -- Senior Director-Investor Relations

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 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 definition, is available on 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 through supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making.

With those cautions, I will hand the call over to Mike.

Michael Tokich -- Senior Vice President & Chief Financial Officer

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 prices. Gross margin for the quarter decreased 10 basis points to 42.1% that was impacted favorably by price, currency and divestitures, offset by a revenue mix shift toward capital equipment and investments in our outsourced 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 the 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 20%.

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 38 -- $34.8 million, while depreciation and amortization was $46.1 million.

With that, I will turn the call over to Walt for his remarks.

Walt Rosebrough -- Chief Executive Officer, President and Director

Thank you, Michael and good morning, all. I hope you've all voted in the mid-term 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 then 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 Consumable organic revenue increased to double-digits.

Our operating profit in the 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 Science' 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 Science 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 Science this quarter, which is expected given the higher mix shift to capital equipment. Our ASP 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 ASP 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 US. Investments in these new ORC opportunities are reflected in the segments' 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 recognized that our first half growth rate is somewhat higher than that, with the outperformance of our Healthcare Products business in the second quarter is not anticipated to repeat, and we have tough comparisons in Life Science and ASP 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 US 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 outsource reprocessing centers started 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, in 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 uncertainties surrounding Brexit. Simply put, significant benefits are at risk if we remain domiciled in the country that is no longer a member of the EU.

As a result, we looked at several alternatives and determine that redomicile into 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.

Julie Winter -- Senior Director-Investor Relations

Thank you, Mike and Rob, for your comments. Austin, would you please give the instructions, and we'll get started.

Questions and Answers:

Operator

Absolutely. (Operator Instructions) And our first question comes from Isaac Ro with Goldman Sachs. Please go ahead.

Isaac Ro -- Goldman Sachs -- Analyst

Good morning, guys. Thanks. There have been some changes in the competitive landscape from some of your key players in the US. Can you give us a little sense of what you saw this quarter, can you sense there was any interesting behavior there, and really how you're game planning that throughout the rest of those fiscal year?

Walt Rosebrough -- Chief Executive Officer, President and Director

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 hand. 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.

Isaac Ro -- Goldman Sachs -- Analyst

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?

Michael Tokich -- Senior Vice President & Chief Financial Officer

Yes, I mean I would characterize most of our work is being steady as she goes. Having said that, we -- kind of their two operational levers that we naturally work on. One is, just in general improvement through lean and the other is outsourcing which -- insourcing, excuse me, components, which is partially a function of lean, as we get -- as we free up capacity in our plants, we can then in-source more of our production, both of those are running. We have accelerated them a little bit, but in truth, we would have accelerated just as much. So 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 with currency headwinds.

Isaac Ro -- Goldman Sachs -- Analyst

Understood. Thank you guys.

Operator

(Operator Instructions) And our next question comes from Matthew Mishan with KeyBanc. Please go ahead.

Matthew Ian Mishan -- KeyBanc Capital Markets -- Analyst

Okay, great and thank you for taking the questions and congratulations on a nice quarter. As 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 launch is progressing, and is quoting still active and is there still a lot of interest?

Walt Rosebrough -- Chief Executive Officer, President and Director

Yeah. Good morning, Matt well I'll reverse the order of the question, 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 are at capacity and don't have an ability to add in the short-term and the medium-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 out their -- outside the 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 in this coming is, 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.

Matthew Ian Mishan -- KeyBanc Capital Markets -- Analyst

Okay. Are you planning on giving a running update on annualized contract volume in HSS for that business or was that -- is that a one-time thing for you?

Walt Rosebrough -- Chief Executive Officer, President and Director

Yes, I would not expect that we would do that. We'd just give forecast of revenue, there are a number of contracts, both in place and moving forward and some of them, as I said, are the smaller kinds of contracts, which we really haven't spent a lot of time talking about, because most people 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 messy and messier to do that.

Matthew Ian Mishan -- KeyBanc Capital Markets -- Analyst

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 pair as an additional service on top of your presence there. How is that going?

Walt Rosebrough -- Chief Executive Officer, President and Director

Yeah, you are correct, Matt that both part of our general strategy was to do more ORC (ph) repair in Europe and more ORC in America and both of those are in relatively into 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 really the Brexit, really are -- 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, in sort of 2% or 3%, maybe 5% or 6% something like that. And since that's labors is a significant component we're having to offset that with improvements in productivity.

Matthew Ian Mishan -- KeyBanc Capital Markets -- Analyst

Okay. And then if I could squeeze one last one and sorry for the guys behind me. You haven't talked about US endoscopy in awhile, 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 as a percentage of your Healthcare Consumables?

Michael Tokich -- Senior Vice President & Chief Financial Officer

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 in time. So progressing very well, probably one of the -- I wish I could do 10 of those acquisitions from US endoscopy standpoint. But, yeah, there is -- you don't hear us talk about it because it is doing so well.

Matthew Ian Mishan -- KeyBanc Capital Markets -- Analyst

All right. Mike, that can you just speak to and then I'll be happy.

Michael Tokich -- Senior Vice President & Chief Financial Officer

Hope he's gone.

Operator

(Operator Instructions) And our next question comes from David Stratton with Great Lakes Review. Please go ahead.

David Michael Stratton -- Great Lakes Review -- Analyst

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?

Walt Rosebrough -- Chief Executive Officer, President and Director

Yeah you know 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 in 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 rescind to the fact that the uncertainty is their future. And so I think the 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 give 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, but whatever you are going 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 of projects 18 months to 24 months that you recall that about two-thirds of our business is roughly, two-thirds is, I'll call routine replacement of capital spending where you know it just something gets too older, 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 months to 24 months out, and the others, we see more near-term 6 months to 12 months out in both of those pipelines still appear to be quite strong in our view.

So we see them a 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 you 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 inventory surgery centers and those all require both operating and type equipment as well as the Central Sterile type equipment. So both of those we see is positive for our piece of capital spending. So when you put that all together, we're feeling pretty good right now.

David Michael Stratton -- Great Lakes Review -- Analyst

Great, thank you for all the detail. That was it from me.

Operator

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.

Julie Winter -- Senior Director-Investor Relations

Thank you, Austin, and I 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 yet today, and look forward to seeing many of you at the Stephens Conference tomorrow.

Operator

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

Duration: 24 minutes

Call participants:

Julie Winter -- Senior Director-Investor Relations

Michael Tokich -- Senior Vice President & Chief Financial Officer

Walt Rosebrough -- Chief Executive Officer, President and Director

Isaac Ro -- Goldman Sachs -- Analyst

Matthew Ian Mishan -- KeyBanc Capital Markets -- Analyst

David Michael Stratton -- Great Lakes Review -- Analyst

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