Oct 30, 2013
Executives
Julie Winter - Director, Investor Relations Walt Rosebrough Jr. – President, Chief Executive Officer Mike Tokich - Chief Financial Officer, Senior Vice President
Analysts
Konstantin Tcherepachenets - Raymond James Erin Wilson - Bank of America/Merrill Lynch Mitra Ramgopal - Sidoti Greg Halter - Great Lakes Review
Operator
Welcome to the STERIS’ Fiscal 2014 Second Quarter Conference Call. All lines will remain in listen-only until the question-and-answer session.
At that time instructions will be given should you wish to participate. At the request of STERIS today’s call will be recorded for instant replay.
I would now like to introduce today’s host, Julie Winter, Director of Investor Relations. Ma’am, you may begin.
Julie Winter
Thank you, Jane, and good morning, everyone. It’s my pleasure to welcome you to our fiscal 2014 second quarter conference call.
Thank you for taking the time to join us this morning. As usual, participating in the call this morning are Walt Rosebrough, our President and CEO; and Mike Tokich, our Senior Vice President and CFO.
Now just a few words of caution before we begin, 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.
I would also like to remind you that this discussion may contain forward-looking statements relating to the company, its performance or its industry, that are intended to qualify for protection under the Private Securities Litigation Reform Act of 1995. No assurance can be given as to any future financial results.
Actual results could differ materially from those in the forward-looking statements. The company does not undertake to update or revise these forward-looking statements, even if events make it clear that any projected results, expressed or implied, in this or other company statements will not be realized.
Investors are further cautioned not to place undue reliance on any forward-looking statements. These statements involve risks and uncertainties, many of which are beyond the company’s control.
Additional information concerning factors that could cause actual results to differ materially is contained in today’s earnings release. And finally as a reminder, during the call we will refer to non-GAAP measures including adjusted earnings, free cash flow, backlog, debt-to-capital and days sales outstanding, all of which are defined and reconciled as appropriate in today’s press release or our most recent 10-K filings, both of which can be found on our website at steris-ir.com.
With those cautions, I will hand the call over to Mike.
Mike Tokich
Thank you, Julie and good morning everyone. It is once again my pleasure to be with you with this morning to review our second quarter financial results.
As usual my comments this morning regarding total company and healthcare results will be based on adjusted figures. Please see the reconciliation table included in our press release for additional details.
Let me now begin with a review of our second quarter income statement. Total revenue grew 14% during the second quarter driven by a 10% increase from acquisitions, 3% increase in organic volume and 1% improvement in pricing.
Foreign currency was neutral to revenue during the quarter. Gross margin at 40.3% represent an increase of 90 basis points over the prior year.
The increase is driven by 140 basis points from acquisitions and 60 basis points from price. This increase was somewhat offset by our investments insourcing along with the medical device excise tax each of which was approximately $2 million.
EBIT improved $7.8 million in the quarter. EBIT at 14.3% of revenue increased both sequentially and year-over-year.
Year-over-year EBIT as a percent of revenue increased 30 basis points as gross margin improvements were somewhat offset by higher R&D expenses. R&D expense in the quarter increased $3.7 million compared to the prior year and includes almost $1 million related to a disallowance of foreign R&D government subsidies.
The effective tax rate in the quarter was 35.2% compared with 29.4% last year. The prior year tax rate is lower due to the timing of discrete item adjustments.
As a result, net income increased to $32.6 million or $0.55 per diluted share compared with $30.9 million or $0.53 per diluted share last year. Moving on to our segment results, healthcare revenue in the quarter grew 17%, healthcare capital equipment revenue grew 3% including a negative 1% impact from our SYSTEM 1E year-over-year unit sales decline.
This is our final quarter to be impacted by the SYSTEM 1 1E transition. Healthcare consumable revenue increased 26% driven by both acquisitions and organic growth.
Consumable organic growth during the quarter was a positive 3%. Service revenue grew 34% driven by both acquisitions and organic growth.
Service organic growth during the quarter increased 6%. Healthcare backlog increased double digits both sequentially and year-over-year ending the quarter at $133 million.
Healthcare operating income increased 14% to $30.3 million in the second quarter. The increase in operating income year-over-year was primarily driven by the acquisitions and increased volume.
This increase was somewhat offset by the medical device excise tax, increased R&D expense and investments in insourcing. Life Sciences revenue increased 7% during the quarter.
Consumable revenue had another good quarter of growth up 8% while service revenue was flat. Capital equipment revenue grew 13% in the quarter and as per usual capital equipment shipments within this segment tend to vary from quarter-to-quarter.
Backlog in Life Sciences ended the quarter at $47.8 million, a decline of 6% compared with the prior year but an increase of 7% compared to the first quarter. Life Sciences second quarter operating income set an all time high at 24.1% of revenue.
While we are pleased with this quarter’s operating margin rate. It was unusually high as we experienced a very favorable gross margin mix within Life Sciences capital equipment business.
Revenue for Isomedix increased 7% in the quarter to $47.4 million. Isomedix operating margin was 28.9% of revenue an increase of 30 basis points as compared to the prior year.
During the quarter we did have success in filling our expanded capacity. However, at the same time, we did have several chambers offline during the quarter for maintenance purposes and did experience higher repairs and maintenance costs both of which did have a slight drag on our operating margin in the quarter.
In terms of the balance sheet, we ended the quarter with $164 million of cash and $509 million in long-term debt. We remained comfortable with our current leverage profile, total debt to capital of 34% and total debt to EBITDA of 1.7x.
A free cash flow for the first six months was $32.9 million compared with $67 million in the prior year. The decline in free cash flow is primarily due to the payments of our annual incentive compensation program which did not occur in the prior year as well as the impact of strong working capital improvements in the prior year.
Capital spending was $25.4 million in the quarter while depreciation, amortization was $17.8 million. With that I will now turn the call over to Walt for his remarks.
Walt?
Walt Rosebrough Jr.
Thanks Michael, and good morning, everyone. We appreciate you taking the time to join us.
Now that you have heard an overview of our results from Mike, I will spend my time focused on a few highlights and our outlook for the year. As we told you in August, we believed that our first quarter results were largely a matter of timing and not a change in underlying demand or sustainability or profitability.
We are pleased to report results today that reflect those views with substantial improvements sequentially and strong indicators for our second half. As we have said for some time now, we continue to see generally stable market trends in the United States and believe the market is growing modestly.
Our healthcare segment delivered organic growth in line with the market and the businesses we acquired last year continue to meet or exceed our bottom line growth expectations in aggregate. We continue to be very pleased with the trajectory of the acquired businesses.
As Mike mentioned, we had a good quarter for healthcare capital equipment where shipment is growing 3% and at the same time, we closed the quarter with a double-digit growth in backlog. As expected, we saw a double-digit growth in capital equipment revenue in the United States.
In addition, our organic healthcare consumables franchise return to growth increasing 3% year-over-year. It does not appear to us that we will see a surge of consumables business to cover the softness we experienced in the first quarter but we appeared to be back on the growth path we expected.
We continue to forecast growth in consumables both sequentially and year-over-year for the full year. Life Sciences and Isomedix, both had another quarter of good growth and strong margins.
Our capital equipment and consumable business in Life Science continues to show strong sales in the pharmaceutical space and Isomedix continues to grow into the recent capacity expansion. Looking out to the second half of our fiscal year, we continue to believe that we will deliver top line growth in the range of 8% to 10% for the full year.
Our strong backlog gives us a good start on capital equipment shipments and our people on the field indicate that our expectations for consumables and service can be achieved. From an earnings perspective, we are pleased to see that the majority of the headwinds we experienced in the first quarter have abated as expected.
However, do mostly to the timing of investments for our insourcing projects, we now anticipate that earnings will fall in the lower half of our previously provided range for this fiscal year. Let me expand on that a bit.
While we have made substantial progress on insourcing this year, our original expectations for the cost incurred in the first half of the year would be fully offset by savings in the second half to get us to a neutral position for the full year. We now anticipate that instead of being neutral, our insourcing work will have a net cost of about $3 million to the P&L this fiscal year.
More specifically, we now anticipate that we will continue to have net expenses in the third quarter and only modest savings in the fourth versus our prior expectations of savings in each quarter. We remain confident that we will achieve or beat the anticipated cost savings in the longer term but we now think that the bulk of the savings will get pushed into fiscal 2015 and 2016.
An example of the delays we are facing is the challenge we are finding enough of the appropriate skilled labor in one of our insourcing facilities. We have about 15% of the positions open that we expected to be filled by now.
And we cannot insource additional components until those people are hired and trained. Looking longer-term, our early results support our belief that the insourcing projects will generate savings of $8 million to $10 million per year and improve the quality and delivery of our products as we expected.
We now believe, we will see the full benefit in fiscal 2016. For fiscal 2015, we anticipate generating between $4 million and $7 million in savings in new projects.
Although, a little behind our original plans, this is still a great return on the investments we’re making and the right strategy for the long-term. In closing, we are pleased with the sequential improvements in our business and the progress we’ve made integrating the acquisitions from last year.
While we clearly have work to do to deliver on our expectations in the second half of this year and into fiscal 2015, our organization is dedicating to doing so, in particular, we anticipate good growth in the U.S. and Europe and better leverage of our P&L to drive margin improvement.
With that, I will turn the call back over to Julie to begin the Q&A.
Julie Winter
Thank you, Walt and Mike for your comments. We’re now ready to begin the Q&A.
So, Jane, would you please give the instructions and we’ll get started.
Operator
Thank you. (Operator Instructions) Our first question comes from Konstantin Tcherepachenets with Raymond James.
Your line is open.
Konstantin Tcherepachenets - Raymond James
Thank you. Hey guys, thanks for taking the question.
I guess maybe if we can just start with, can you comment on what are you seeing growth rates from your U.S. Endoscopy business, and also talk kind of what growth are you seeing from the specialty services business that you guys acquired last year?
Walt Rosebrough Jr.
Konstantin, good morning it’s – we are not going to give detailed numbers on [indiscernible] segments as normal but we anticipated double-digit growth in both of those businesses and we are seeing that both in revenue and earnings.
Konstantin Tcherepachenets - Raymond James
Okay. That’s true I think.
And then the second question is, as a follow up, as you guys think about your M&A strategy and I think Walt, you have articulated that you kind of I think there is a desire to kind of take the specialty service business kind of from regional to a more kind of national business, can you just provide us an update in terms of rollout of that strategy and maybe you can just update us on your latest thoughts on M&A?
Walt Rosebrough Jr.
Sure. We said consistently that the place we want to do M&A first is, in support of the businesses we already have as opposed to stepping outside and looking forward to the next, I will call it expansion for lack of better terms.
And so we clearly are focusing on not just specialty service business not just the endoscopy business but we are focusing in all of our businesses, each of our units is looking for opportunities. But just as we had said articulated we are interested in making acquisitions in that space to the extent that people are going to sell.
Konstantin Tcherepachenets - Raymond James
Got it. Thank you.
Operator
Our next question comes from Erin Wilson with Bank of America/Merrill Lynch. Your line is open.
Erin Wilson - Bank of America/Merrill Lynch
Thanks for taking my questions. There seems to be sort of a rebound in organic growth both consumables, services business, I guess compared to what we saw in the first quarter.
Can you speak to the underlying trends there what was related to overall procedure volumes, new products and how should we think about the quarterly progression going forward?
Walt Rosebrough Jr.
You know, Erin, as we told you last quarter, we were a bit confused ourselves about what was going on last quarter and we thought it was a temporal activity these are stocking up or stocking out more than any kind of significant change in trend. And now we are feel even more from that was a case.
We had a pretty strong fourth quarter and a pretty strong second quarter and the first quarter seems to, we will just have a temporal fluctuation there. But, we did as you know we were in the first quarter particularly in the consumable side and our thinking was when we looked out, we didn’t see a change in things significantly so.
And now we are back to that level. But we are seeing modest growth in market growth in that area, we are not seeing double-digit growth in procedures or those things we are seeing, I would call it flat to a modest increase growth in the marketplace.
And we are trending with that growth rate.
Erin Wilson - Bank of America/Merrill Lynch
Okay. Great.
And now that you are one-year off in acquisition of U.S. Endoscopy, are you starting to see some of that representing synergies materialize or how do you or do you have any sort of meaningful even just anecdote that sees a synergistic relationship between the two businesses and how that is progressing?
Walt Rosebrough Jr.
Well, in terms of our expectations with U.S. Endoscopy and with the specialty services business we are seeing what we expected that is the -- I thought the modest back office synergies have been realized and we are beginning to see some modest revenue synergies between the businesses.
And really there are potential synergies across all three businesses, our historic business the repair business that we acquired and the U.S. Endoscopy business.
But to get any details, its still as we expect, it is still relatively modest and a lot of what we did was buy into a business that we thought a good growth in, good new product development and may continue to do that. So they are on their plan.
We have seen some modest synergies, cross synergies on the selling side, but its nothing I would point to you specifically.
Erin Wilson - Bank of America/Merrill Lynch
Okay. Great.
Thanks so much.
Operator
Our next question comes from Mitra Ramgopal with Sidoti. Your line is open.
Mitra Ramgopal - Sidoti
Yes. Hi, good morning.
Just a few questions. First of all, the insourcing projects, will they be completed by the end of fiscal 2014 or will be there additional projects that you will be looking at going forward?
Walt Rosebrough Jr.
The projects that we have as I mentioned before if we characterize them kind of in two or three projects but its really a series of components and parts and projects in multiple plants. It will not be concluded in fiscal 2014.
And in my view it won’t be concluded in 2015 or 2016 either but there will be additional projects that we have not counted on or given forecast on. I would expect those generally to be smaller in nature and kind of add-ons to things we are currently doing.
But I would say time wise, I’m not 100% certain on these projects but I would say the preponderance will be done and completed the work in fiscal 2015 and we maybe phasing some of that in yet. We will be phasing some of them in 2016 as you – as we are able to build different things, you don’t just convert everything all at once.
You take them a part at a time or a product at a time and build those through. So the implementation of that will carry into 2015.
Mitra Ramgopal - Sidoti
Okay. That’s helpful.
And so the savings numbers you cited earlier the 8 to 10 say 2016, that’s not necessarily a net figure?
Walt Rosebrough Jr.
Yes. We would consider that a net figure for those specific projects.
If we added projects in the future there would be another set of netting that I can’t comment, I do not yet know the cost or the savings. But you can be assured we are not going to do them, if we are not -- we may have some investments in the short run but we would not be doing if we are not going to see more significant savings relatively quick.
Mitra Ramgopal - Sidoti
Right.
Walt Rosebrough Jr.
We see these as very fast returning projects. And it needs a couple of years for some of these big projects.
Mitra Ramgopal - Sidoti
Okay, thanks. And moving on to international, I know if you are looking to say the mix of revenue, it’s down a little in the first half versus what we have seen in the past.
Is there something more reflecting of what’s going on for example in foreign markets or does it sort of indicate more of focus or is that domestic?
Walt Rosebrough Jr.
No, I would not at all characterize it as focusing more toward domestic. We continue to believe that the developing countries will be a source of significant revenue for us.
And international will be a source of significant revenue. We have seen in the capital business specifically our U.S.
and the EMA business has been doing what we expected this year. But the business outside U.S.
and EMA which are of course our larger market, we have seen some softness in both in Asia pacific and in Latin America. We think that is somewhat market based -- their economies have not been running as rapidly as they were a couple of years ago.
So part of that is, I think general economy in those spaces but also think part of it since we are predominantly U.S., European manufacturers shipping into those markets and particularly the dollar has strengthened versus most of those market last 12 to 18 months. We have also seen some pressure based on that.
Mitra Ramgopal - Sidoti
Okay, thanks. Then finally on the capital equipment side in the U.S.
are you sort of seen similar interests as it relates to say new built outs or is it more towards renovations?
Walt Rosebrough Jr.
Yes. That mix for us is generally kind of a 60:40 mix and we haven’t seen a radical departure that maybe a little bit more towards large projects.
It’s kind of been bouncing around but I think if anything a little bit toward large projects at this point but not something that’s radically significant.
Mitra Ramgopal - Sidoti
Okay. Thanks again.
Operator
(Operator Instructions) Our next question comes from Greg Halter, Great Lakes Review. You may ask your question.
Greg Halter - Great Lakes Review
Yes. Couple of questions here, good morning and congrats on a good results.
First one is on R&D, Mike, you had made some comments about $1 million or so. Can you explain that a little further?
Mike Tokich
Yes, certainly. We had almost $1 million of foreign R&D government subsidies disallowed.
And what that has really based on is the foreign government that we submitted for subsidies for came back and actually believed that the R&D products that we submitted were more engineering type changes rather than strictly innovation based in their view. And so they disallowed that subsidy for us and this is over a couple of year period of time that subsidy.
So going forward, we believe we had limited to no further exposure on this type of disallowance.
Greg Halter - Great Lakes Review
Okay. So that $1 million was an increase in the R&D expense, correct?
Mike Tokich
Correct, yes. So the subsidy had been received and we had to subsequently payback that subsidy that we received.
Greg Halter - Great Lakes Review
Okay.
Mike Tokich
So would increase the R&D expense for the quarter.
Greg Halter - Great Lakes Review
All right.
Walt Rosebrough Jr.
Even when you think about that, it’s kind of like a discrete tax adjustment, I mean that’s really the easy way to think about it. It just -- it doesn’t come through on the tax line, it comes through in the R&D line.
Greg Halter - Great Lakes Review
Okay. Thank you.
And even excluding that, let’s say its $12.5 million, I think that’s the record for your company in terms of dollar spend and obviously as shareholders and so forth people like to see the return there and just wonder if you could comment on if you expect that number to remain at that type of level and what kind of products are coming out of the effort?
Walt Rosebrough Jr.
Sure. Couple of things, we’ve already mentioned it.
We’re in that kind of 3% range. Two things have occurred in terms of both the raw dollars and the percentages, U.S.
Endoscopy in particular has a significantly higher R&D spend as a percent of their revenue and has a faster turn of new products and that’s we bought -- that’s where we want to continue. So part to that is and it’s absolutely natural in that business and the business they’re in, we expect that to continue.
So that shifted the percentages up a little bit. And we do, we have increased R&D spend and we’ve done a lot the last several years to refresh our line.
And we have a number of new products coming out in the future. We don't comment on what’s coming.
But we have introduced fairly recently a new set of steam sterilizers. We have worked on a number of our other products which we can see coming out the next six to 18 months.
So we have picked up R&D spend a little bit in the base design a percentage basis, the balance of the percentage increases really are called a mix shift to U.S. Endoscopy.
Greg Halter - Great Lakes Review
Okay. And we’ve covered the company since I think February of 1994, so it’s a long time.
And I can recall back eight to 10 years that the Life Sciences business was something that I think there were even some divestitures in and are you trying to get out of that in some respects and I just wondered what has changed to give you such a high profit margin now. I know the 24% you said is all time high and the mix [indiscernible] and so forth.
But wonder whether or not, first what has changed there and whether or not that sustainable in your view.
Walt Rosebrough Jr.
Yes, I would break it, there is multiple things that have happened over course of that timeframe but I would break it into two or three things specifically. The first is and we talk about this maybe five years ago, when we were having most of the conversation as we were doing a lot -- the Life Science business is not a standard in general as the healthcare business that is every sterilizer might has some slightly different modification because you’re putting it into the assembly line or the line of the company -- of the pharmaceutical company or it’s a very heavily used item.
So they want it engineered specifically for their purpose. Some of these things are the size of our room.
And so, it was a very heavily engineered business and we were not doing a good job of capturing the engineering. We’re doing a good job of capturing the cost if you will but of the design and changes and engineering, we would -- we’re not doing a good job of that four, five, six years ago and as a result we were under-pricing our products.
We have a stopped doing that. And so we now price appropriately for the work that we do for the specialty built items, these large specialty built items.
So that’s one thing that we’ve done. The second thing, we’ve done is, we have [ph] quit chasing business that is sure low-end business and the third thing we’ve done is, we improved on the capital side.
We’ve improved our plant significantly. Now, most to those plants are shared with the healthcare business and so it is the healthcare business is the predominant or the large user of those factories as we improve those factories and you have seen results in those factories and healthcare business too that drops to very quickly on the Life Science side.
And then the second major -- other major areas on the Chemistry side, we have increased our chemistries, the mix of our product has moved toward chemistries and to some extent service but certainly on the Chemistry side and the Chemistry side is a more profitable business. So we’ve had a mix shift over those four, five years.
We do believe that if you look at our – don’t look at this quarter, but you look at the year, we believe those are sustainable kind of numbers. You look at the quarter.
We had heck of a nice quarter. We had very heavy positive mix if you will.
But yes, we do think that those kind of numbers are sustainable and we have been investing in that business and continue to invest to grow that business as opposed to you are correct six, seven, eight years ago there were a lot of people suggesting we might want to think about exiting the business. We don’t think that’s appropriate.
Greg Halter - Great Lakes Review
Okay. Well, now that’s for sure.
Keep it up.
Walt Rosebrough Jr.
We didn’t think so six years ago, we feel much more strongly about it today.
Greg Halter - Great Lakes Review
And do you expect any changes in your tax rate going forward around this 35% level, I know it bounces around quarter-over-quarter but generally --?
Mike Tokich
Yes. I mean, Greg, we have been in the range 34% to 35%, which is what we think for the year will remain in our forecast.
Now longer term, obviously, the more international growth we can get to more profitable, we can get outside of the United States, obviously, there are possibilities to reduce that. But, right now, for this fiscal year, 34% to 35% is what we are forecasting.
Greg Halter - Great Lakes Review
Okay. And any update on the share repurchase program of the company?
Mike Tokich
Yes. During the quarter, we actually bought a little bit of shares, we bought just over 321,000 shares for a total of about just under $14 million.
And then for the year, we got to about 427,000 shares for about $18.5 million. So we still have about $93 million left on our authorization.
But again, we are just buying a little bit at a time here. Again, our preference would be to invest in our business or do M&A [indiscernible] and continue with a larger share repurchase.
Greg Halter - Great Lakes Review
Okay.
Walt Rosebrough Jr.
Right now we are buying shares in effect to offset dilution from the company’s stock and option programs. So at a high level that’s kind of what our thought – my thought is as long as we see the M&A and investments in the business and M&A, which we think dominate that third option.
Greg Halter - Great Lakes Review
All right. And on the insourcing, you indicted some issues with skilled labor and so forth, is that things like welders or how would you characterize that?
Walt Rosebrough Jr.
Yes. You are exactly right.
It’s machiners, welders, skilled manufacturing people, not assembly labor that’s very easy to come by but skilled workers, light machiners of various types and welders of various types. That’s correct.
Greg Halter - Great Lakes Review
All right. And one last –
Walt Rosebrough Jr.
We don’t see that being a – this isn’t tenure – it’s a tenure problem for the country. We don’t think it’s a tenure problem for us.
We think we will [indiscernible] just take a little longer than we thought.
Greg Halter - Great Lakes Review
You got Lincoln right down the street and you need to call them though.
Walt Rosebrough Jr.
They are good friends of ours.
Greg Halter - Great Lakes Review
Of course, the last one is --
Walt Rosebrough Jr.
Actually they probably better – probably think of us better because we are the customer, right.
Greg Halter - Great Lakes Review
One last one for you. Any changes in competition that you like to note?
Walt Rosebrough Jr.
I can’t think of any significant change that we would note.
Greg Halter - Great Lakes Review
All right. Thank you.
Operator
I show no other questions at this time. I will turn the call back now for closing remarks.
Julie Winter
Thanks everybody for joining us and have a great day.
Operator
Thank you for participating. You may now disconnect.