Steris: Strong Healthcare Products Growth Coupled With Weak AST Business (NYSE:STE)

Steris (NYSE:STE) reported its Q3 FY24 results on February 7, along with an increase in their full-year organic revenue growth guidance. In my introductory article, I emphasized their comprehensive sterilization and disinfection portfolios. While I admire the outperformance of their Healthcare products business in the quarter, I believe the stock price is currently overvalued. Therefore, I maintain a ‘Hold’ rating with a fair value of $190 per share.

Strong Healthcare Products and Life Sciences Growth

In Q3 FY24, they achieved 10% organic revenue growth and 9.9% adjusted EPS growth, driven by robust performance in their Healthcare Products and Life Sciences segments, as depicted in the table below. Organic revenue growth comprised 2.7% from pricing increases and 7.3% from volume growth, as outlined in the earnings call. This significant volume growth indicates strong end-market demand for the quarter, particularly evident in the Healthcare Products segment.

On the margin side, the company has experienced a situation where the price increase surpasses the material and labor cost inflations, thus contributing positively to their margins. However, increasing incentive expenses alongside a shift in mix towards the AST business have posed margin headwinds for the company. Consequently, their adjusted operating margin declined by 80 basis points year over year. Despite this, they maintain a solid balance sheet with a gross debt leverage of 2.2x. Notably, they have exhibited strong free cash flow growth for the first nine months of FY24, with a 74% year-over-year increase, driven by earnings growth and reduced capital expenditures.

My key takeaway from the earnings call is the strong performance in their Healthcare Product business. Management attributed this growth to procedure volume increases and market share gains. Additionally, capital equipment orders in the Healthcare Product segment grew at a double-digit rate in the quarter, indicating robust end-market demand driven by procedure growth. This trend of strong procedure growth is likely to continue driving growth in the Healthcare Product business in the near future.

There are several reasons for this procedure growth. During the pandemic, many elective procedures were delayed, leading to a backlog in hospitals. As the post-pandemic era began, these patients started to return to hospitals for their postponed surgeries. However, hospitals still faced staffing shortages, prolonging the time required to clear the backlog.

Furthermore, the Life Science business saw a growth of 19.7% in the quarter, driven by strong product shipments and a weak comparable performance in the same quarter last year. Management expresses confidence in long-term growth stemming from septic drugs, injectable drugs, biologics, as well as cell and gene therapies.

FY24 Outlook Update

Due to the strong growth observed in the Healthcare Products segment during the quarter, Steris management has raised their full-year organic growth target to 7-8%, up from the prior expectation of 6-7%. Adjusted earnings per diluted share are now anticipated to fall within the range of $8.60 to $8.70, compared to the previous estimate of $8.60 to $8.80.

In the first nine months of FY24, Steris achieved 9.8% organic revenue growth. They expect growth in the last quarter to be low-single-digit. Procedure volume is likely to continue growing in the next quarter, contributing to Healthcare Products growth. However, the Life Sciences business may face tough comparables in the next quarter, as Steris grew that segment by 11.3% in Q4 FY23.

If assuming Healthcare Products grow by 10%, Life Sciences decline by 2%, Dental decline by 5%, and AST decline by 8%, the combined organic revenue growth would range between 4-5% in the next quarter. Uncertainty arises from bioprocessing volume growth, as the company lacks visibility on destocking and market recovery. Current guidance implies weak bioprocessing growth in the next quarter.

Valuation Update

The assumptions for FY24 align with the company’s full-year guidance, indicating 8% organic growth and 3% growth from acquisitions and foreign exchange. For normalized growth, I maintain 8% organic revenue growth and 30 basis points of tuck-in acquisition growth. Over the long term, I anticipate the AST business will continue to perform, delivering at least the historical average of 8% growth, driven by increasing demand for septic drugs, injectable drugs, biologics, cell, and gene therapies.

On the margin side, the primary drivers are operating leverage and easing inflation over raw materials and manufacturing costs. The company has indicated improvements in the supply chain and manufacturing, which should enhance gross margins going forward. I estimate that the company only needs to increase operating expenses by 7.5% to support their topline growth. As a result, margin expansion is estimated to be around 50 basis points per year in the model.

All other assumptions remain unchanged, and the fair value is calculated to be $190 per share. The current stock price is trading at 27 times FY25’s free cash flow.

Key Risks

The Applied Sterilization Technologies (AST) business only achieved 4% organic growth in the quarter, significantly lower than its historical average growth rate of 8%, as indicated in the chart below. Specifically, bioprocess volumes continued to contract, posing growth headwinds for the AST business. During the earnings call, management expressed a lack of visibility regarding how long this weakness will persist and when they can anticipate a recovery. Consequently, another weak growth outlook has been factored into guidance for the next quarter. The company is waiting for the completion of bioprocessing destocking before anticipating any significant improvements. As a result, Steris’s full-year growth will largely depend on the performance of their Healthcare Products and Life Science business segments.

Furthermore, Steris’s Dental business has experienced four consecutive quarters of weak growth, declining by another 6.2% in Q3. Management attributes this weak performance to reduced orders from a large customer following a temporary disruption of their operations due to a cybersecurity incident experienced during the quarter. However, even excluding this customer, Steris’s Dental business would have remained relatively flat in the quarter. As I highlighted in my previous coverage, the dental industry is not experiencing significant growth and faces strong competition. Fortunately, Dental only represents 8.5% of group revenue.

Conclusion

I acknowledge that Steris is a unique growth company with comprehensive sterilization and disinfection portfolios. However, I believe the stock price is currently overvalued, so I maintain a ‘Hold’ rating with a fair value of $190 per share.