Welcome to the STERIS Fiscal 2014 Second Quarter Conference Call. [Operator Instructions] At the request of STERIS, today's call will be recorded for instant replay..

I'd now like to introduce today's host, Julie Winter, Director of Investor Relations. Ma'am, you may begin. .

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 express 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, express 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 filing, both of which can be found on our website at steris-ir.com..

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 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, a 3% increase in organic volume and a 1% improvement in pricing. Foreign currency was neutral to revenue during the quarter..

Gross margin, at 40.3%, represents 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 in in-sourcing 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 in-sourcing..

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 remain comfortable with our current leverage profile of total debt to capital of 34% and total debt to EBITDA of 1.7x..

Our free cash flow for the first 6 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 and amortization was $17.8 million..

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

Walt?.

Thanks, Michael, and good morning everyone. We appreciate you taking the time to join us. Now that you've 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 and profitability. We are pleased to report results today that reflect those views with substantial improvement 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, with shipments growing 3% and, at the same time, we closed the quarter with a double-digit growth in backlog. As expected, we saw double-digit growth in capital equipment revenue in the United States..

In addition, our organic Healthcare Consumables franchise returned 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 appear 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 their recent capacity expansions..

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 in 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 in-sourcing 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 in-sourcing this year, our original expectations were that costs 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 in-sourcing 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 of finding enough of the appropriate skilled labor in one of our in-sourcing facilities. We have about 15% of the positions open that we expected to be filled by now. And we cannot in-source additional components until those people are hired and trained..

Looking longer-term, our early results support our belief that the in-sourcing projects will generate savings of $8 million to $10 million per year and improve the quality and delivery of our products, as we expected. But 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 from these projects. Although a little behind our original plans, this is still a great return on the investments we are 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 have 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. .

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 Instructions] Our first question comes from Konstantin Tcherepachenets with Raymond James. .

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?.

Konstantin, we're not going to give detailed numbers on product lines or segments, as normal, but we anticipated double-digit growth in both of those businesses and we're seeing that, both in revenue and earnings. .

Okay, that's terrific. 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's 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?.

Sure. We've 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 for the next, I'll 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're focusing in all of our businesses, each of our units is looking for opportunities. But just as we had said, and you've articulated, we are interested in making acquisitions in that space to the extent that people are willing to sell. .

Our next question comes from Erin Wilson with Bank of America Merrill Lynch. .

There seems to be sort of a rebound in organic growth for the consumable 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?.

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, either stocking up or stocking out, more than any kind of significant change in trend. And now we are -- feel even more firmly that was a case.

We had a pretty strong fourth quarter and a pretty strong second quarter and the first quarter seems to -- you just have a temporal fluctuation there.

But we did -- as you know, we were in the first quarter, particularly on the consumable side, and our thinking was when we looked out, we didn't see a change in things, significantly, so -- and now we're back to that level. But we're seeing modest growth in market growth in that area. We're not seeing double-digit growth in procedures or those things.

We're seeing, I would call it, flat to modest increase growth in the marketplace. And we're trending with that growth rate. .

Okay, great.

And now that you're 1 year off on the acquisition of US Endoscopy, are you starting to see some of the revenue synergies materialize? Or how do you -- or do you have any sort of meaningful even just anecdotes as to the synergistic relationship between the 2 businesses and how that is progressing?.

Well, in terms of our expectations with US Endoscopy and with the specialty services business, we are seeing what we expected. That is, the I'll call it 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 3 businesses, our historic business, the repair business that we acquired and the US Endoscopy business.

But to get into any details, it's still -- as we expected, it's still relatively modest and a lot of what we did was buy into a business that we thought had good growth and good new product development and they continue to do that. So they're on their plan. We have seen some modest synergies, cross synergies on the selling side.

But it's nothing I would point to specifically. .

Our next question comes from Mitra Ramgopal with Sidoti. .

Just a few questions.

First, Walt, the in-sourcing projects, will they be completed by the end of fiscal 2014 or will there be additional projects that you will be looking at going forward?.

The projects that we have, as I've mentioned before, it's -- we characterize them kind of in 2 or 3 projects but it's 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 '15 or '16 either, but there will be additional projects that we have not counted on or given forecasts on. I would expect those generally to be smaller in nature and kind of add-ons to the things we're 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 in -- completed the work in fiscal' 15 and we maybe phasing some of that in yet. We will be phasing some of that in '16 as you -- as we're 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 '15. .

Okay. That's helpful.

And so the savings numbers you cited earlier, the $8 million to $10 million in, say 2016, that's not necessarily a net figure?.

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 because I do not yet know the cost or the savings.

But you can be assured we're not going to do them if we're not -- we may have some investment in the short run but we would not be doing if we're not going to see more significant savings relatively quick. .

Right. .

We see these as very fast returning projects. Inside a couple of years for some of these big projects. .

Okay, thanks. And moving on to international. I know if we look at, say, the mix of revenue, it's down a little in the first half versus what we have seen in the past.

Is that something more reflecting of what's going on, for example, in foreign markets? Or does it sort of indicate more a focus towards domestic?.

No, I would not at all characterize it as us 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 EMEA business has been doing what we expected this year. But the business outside U.S. and EMA, which are of course our larger markets, we've seen some softness, 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 I 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 markets the last 12 to 18 months, we've also seen some pressure based on that. .

And finally, on the capital equipment side in the U.S.

Are you sort of seeing similar interests as it relates to, say, new build outs or is it more towards renovations?.

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 toward large projects. It's kind of been bouncing around but I'd say, if anything, a little bit toward large projects at this point. But not something that's radically significant. .

[Operator Instructions] Our next question comes from Greg Halter, Great Lakes Review. .

Yes. Couple of questions here. Good morning and congrats on a good results. First one is on the R&D. Mike, you had made some comments about $1 million or so.

Can you explain that a little further?.

Yes, certainly. We had almost $1 million of foreign R&D government subsidies disallowed. And what that is 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 have limited to no further exposure on this type of disallowance. .

Okay.

So that $1 million was an increase in the R&D expense, correct?.

Correct, yes. So the subsidy had been received and we had to subsequently payback that subsidy that we received. So it increased the R&D expense for the quarter. The easiest way to think about that, it's kind of like a discrete tax adjustment. I mean, that's really the easiest way to think about it.

It's just that it doesn't come through on the tax line, it comes through in the R&D line. .

Okay. Thank you. And even excluding that, let's say its $12.5 million, I think that's a record for your company in terms of dollar spent. Obviously, as shareholders and so forth, people like to see the return there.

I 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?.

Sure. Couple of things, we've already mentioned it, that we're in that kind of 3% range. Two things have occurred in terms of both the raw dollars and the percentages, is US Endoscopy in particular has a significantly higher R&D spend as a percent of their revenue and have a faster turn of new products.

And that's what we bought and that's what we want to continue. So part of that is -- and it's absolutely natural in that business and the business they're in and we expect that to continue. So that's 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 see coming out the next 6 to 18 months. So we have picked up R&D spend a little bit in the base -- on a percentage basis. The balance of the percentage increase is really -- I'll call it a mix shift to US Endoscopy. .

Okay. And we've covered the company since, I think, February of 1994. So it's a long time. And I can recall back 8 to 10 years that the Life Science business was something that I think there were even some divestitures in and you were 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 is favorable and so forth.

But wonder whether or not -- first, what has changed there? And whether or not that's sustainable in your view?.

Yes, I would break it -- there's multiple things that have happened over the course of that timeframe but I would break it into 2 or 3 things specifically.

The first is, and we've talked about this maybe 5 years ago, when we were having most of the conversation, is we were doing a lot -- the Life Science business is not as standard, in general, as the healthcare business.

That is, every sterilizer might have 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 were doing a good job of capturing the cost, if you will, but of the design and changes and engineering, we were not doing a good job of that 4, 5, 6 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 have done. The second thing we've done is we have quit chasing business that is pure, low-end business.

And the third thing we've done is we've improved -- now I'm talking on the capital side, we've improved our plants significantly. Now most of 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.

But as we've improved those factories and you've seen results from those factories in the healthcare business, too, but that drops through very quickly on the Life Science side. And then the second major -- other major area is 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 4 or 5 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've been investing in that business and continue to invest to grow that business as opposed to, you are correct, 6, 7, 8 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. .

Okay. Well, not now, that's for sure. Keep it up. .

We didn't think so 6 years ago. We feel much more strongly about it today. .

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?.

Yes. I mean, Greg, we've 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 the 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 where we're forecasting. .

Okay.

And any update on the share repurchase program of the company?.

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've got 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 rather than continue with a larger share repurchase. .

Right now, we're buying shares in effect to offset dilution from the company's stock-and-option program. So at a high level, that's kind of what our 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. .

All right. And on the in-sourcing, you've indicted some issues with skilled labor and so forth.

Is that things like welders or how would you characterize that?.

Yes. You're exactly right. It's machinists, welders, skilled manufacturing people. Not assembly labor, that's very easy to come by. But skilled workers, like machinists of various types and welders of various types. That's correct. .

All right. And one last one... .

And we don't see that being a -- this isn't a 10-year -- it's a 10-year problem for the country. We don't think it's a 10-year problem for us. We think we will work our way through that. It's just taking a little longer than we thought. .

You got Lincoln right down the street. You need to call on them. .

They are good friends of ours. .

Last one is... .

Actually, they're probably better -- they probably think of us better because we're the customer, right?.

One last one for you.

Any changes in competition that you'd like to note?.

I can't think of any significant change that we would note. .

I show no other questions at this time. I'll turn the call back now for closing remarks. .

Thanks, everybody, for joining us and have a great day. .

Thank you for participating. You may now disconnect..