2023-11-08 18:24:05 ET
Summary
- Steris offers comprehensive sterilization and disinfection portfolios to healthcare providers, with 80% of their revenue being recurring.
- The company has a strong presence in the Applied Sterilization Technologies and Life Science industries, contributing to its profitability.
- Steris' stock price is currently overvalued, leading to a 'Hold' rating, but the company's growth potential and recurring revenue make it an attractive investment.
STERIS ( STE ) offers comprehensive sterilization and disinfection portfolios to a wide range of healthcare providers. The company boasts a long history of mid-to-high revenue growth and double-digit EPS growth. Approximately 80% of their revenue is recurring in nature. I consider Steris a growth company, primarily driven by overall procedure volumes. In my valuation model, I estimate the fair value of their stock price to be $180. Given the current overvalued stock price, I am initiating coverage with a 'Hold' rating.
Business Overview
Steris has consistently achieved mid-to-high single-digit organic revenue growth and double-digit EPS growth in recent years, with the exception of the pandemic year. Their products and services cater to a wide range of healthcare needs, including procedures, devices, pharmaceuticals, and dental care.
Steris's Healthcare Products segment accounts for 62% of the group's revenue and 60% of its operating profits. This segment focuses on sterile processing departments and procedural centers, including operating rooms and endoscopy suites. Steris offers a range of products and services such as cleaning chemistries, sterility assurance products, and automated endoscope reprocessing systems. They also provide related services like installation, maintenance, and repair.
Additionally, Steris is a leading player in Applied Sterilization Technologies ((AST)), serving as a third-party provider for contract sterilization to medical device and pharmaceutical manufacturers. These manufacturers rely on sterilization services before shipping their products to end-customers or distributors. While some larger companies might build their own sterilization facilities, many prefer outsourcing to third-party providers. This approach allows them to adopt an asset-light business model, which is favored by investors. For mid-sized and small manufacturers, outsourcing sterilization is often the most viable option due to capital and capacity constraints. The AST division represents 18% of group revenue and 36% of operating profits, making it a highly profitable venture for Steris.
In addition to AST, Steris is active in the Life Science industry, offering essential products such as formulated cleaning chemistries, barrier products, sterilizers, and washer disinfectors to pharmaceutical manufacturing facilities. These products are fundamental for pharmaceutical manufacturing processes. The Life Science segment contributes 10% of group revenue and 18% of group profits, mirroring AST's high-profit margin characteristic.
On the other hand, Steris's Dental segment, acquired through the Cantel Dental acquisition in 2021, is the smallest business segment. Steris operates as a relatively small player in the dental field, providing dental instruments, infection control products, conscious sedation, personal protective equipment, and water quality products. This segment represents 7% of group profits and is not considered a core focus for Steris.
Historical Financial Analysis
As shown in the table below, Steris maintains reasonable gross margins and cash conversion rates. Their capital expenditures are relatively higher than other healthcare companies due to their asset-heavy sterilization segment. In FY23, their operating margin declined to 5.4%, primarily due to a goodwill impairment charge of $490 million. Steris acquired Cantel Dental in 2021 for a total equity value of $3.6 billion, and they wrote off $490 million in FY23. In hindsight, this acquisition appears unwise, suggesting that they may have overpaid for the deal.
Despite the acquisition impairment, Steris maintains robust financials with solid organic revenue growth and profitability. Their debt leverage stands at above 3x, which is relatively high compared to other healthcare companies. However, Steris benefits from the stability provided by the fact that 80% of their revenue comes from recurring sources, including consumables and long-term sterilization contracts. This recurring revenue stream mitigates the potential risks associated with their level of debt leverage.
Key Growth Drivers
Applied Sterilization Technologies provides contract sterilization and testing services to medical device and pharmaceutical manufacturers. Their main competitors are the internal sterilization facilities of these manufacturers. In recent years, there has been a noticeable trend among medical device and pharmaceutical/biopharmaceutical companies to reduce their capital intensity by outsourcing most of their manufacturing-related services to third parties. These companies are increasingly focusing on R&D and adopting asset-light business models.
According to Research and Markets , the global sterilization services market is expected to reach USD 5.5 billion by 2026, up from an estimated USD 4.1 billion in 2021, with a compound annual growth rate of 6.0% during the forecast period. The significant growth in the market is attributed to mandates introduced by government and regulatory bodies in the healthcare industry.
As a major player, Steris has consistently outperformed the overall market growth. This growth can be attributed to Steris gaining market share from smaller players, along with the increasing preference of medical device and pharmaceutical/biotech manufacturers for third-party service providers.
In the Healthcare sector, Steris primarily serves major customers such as hospitals, surgery centers, and endoscopy centers. The company's growth is closely aligned with overall healthcare procedure volumes, and its management aims for an approximate 5% organic revenue growth rate. This sector constitutes a recurring business, with 35% of revenue coming from service components, 35% from consumables, and 30% from capital equipment.
Quarterly Review and Outlook
In Q2 FY24 , Steris reported 8.3% organic revenue growth and a 2% increase in adjusted EPS, while maintaining their full-year guidance. However, this quarter posed challenges, particularly in their AST business, which saw a 1% decline organically. The company faced headwinds due to reduced demand from bioprocessing customers, a consequence of the tight capital investments and cost-cutting measures prevalent in the biotech industry amid high-interest rates. Many biotech companies have had to freeze hiring, delay projects, and cut expenses.
It's worth noting that the AST business carries a significantly higher operating margin. Consequently, weak top-line growth puts additional pressure on Steris's earnings. Steris's management anticipated a robust growth in the second half of the year for their AST business, despite a weak performance in the first half caused by inventory destocking among medical device companies.
Steris has maintained its full-year guidance, with reported revenue growth expected to be between 9-10% and constant currency organic revenue growth in the range of 6-7%. The company anticipates adjusted EPS to be between $8.60 and $8.80, and free cash flow is expected to reach $685 million.
In summary, investors should keep a close watch on the Applied Sterilization Technologies business, especially concerning the industry destocking, to assess whether the situation is expected to improve in the second half of FY24.
Key Risks
20% of Capital Equipment Exposure : While Steris's business is largely recurring, they still have a 20% capital exposure in the healthcare end-markets. Their capital equipment portfolio includes items like sterilizers, surgical tables, automated endoscope reprocessors, and connectivity solutions. Sales of these capital equipment items can be cyclical, closely tied to hospitals' and labs' capital spending. During economic downturns, hospitals and emergency rooms might reduce their capital expenditure, potentially creating growth challenges for Steris.
Acquisitions : Steris has a track record of pursuing large acquisitions relative to their size. They acquired Synergy Health in 2015, a move that has been considered successful. However, their Cantel Dental deal in 2021, as discussed earlier, is viewed as a failed acquisition. Over the past seven fiscal years, Steris spent $1.7 billion on acquisitions, while generating $2.5 billion in free cash flow during the same period.
In June 2023, Steris announced the acquisition of surgical instrumentation assets from Becton, Dickinson and Company ( BDX ) for $540 million. It's worth noting that poorly executed acquisitions could potentially disrupt Steris's business in the future.
Valuation
The key assumptions for FY24 align with the range provided in their full-year guidance. To estimate the normalized growth rate, I've used the average organic revenue growth over the past six years, which stands at 8% in my model. I anticipate that the Applied Sterilization Technologies business will outpace the group's overall growth rate. Even if the overall procedure volume increases at a mid-single-digit rate, I believe Steris can achieve mid-to-high single-digit revenue growth by gaining market share from smaller players. Therefore, an 8% organic revenue growth rate seems reasonable in this context.
Additionally, I've assumed a 0.3% revenue growth from acquisitions. The Applied Sterilization Technologies business, growing at a faster rate with higher operating margins, could drive overall margin expansion due to the mix shift. Furthermore, with 8% organic revenue growth, Steris has the potential to benefit from margin expansion through operating leverage.
The model incorporates a 10% discount rate, a 4% terminal growth rate, and a 21.5% tax rate. After discounting all the free cash flows, my estimate projects the fair value of Steris's stock price to be $180.
Conclusion
I appreciate Steris's highly recurring business model that aligns with overall procedure volumes. Their impressive mid-to-high revenue growth and double-digit EPS growth are noteworthy. Despite the challenges faced by their Applied Sterilization Technologies business and the current overvaluation of the stock price, I am initiating coverage with a 'Hold' rating and a fair value price of $180.
For further details see:
Steris: Comprehensive Sterilization Portfolios Tailored To Procedure Volumes