Good morning, and welcome to the Steris plc Second 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, ma’am.

Thank you, Keith, and good morning, everyone. As usual, on today’s call, we have Walt Rosebrough, our President and CEO; and Mike Tokich, our Senior Vice President and CFO. I do have a few words of caution before we open for comments. This webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission or rebroadcast of this call without the expressed written consent of Steris is strictly prohibited. Some of the statements made during this review are or may be considered forward-looking statements. Many important factors could cause actual results to differ materially from those in the forward-looking statements, including without limitation, those risk factors described in Steris’ securities filings. The company does not undertake to update or revise any forward-looking statements as a result of new information or future events or developments. Steris’ SEC filings are available through the company and on our website. In addition, on today’s call, non-GAAP financial measures, including adjusted earnings per diluted share, segment operating income, constant-currency organic revenue growth and free cash flow, will be used. Additional information regarding these measures, including definitions, is available in today’s release, including reconciliations between GAAP and non-GAAP financial measures. Non-GAAP financial measures are presented during this call with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. With those cautions, I will hand the call over to Mike.

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

Thanks, Michael, and good morning everyone. As you’ve already heard from Mike, our second quarter continued the trend of outperformance that began in our last fiscal year with growth meeting or exceeding our expectations in all four segments. The additional volume, higher margin attainment and a lower effective tax rate combined to drive earnings above our expectations for the quarter. Based on our performance in the first half and our expectations for the rest of the fiscal year, we are once again updating our full year outlook. Starting with revenue, we now expect constant currency organic revenue growth of 7.5% to 8.5% for fiscal 2020 up 150 basis points from our prior range of 6% to 7%. The increase is due to outperformance of the underlying business as well as the impact of several small tuck-in acquisitions that we have completed, primarily in healthcare products. While none of the transactions are material on a standalone basis, when combined we expect they will add about $30 million or 100 basis points to our constant currency organic revenue growth for the full fiscal year. For your modeling purposes, second quarter revenue benefited by about $5 million from these tuck-in acquisitions with the balance to be spread across the second half of the fiscal year. As a reminder, our fourth quarter has challenging comparisons, which gives us some caution on the growth rate for the second half of the fiscal year. Healthcare Products and AST are the two segments principally driving this increased organic revenue growth. Healthcare Products are seeing improved demand across the segment with steady growth and consumables, improved performance from service and ongoing strength in capital equipment. AST is delivering strong growth, as increased demand from our core medical device customers continues and the capacity expansions that have come online…

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

Yes, certainly. We will now begin the question-and-answer session. [Operator Instructions] And the first question today comes from Dave Turkaly from JMP Securities.

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

Yes. Good morning, Dave. First answer to your question, I guess – to answer your first question, how many facilities we have? We have about – we have nine facilities in the U.S., that sterilize using ethylene oxide and about double that worldwide, which makes sense, because this is used globally. And for all intents and purposes, it’s the only gas use for this purpose around the world. Second answer to your question is, I do think, this is more around fear than around science. And there are conversations going on that are scientifically don’t make a lot of sense. And that’s just one of the things that has happened in this process. But our view is – we are absolutely adamant about running safe facilities. Safety may be the strongest virtue inside of Steris. And when we talk about safety, we think that about the people that work with us and for us. And we also think about the community that we live in. So we are absolutely committed to safety. We have – we know that we are at the – I’ll call it the better end or strong end of the industry, in terms of the way we deploy everything about our facilities, not just how we handle gas. And also – because we do it so much, we can look across plants and look for best ideas across those facilities. So we do think we are at the positive end of the spectrum. As we understand it, roughly 100 plants around the country to do this kind of work. And so, I’m sure there’s a full spectrum of activity. So, but I do think most of the conversation has not been handled scientifically. And I do think, I applaud both the FDA and EPA for working hard to manage this effort and to handle things scientifically in the process. And I think that’s the way it will end up.

Great, thank you for that. And I apologize, I’ve asked you this a number of times, but I’m still trying to get my finger on the pulse of what is happening in terms of surgical procedures. So I mean, another 10% constant currency growth, I know you had maybe a little help from some small deals. But we talked a little bit about baby boomers and the number of procedures, maybe there’s something from, I don’t know, fear about Medicare for all, but any anecdotal commentary from your hospital customers, like, what’s driving the strength and how sustainable do you think it is?

Yes. I mean, I think, we’ve talked about this, and this was a broad question. And there are variances over time, as you pointed out, when people have more ability to pay for things, they tend to do a little more and then they have less ability to pay for things. They do a little less. But since this is healthcare, much of it or most of it is not necessarily something one can decide to or not to do. There are some cosmetic procedures, obviously, where that’s not the case, but those tend not to be driven by healthcare reimbursement. Those tend to be driven more by personal payments. So in broad, it’s just very clear that the number of procedures is rising. And in my view, it will continue to rise. We are – right now, we’re the middle of the baby boom generation is in their mid-60s. And so we still have, I’ll call it the back half of the baby boom generation to get to the mid-60s and really it’s the 60s and 70s, where we spend most of our money, so in terms of healthcare. So procedures are clearly rising. And as we’ve discussed, there’s more and more going out to outpatient type facilities, both in hospital systems and outside of hospital systems. But at the same time, the hospitals are still busy and more and more complex procedures are being done. So for every arthroscopic knee that goes to outpatient, there’s another transplant of hearts or lungs or something that goes, stays in inpatient. So even though the number may not be rising the complexity continues to rise in the hospital settings, and then in many respects, in the outpatient settings. Their complexity is rising as well. And when you put all that together, that drives growth in the industry. I think, you guys have seen the other medical device companies reporting and their reporting strength as well. And that’s a function of procedures.

Thank you.

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

Thanks. Good morning, everyone.

Good morning, Larry.

I want to come back to the EO comments and I agree with your thoughts there. But, look, there certainly are communities that are voicing concern about having EO facilities in their backyard. So – and I also recognize at the same time, there was just…

Hey, Larry, you are very soft and breaking up. So we did not catch the last piece of your comment.

Yes, sorry about that.

That’s better.

Yes. So really the question here is, look, I recognize there are lack of viable alternatives for EO, but communities are voice and concern about it. So what do you think comes out of the Adcom this week? Where do you think the suggestions from the FDA are going to be to handle at the situation?

Well, I think, Larry, again, the agency is doing a good job of gathering information. I believe those who attend the meeting and for those who don’t know this, I mean, the FDA has called in order to discuss potential alternatives to ethylene oxide and to discuss other sterilization methods, my personal view, we are presenting there, if you would like to see our – some of our thoughts, if you will, in that space. The FDA asked for presenters, they chose the ones that they thought would be the better ones to discuss or not every presenter who requested to speak is speaking. So in any event, I think you will see what we largely know, that is there a lot of ways to sterilize things. And we know that because we use virtually all of them someplace, somewhere it is just certain methods of sterilization are better for certain activities. And at this moment in time, and I think for the – certainly the intermediate to long-term future ethylene oxide is going to be a significant portion of that, because it’s particularly effective for single use devices that cannot withstand heat or radiation. And on the other hand can accept that gas and that gas is very gentle on the devices. And frankly, a lot of that is because it’s been the method of choice by both the agency and medical device makers for decades now. And so everyone’s designed around that, designed for that. So for a long time, in my opinion, that will be a significant method. And even though, my earlier comments were, I believe exactly what I said, that we have a lot of non-science being discussed. That doesn’t mean, in our view that we can’t continuously improve. We have been improving our processes…

Okay. That’s helpful. And then two other questions for you. Just help us think a little bit more about the implied deceleration in the organic constant currency revenue base for the second half of the year. I think, if you use the midpoints of the range and take that 100 basis points of inorganic contribution, the back half is going to imply something like, 4.5%-ish. So maybe just again, flush that out a little bit. And I guess the other question is, how do we think about the Healthcare Products backlog, which I believe declined about 2% in this quarter. Thank you.

Sure, Larry. As we mentioned in the – in our prepared remarks, the fourth quarter last year was pretty phenomenal and it was pretty phenomenal on top of a previous year of pretty phenomenal. And we just don’t forecast beating beats all the time. And so our pause is related to the strength of the fourth quarter last year, not a lack of strength in our current business. And as I mentioned before, as our plants get more full, which they are getting pretty full right now, it is more difficult, if you have built something for one customer. And they – at the last minute decide they’re not going to take something and if you have a lot of capacity, it’s easy to flip that to another customer or to move things around. It is more difficult to do that, when we’re at the stronger end if you will of use of our capacity. Our guys have done a great job, adding capacity without building buildings the last several years. And so we do have the ability to do that. We do have the ability to meet the forecast we have in place, but we have less flexibility at the last minute to move something. So it could slip out of the quarter. It only takes a couple of significant projects to move out of the quarter, in order for us to have a little bit lower growth rate. I think your numbers might be a little low, in terms of the numbers – in terms of what the “implied” deceleration means. But – and truthfully, we don’t worry that much about quarters, the implied acceleration in the year is pretty positive. In terms of backlog, backlog is a function of orders coming in and shipments going out. And as you have seen, our shipments in healthcare have been extraordinary in the last two quarters. And as a result – and our orders have been quite strong and our pipeline continues quite strong. And so we have this temporal thing, where we shipped a little bit more than the orders that came in, but you’re talking minute levels, I think couple of million dollars or something like that year-over-year.

Yes, Larry, it’s Mike. If you look, we did grow backlog sequentially by about $12 million. And to Walt’s point, our first half capital equipment shipments in healthcare were up almost 9% year-over-year, which is we haven’t seen that in the past. So that definitely explains why backlog is down just slightly year-over-year.

Okay.

And the like, the backlog is at near record levels. So total backlog is still up about 2%.

Great. Okay. Thank you very much. Appreciate the thoughts.

You’re welcome.

Thank you. And the next question comes from Jason Rodgers with Great Lakes Review.

Yes. I wonder if you could just make some comments on any new developments as far as the outsourcing trend in the U.S. that’s picking up any steam at all.

Sure. The – we continue to have customers talking to us about outsourcing. As I mentioned before, I think the models will be somewhat different in the United States and they have been in the UK. And I think there will be various models that come into play. But we’re still on track for the revenue growth that we’ve – revenues that we’ve expected, revenue growth that we’ve expected. And we don’t have any reason to change that view. So we still think that’s a positive grower for our business and we continue to see the same. In fact, one of the things we talked about is that we are spending money again in the service business. You have to spend in front of growth, that’s not always true in every business. But we have to spend money in front of growth to get people ready for future revenues. And so we clearly have seen that win. I suspect we’ll see that in the back half of the year that we will have – we’ll be spending ahead of future growth in the business.

And speaking of spending for future growth, looking at the HSS segments, the operating income was held back somewhat by the investments there. Is that the expectation over the next few quarters?

I don’t know about next few quarters, I definitely would say, the next quarter, I’m pretty sure that’s the case. And then the question is how quickly the revenue comes in to support it. But we are continuing to and expect to continue to spend for growth going forward. The question is how quickly the revenue comes along with it. But orders of magnitude, we’re still thinking double-digit kind of profitability. So it’s not like, we’re not anticipating going from where we are now to 8% or something like that. It’s more modest conversation I think.

Yes. Thank you.

Thank you. And the next question comes from Chris Cooley with Stephens.

Good morning and appreciate you taking the questions and congrats on a really strong fiscal second quarter. Just maybe two for me. On the growth side, while that’s little bit uncharacteristic for you to raise full year guidance after the second quarter. I’m looking back here, historically, that’s 3Q event for you. So with a strong fourth quarter comp that you’ve referenced a number of times here now this morning, could you maybe just help us think through all the different puts and takes here in the back half and what really gives you that much confidence in this kind of revised range, when we look at both of revenue and earnings and cash flow? And then I have a quick follow-up as well.

Sure. Chris. I mean, first of all, we’ve discussed that these tuck-in acquisitions raise revenue a point and we moved to 1.5 points. We needed to move because of those and for another 0.5 point we thought that was well within what we should expect. And we kept the range roughly the same. So at a high level, that’s really the simple description. When we – on the earning side, again, there’s the first component is indeed the piece that we talked about with the business development. So those acquisitions do provide some level of earnings. But then in addition to that, we’ve clearly seen, our plants are running full and when plants run full, they tend to do a little bit better. That’s the expansion. And we continue – we don’t – haven’t talked about it, but we continue to do more and more in-sourcing. And so our plants, in addition to adding volume are continuing to in-source and that’s – that just squares the impact, because you’re growing and you’re in-sourcing. So it makes it even better. So that’s the – those are the positive things. Now, we did leave the range in earnings roughly the same, which for the year, we only have half a year to go, but we still haven’t seen device tax sort out. We still haven’t seen Brexit sort out. We still have – trade is an every other day conversation. So we left the range as it is, because we do think there’s a bit more uncertainty of what may occur. But given what we have already put in the bank and what we anticipate in the orders we have in hand and the orders we see coming, we just thought it was advisable to move up.

Understood, I appreciate the additional color. I apologize hopping between a couple of calls here this morning. My final one is just on the cash flow guidance. And it’s hard to nitpick at what’s essentially 10% of sales at the mid point of guidance, really healthy cash flow target for the year. But we’re not really getting that much leverage there. It looks like it’s the CapEx delta, that’s really now going into cash flow. So I guess just to bring it together, I understand you have to spend to continue to grow and there’s been a lot of investment in AST. But is this kind of, as good as we can get, when we think about cash flow going forward. Or is there opportunity for greater leverage from a cash flow perspective as we just kind of think dramatically over the next three years, as you start to leverage some of the different investments you’ve made and the capacity comes online and gets utilized at AST. Thank you so much.

Hey, Chris, this is Mike. So good question, and all we did – you’re right in the guidance is we have taking down CapEx and we did increase cash flow by the exact same $20 million. But what you’re not seeing is we do not adjust free cash flow. So there is another roughly $15 million of impact to free cash flow for the acquisition, the integrations, our restructuring costs are still coming and impacting us. So if you were to back those out, you would add another $15 million, which I think would help solve the issue that you’re looking for in still doing a nice job of generating solid free cash flow.

Super. Congrats on a super quarter. Thanks.

Thanks, Chris.

Thank you. [Operator Instructions] And the next question comes from Matthew Mishan with KeyBanc.

Great. Thanks for taking questions. Well, Mike, Julie and congratulations on really continued strong momentum in the business.

Thank you, sir.

Just a quick question on the sites that you’re – in AST, on the sites that you’re opening expanding, could you give us a sense of the breakdown between EO, Gamma, e-beam, and whether or not that’s U.S. capacity or international capacity?

Yes. We’re doing so many, Matt. At the top of my head, that level of breakdown is a little tough. I will tell you that we do announce those on our website. And so if you want details, you could easily pick them up off of our website. But at a high level, I can say, the preponderance of the openings, both U.S. and globally are radiation based, not ethylene oxide based. And we are growing our capacity in ethylene oxide and we have grown it in both the U.S. and OUS. And orders of magnitude, roughly in line with our expectation of what EO growth will be, which is more on that 5% to 7% range. But on the other hand, on the radiation side, we have expected a bit faster growth. And so we are growing our radiation business, again, both in the U.S. and OUS more rapidly even than that have and continue to. And all things being equal, we are expanding much more in either e-beam or x-ray than we are in cobalt gamma radiation. And we see those as being complimentary. And so, generally speaking, we’re expanding in either x-ray or e-beam in or both in or around cobalt facilities we already have, as well as locating some in new sites. And the reason for that is customers, may not be comfortable or said differently, we’d be more comfortable moving to x-ray or e-beam, if they have a cobalt backup is the one thing. That’s also where the customers are that need radiation. So it’s a combination of those two events. So generally speaking, we expect to see cobalt around a long, long, long time. But more of the growth of the business we expect to happen in either e-beam or x-ray, so those forms of radiation.

Hey, Matt, just for some context, if you look at our EO business, our EO is about 25% of total AST revenue. So that gives you some context of the impact of EO with our facilities and the total revenue for the year.

I mean, maybe this is a bad question. I tend to ask a lot of those, but how interchangeable or some of the products between EO and gamma. Is there a certain percentage that that could switch and the same question EO versus the e-beam and x-ray?

Yes, you can answer that kind of gas versus radiation in short and EO – specifically EO. There is a small percentage of product that can be done with either one. And they are, for lack of better term, semi interchangeable. We happen to have surprise of our own that we sterilize that we know we can do either way. Having said that, the preponderance of products are one or the other. Because the, it’s not that they both wouldn’t sterilize in most cases, there are some cases, where they actually wouldn’t sterilize, because the radiation or gas can’t get to the product. But generally speaking, they could sterilize, but you ruin the product with the sterilization methodology. And so obviously, we can’t ruin the product, while we’re sterilizing. So at a high level, I’d say, it’s – this is ballpark with maybe 10% or 15% of either one could go either way, but we’re not talking 90% that can go either way. Is at a high level. So there is some substitution possibility, but limited. Having said that, that’s why we have virtually every form of sterilization on the planet, because what is really good to do in hospitals for reprocessing, where we commonly use hydrogen peroxide is almost useless for most industrial sterilization, where we’re doing it in the first time and things that are pre-packaged for a variety of reasons. The same is true for most of the gas versus and will steam, for example, steam is commonly used in hospitals. It’s completely irrelevant industrial, because that’s already packaged. And so you would be ruining the packaging, if nothing else and it probably wouldn’t work anyway. So at a high level, it’s very limited. Now when you come to the inside of radiation, x-ray versus e-beam versus cobalt, there the combination of x-ray and cobalt, there’s much more substitutability if you will. And it varies based again on the device itself, the packaging the device, the way it is put in place. So there is much more substitutability radiation versus radiation, there is very limited really substitutability gas to radiation at a high level.

Okay. That’s actually very helpful and I really do appreciate you giving all this color on this business, on the conference call. And then just moving to margins, especially on Healthcare Products, we’re now moving into that mid-20s level, it appears. And I remember you’ve talking previously about, you get a little bit worried once you get up into that mid-20s level. Have we kind of reached a point where we’re – those are about to kind of level out?

Matt, your problem is you’ve been covering us too long, we’re going to be looking for a new analyst only been around six or seven years, because I haven’t said that for six or seven years. The short answer is, there is no business that we don’t believe we can improve. And so we’re always working to improvement. In any business, there’s a point at which for any product line or any space, you risk creating a price umbrella and other competitors decide to take that business from you because of price and we monitor that very carefully. We – that’s why, as you know, we reduce costs faster than our profits rise, because we tend to place some of that cost production back into price, if you will, or not raising prices. It’s not that we’re cutting prices, usually, it is that we’re not raising prices. So that’s a part of our mantra. You are correct, you get to certain levels you have to start watching that. But the other side of this, we have to remember is ROS, return on sales is not the only determinant of whether things are price correctly or whether it’s hard or difficult to enter to compete. ROIC is also a very, very important component, in fact, more important component. And so, some of those products that are making very healthy returns on sales, we have to invest an awful lot of capital to get there. And whether that capital is capital, intellectual property types of capital or whether that is, surely capital spending kind of capital or inventory and receivables kind of capital, working capital that we also watch that very carefully. We’re comfortable with where we are. And I’m not ready to declare an end, as I think I said maybe four or five years ago, when we get to 20, we’ll talk about it. Well, we’re talking about it. So we’re not feeling any natural cap in our business.

Right. And excellent. And then the last one I’m done. Of all of the small deals that you’ve done it, is there any that you want to particularly call out as being a long-term growth driver, something that’s a pretty good – it’s something that has pretty nice adjacency to what your strategy looks like?

No, not at this time. These are tuck-ins, I think each one of them will help there. They’re spread kind of across the various product lines. So it’s not like there’s four of them instead than one product line that’s going to change things. When we – at HSS, when we were buying three or four companies at one time, that was significant, because it was concentrated. These are spread out, even though, most of them in Healthcare Products are spread out across the very different product lines and all products. So in total, does that – does it enhance our Healthcare Products business? Absolutely, yes. Does it enhance our ability to serve our customers and hospitals better? Yes. But these are not, I’ll call it world changing acquisitions.

All right. Thank you very much.

Thank you. And the next question is a follow-up from Larry Keusch with Raymond James.

Walt, I suppose at the Adcom, there will certainly be discussion around alternative sterilization methodologies. And again, I certainly recognize that just sort of a purely practical perspective, EO gas is going to remain a key sterilization mode for many, many years. But just on alternates, do you see any out there or do you guys have something that you maybe developing that could be a viable as a large scale commercial alternative to gas to EO gas?

Larry, first of all, we don’t discuss future product to product development, acquisitions for a reason, so that’s kind of statement number one. We are presenting on one alternative, which will be is and will be used in the space, which is a hydrogen peroxide for this space. But it’s our own view and we see, as you might expect, everyone who has a thought or a novel thought about how one might sterilize something when they think about who they should go to see if it works and/or to see if we can commercialize it, since we are the broadest, deepest, widest sterilizer in the world. It has a habit of coming to us one way or another. And I can say unequivocally that for the short to intermediate term, and I’m talking not days and weeks, I’m talking, years and decades. We do not see an alternative of scale that will change the ethylene oxide picture for industrial sterilization in the world.

Okay. Very good. Thank you.

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

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

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