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Steris Corporation (NYSE:STE)

F4Q10 (Qtr End 03/31/10) Earnings Call Transcript

May 6, 2010 10:00 am ET

Executives

Julie Winter – Director, IR

Mike Tokich – SVP & CFO

Walt Rosebrough – President & CEO

Analysts

Daniel Owczarski – Avondale Partners

Bob Goldman – CL King

Jason Rodgers – Great Lakes Review

Joshua Zable – Natixis

Brad Evans – Heartland Funds

Jose Haresco – Brean Murray

Shawn Fitz – Stephens Inc.

Heidi Lawrence – George Weiss Associates

Operator

Welcome to the STERIS fiscal 2010 fourth 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, Investor Relations. Ma'am, you may begin.

Julie Winter

Thank you, Sarah, and good morning everyone. It's my pleasure to welcome you to STERIS's fiscal 2010 fourth quarter and full year conference call. Thank you for taking the time to join us this morning.

Participating in the call this morning, are Walt Rosebrough, our President and CEO, and Mike Tokich, our Senior Vice President and CFO. If you haven't seen the copy of our earnings release, please visit our investor relations website at steris-ir.com, and just a few minutes of, a few words of caution before we begin.

This webcast contains time sensitive information that is accurate only as of today, May 6, 2010. 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, 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 statement. 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. As a reminder, during the call, we may refer free cash flow, backlog, debt-to-capital, and days sales outstanding, all of which you will find in reconciled as appropriate in our most recent 10-K filings.

With those cautions, I'd like to hand the call over to Mike. Mike?

Mike Tokich

Thank you, Julie and good morning everyone. This morning I'll spend my time reviewing our fourth quarter results then Walt will discuss the fiscal 2010 full-year results and view our outlook for fiscal year 2011.

Before I get into details of the quarter, there are few moving parts in our numbers, so for clarity let me remind you that included in the fourth quarter of fiscal 2009, our restructuring expenses.

The actions initiated in the fourth quarter of fiscal 2010 included our decision to transfer the remaining positions in the Erie Pennsylvania to Mentor Ohio as well as to consolidate our European healthcare manufacturing operations into two center locations within Europe.

Both of these actions will take 18 months to 24 months to complete, so did our assumption that additional restructuring expenses of approximately $4 million will be incurred over the next two years relating to this actions. The actions taken in the fourth quarter are anticipated to generate annualized savings of approximately $4 million.

We anticipate these savings will be realized over the next couple of years with approximately $1 million benefiting fiscal 2011 and $3 million benefiting future years. My discussion of the fourth quarter results would exclude the restructuring expenses in both fiscal 2010, and fiscal 2009.

Let me now begin with a recap of the income statement for the fourth quarter. Total revenue decreased 3.6% during the quarter. Volume declined 6.4% while pricing contributed 1.1%. And a weaker U.S. dollar contributed 1.7% to the growth in revenue.

Gross margin in the quarter was 42.8%, an increase of 190 basis points. The increase was driven by pricing, productivity improvements and lower raw material costs. The $1 million favorable impact from raw material cost primarily related to stainless steel. Operating expenses as a percentage of revenue declined 70 basis points to 25.8%.

Included in operating expenses for the quarter are product modification expenses of $3.2 million which is primarily related to changes we made to a portion of our 30 85 surgical tables in the field. EBIT margin for the quarter improved 270 basis points to 17%.

The expansion in EBIT margin is due to improvements in gross margin and our continued efforts to improve efficiencies. The effective tax rate in the quarter was 37.8%, compared with 38% last year. Included in the quarterly rate is an unfavorable discrete item adjustment of approximately $1 million resulting from the provisions of The Patient Protection and Affordable Care Act.

Net income increased 15% while earnings per diluted share of $0.55 represented an increase of 12% during the year. We move on to our segment results. Healthcare revenue in the quarter decreased 5%, as consumable revenue grew 3% in the quarter driven by growth in new products specially Prolystica Ultra Concentrate chemistries offset by lower SYSTEM 1 consumable sales and a negative impact from the timing of H1N1 purchases.

Service revenue grew 4% due largely to the timing of installation projects that were completed during the quarter. Healthcare capital equipment revenue declined 13% in the quarter with comparable declines in both of our infection prevention and surgical businesses. With backlog increasing 7% to $127.8 million in the quarter, we believe that the capital equipment declined is largely a matter of timing.

As we've discussed in the past, our fourth quarter has typically been our strongest quarter for shipments of capital equipment. And as you know, we've been working to level our production. Healthcare operating margin improved 200 basis points to 18% of revenue driven by improved gross margins offset somewhat by the product modification expenses booked in the quarter.

Life Sciences revenue in the quarter was flat, as compared to the prior year. as a result of the 11% increase in consumable revenue, a 6% increase in service revenue offset by 10% decline in capital equipment revenue. Capital equipment in Life Sciences continues to be impacted by consolidations limiting the order levels of our pharma customers.

Backlog to Life Sciences in the quarter declined 8% to $41.8 million. Life Sciences operating margin improved 670 basis points to 14% of revenue driven by product mix and efficiency initiatives. Revenue for Isomedix increased 5% in the quarter. We once again were able to offset the loss revenue from our facility sales last year with a modest increase in demand from our core medical device Customers.

Isomedix operating margin as a percentage of revenue increased 23.6%. In terms of the balance sheet, we ended the fourth quarter with $215 million in cash. Our total cash position currently exceeds our long-term debt by $5 million.

In addition, during the quarter we repaid the outstanding $100 million from our credit facility. Capital expenditures and depreciation and amortization were each $14.2 million in the fourth quarter. We finished the year with a record $184 million in free cash flow.

This represents a 26% increase as compared to the prior year. The improvement in free cash flow, as a result of our increased earnings, and our continued improvements in working capital management. This completes my review of the fourth quarter results.

I'll now turn the call over to Walt for his remarks. Walt?

Walt Rosebrough

Thanks, Mike, and thanks and good morning to all of you on our call. Now that Mike has put the quarter in perspective. Let me spend some time on our full-year. We entered the fiscal 2010 with more uncertainties than we had seen in the last several years.

This was a result of the economic environment in United States including our customer's lack of access to capital. The new administration's healthcare reform proposals and our SYSTEM 1 regulatory matters. As we close our 2010 fiscal year and start 2011, we have greater clarity on many of these matters and are very pleased with our performance in that challenging 2010 fiscal year.

We completed fiscal 2010 with total revenue down only 3% and a strong capital backlog. Focusing on a few highlights for the year; one was clearly the performance of our consumables franchise across the business. Healthcare consumables grew 7% for the year led by growth in new products such as Prolystica Class 6 [ph] indicators as well as an increase due to the H1N1 virus endemic.

On the Life Science side, consumables grew 13% again impacted by H1N1, but also a result of volume increases and some price recaptures. While it was a more challenging year for capital equipment, we did have pocket to strength particularly for new product lines like Vision washers, V-Pro Sterilizers and LED lights.

Shifting to profitability, we generated even more efficiencies than we anticipated which led to a substantial expansion in EBIT margins. We are particularly pleased with the progress our people made outside of North America. Last year, we were profitable in all major geographic regions and all regions contributed the profit growth.

As a result, our earnings per diluted share excluding restructuring charges for a record $2.21 or 15% better than our very solid 2009. These results were achieved even though we saw a decline of about $20 million in revenue for the year and SYSTEM 1 capital equipment consumables and service.

As we recently announced, we reached an agreement with the FDA on the transition plan for our SYSTEM 1 customers, and received clearance on SYSTEM 1E, which will be an important part of that transition plan. We believe SYSTEM 1E is the most compatible single product on the market to replace SYSTEM 1.

It is clear for the process of immersible, usable, semi-critical and critical heat sensitive medical devices, which are the most common applications of SYSTEM 1. But it has only been a short time since the new product has been cleared for marketing. The initial feedback we're getting from our customers is encouraging.

Looking forward to fiscal 2011, we anticipate that our core markets will generally improve to more normalized growth levels. In particular, within our healthcare segment, we anticipate mid-single digit revenue growth with the majority generated from market improvement and 1% to 2% from the net impact of SYSTEM 1 and SYSTEM 1E and their associated consumables.

That in combination of flat performance in our Life Science segment and low single digit growth in Isomedix is anticipated to result in total company revenue growth of approximately 5% for the year. We expect our EBIT margins to be in the 15% to 16% range with the somewhat higher anticipated tax rates in fiscal 2010.

We anticipate earnings per share to be in the range of $2 to $2.30 for the full-year. Now this is a bit of a wide range, but the uncertainty surrounding the SYSTEM 1 transition, potential increases in commodity cost, the impact on the economies in Europe and resulting exchange rate uncertainty and some lack of clarity around health reform applications causes to have some caution in our outlook.

We anticipate that earnings will be fairly evenly split in fiscal 2011 with approximately 45% to 50% in the first half and the balance in the second half. Our expectations for fiscal 2011 are clearly being impacted by the transition away from SYSTEM 1 to alternative products.

This outlook for 2011 excludes the one time reduction of revenue and operating income with the rebate program as well as restructuring expenses. It does however; include other expenses such as startup cost and the net impact of the transition to 1E.

We expect S20 Sterilant revenues in the United States to fall steadily during the year as we approach the August 2011 deadline to transition from SYSTEM 1. By the end of fiscal year 2011, we anticipate that 50% or more storage SYSTEM 1 use maybe transitioned to alternatives.

Coinciding with that decline in higher margin consumable revenues, we are anticipating a pickup in demand for alternative products in particular SYSTEM 1E. In order to accommodate our customers, we plan to sell SYSTEM 1E for just slightly more than SYSTEM 1 during the transition period.

We believe SYSTEM 1E is the most capital efficient option on the market for customers transitioning from SYSTEM 1. Our outlook is that we will be able to manufacture significantly more units than we have in the past putting us around 4 to 6000 1E units in fiscal 2011.

As we mentioned in our call two weeks ago, we're not planning on passing along the additional expense to build SYSEM 1E capital and thus the capital units will make significantly lower margins in SYSTEM 1 capital equipment and meaningfully lower margin than the S20 consumable revenue that we anticipate losing throughout the year.

Further as we ramp-up S40 volume, it will cost more to make than S20, but we are pricing at the same as S20 to our customers. As volumes build in future years, we expect the new Sterilant to cost about the same as S20. The lower profitability from these capital and consumable sales will impact gross margins, as our SG&A is anticipated to be flat to be down on $1 basis during the year.

Outside of SYSTEM 1, our growth opportunity is clear. We believe we have the precious product line in our history and we will continue to innovate. We're receiving favorable customer reaction from our new line of operating room tables and iQ 2100 OR integration unit and see good results from our V-PRO, new line of washers and LED lights.

In addition, consumables including Prolystica continue to grow nicely. We will also improve our efficiencies as we strive to become a lean organization, and we will remain disciplined and not allowing the inefficiencies we have eliminated to feedback into our company's volume improves.

These past few months have been extraordinary for everyone at STERIS. With the customer focus and commitment of our people has been truly first class. I appreciate all their hard work and dedication and the results they have achieved. With that, I'll turn thing back over to Julie to begin the Q&A portion of our call.

Julie Winter

Thank you, Mike and Walt, for your comments. We're now ready to begin the Q&A session. So, Sarah would you please give the instructions and will get started.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Daniel Owczarski with Avondale Partners. Your line is open, sir.

Daniel Owczarski – Avondale Partners

Yes. Thanks and good morning.

Walt Rosebrough

Good morning, Dave.

Daniel Owczarski – Avondale Partners

Walt, you had a comment that customers to early feedback is favorable on the SYSTEM 1E. I was wondering if you could give us any more color is to what their concerns are? What the questions are? What the reactions? Where do they want to dig deeper on this issue of SYSTEM 1E vis-à-vis a swapout SYSTEM 1?

Walt Rosebrough

Well, Dan, I think the main questions were around what devices they will be using or be processing in SYSTEM 1E versus SYSTEM 1 and as you know the product is clear for heat sensitive devices and so they are looking to determine which of those devices that they maybe currently using SYSTEM 1 fit that category.

I would say that's probably the number one generalized question. But then naturally they are wanting to understand what the cost of the new unit is to them going forward and of course as you know, the rebate program is a function of the life of their existing units. So they're looking for that information and of course we're providing. I would say those are two most typical questions from our customers.

Daniel Owczarski – Avondale Partners

Okay. And is it still too early to tell rebate versus the STERIS credits, how that's going to break out versus what you expect the customers to say?

Walt Rosebrough

Yes, I would say it's way too early to tell. We do have good indications. We have a few orders, a handful of orders and we have the SYTEM 1E and we have a number of proposals in quotes out there where customers request for quote I'll call it. But it's way too early to tell how that's going to break out.

Daniel Owczarski – Avondale Partners

Okay, and then you talked about selling it just for a slight premium, the 1E as a slight premium to SYSTEM 1. Could you give us any kind of order of magnitude of how much more expensive – how much more it costs SYSTEM 1E to manufacture than SYSTEM 1?

Walt Rosebrough

Dan, we don't give product line cost and/or profitability. But it is significant.

Daniel Owczarski – Avondale Partners

Okay, and is that because of the extra UV light with the water?

Walt Rosebrough

Absolutely. The bulk of the cost differentiation is the filtering in UV light that added to the product.

Daniel Owczarski – Avondale Partners

Okay. Alright, thank you.

Operator

Our next question is from Bob Goldman with CL King. Your line is open.

Bob Goldman – CL King

Good morning, everybody.

Mike Tokich

Good morning Bob

Walt Rosebrough

Good morning Bob.

Bob Goldman – CL King

Good morning. A couple of questions. First on gross margin, the guidance for 2011, I'm trying to understand what some of these SYSTEM 1E transition factors have on your guidance for gross margin in 2011. Is there a way to call that out to give us some sense of what the gross margin in 2011 would have been relative to 2010, were it not for these transition issues?

Walt Rosebrough

Yes, I would say it would have been flat to slightly positive and in general I would have said, if you go even further down, as I've talked about many times with you all that we generally are looking for kind of high single digit, low double digit growth in EBIT through a combination of growth and revenue and margins and I believe we would have been on track for that kind of growth, were it not from the SYSTEM 1E margin net decline.

Bob Goldman – CL King

And when you look at it a little bit more, say to the following year, is it reasonable to expect that in that year, 2012, your gross margins will have essentially made up that negative impact of transition?

Walt Rosebrough

We're not giving 2012 guidance but I would say that the startup cost portion of that will largely be passed in 2011 but there is still a mix issue we're a long way from doing a forecast on that mix at this point in time. There still could be mix issues between the products. But in terms of the startup costs, I would expect that most of that would be behind us.

Bob Goldman – CL King

And I have a couple of other things. On the free cash flow, your guidance in 2011 is considerably less than in 2010 and perhaps you can walk us through why?

Walt Rosebrough

Yes, and the bulk of that, and I'll let Mike chime in behind me but the bulk of that is the increased capital expenditures. First of all, we had an extraordinarily positive year this year. Literally everything that makes up free cash flow went the right direction for us. So our receivables were down in days, our inventory was down – up in turns, down in dollars and of course we had good net income and relatively capital expenditures under our depreciation and amortization.

Next year we have several discreet items in capital spending and we've announced most if not all of those. Certainly two of them we've made announcements on. One is the center here in Mentor where we're spending about $11 million and the other is our European expansion and consolidation. And so those are two of the four kinds of discreet increases to capital spending and those are all profit improving expansions.

The balance is fairly routine expenditure and we do have, for each one of our large expenditures is in our Isomedix business where we're buying cobalt and that fluctuates a bit based on the cobalt replacement cycle. But that's the principal reason for the difference in free cash flow.

Mike Tokich

Okay, Bob, if I could just add one thing there, we are definitely planning on continuing to improve our working capital management but the year-over-year improvement will just not be as dramatic as Walt has already alluded to. So we will have a little bit of a decrease from a free cash flow standpoint. But all our working capital measurements are planning to improve year-over-year.

Bob Goldman – CL King

And then just one more question. You mentioned in the press release, and this is relative to your discussion on healthcare sale, that you've got efforts underway to reduce the seasonality of capital shipments and frankly, I didn't understand that. I can understand how you can change the seasonality of production. But just explain a little bit more if you can what you mean by reduce the seasonality of capital shipments and how that impacted sales in the quarter?

Walt Rosebrough

Sure. We have worked very hard over the last 24 months, in particular this year to have our shipments mirror our customers demand as opposed to sometimes mirroring our quarters or our annual fiscal cycles. And so this isn't a matter of us moving out. Customer based seasonality exist. It's a matter of us smoothing out seasonality that we create due to our quarters and our years and so in essence, we are working very hard to run our factories, for lack of a better term, I'll call it flat fashion or relatively smoothly and have the differences in our product rates reflect customer demand issues and not our own issues.

Bob Goldman – CL King

Okay. So this doesn't impact sales at all in the quarter?

Walt Rosebrough

It's just timing of sales. If you over the long term, the sales will be the same. It just affects the timing of capital sales.

Bob Goldman – CL King

Okay. I'll follow-up off-line. I've got a few more questions, but thank you.

Walt Rosebrough

Thanks Bob.

Operator

Our next question is from Jason Rodgers with Great Lakes Review. Your line is open.

Jason Rodgers – Great Lakes Review

Good morning.

Mike Tokich

Good morning Jason

Jason Rodgers – Great Lakes Review

Looking at hospital capital spending, I wonder if you could provide some commentary there as far as what you see now versus what you saw last quarter and if you're seeing a pickup now?

Walt Rosebrough

I don't think we've seen a significant change in the last couple months. Clearly compared to this time last year when things were looking kind of ugly, it clearly looks better and different. But I would say, generally speaking, what we have seen is forming to slight improvement of what appears to be our capital pattern anyway. And I think that's generally aligned with what other people seem to be seeing.

Jason Rodgers – Great Lakes Review

Okay, and have you seen changes in payments in Europe given the issues going on there now?

Walt Rosebrough

We haven't seen substantial changes. We have seen of course there some countries that are traditionally slow payers and they continue to be slow payers. But we haven't seen any overwhelming change, no.

Jason Rodgers – Great Lakes Review

And finally the impact of FX, do you have that for the year for sales and operating income?

Mike Tokich

Yes Jason. For FX impacts for the years, we were just slightly favorable from a revenue standpoint less than $1 million and on the EBIT standpoint we were unfavorable by approximately $2 million.

Jason Rodgers – Great Lakes Review

Thank you.

Operator

Our next question is from Joshua Zable with Natixis. Your line is open.

Joshua Zable – Natixis

Hey guys, good morning. Thanks for taking my questions here.

Walt Rosebrough

Good morning Josh.

Mike Tokich

Good morning.

Joshua Zable – Natixis

Great job on the profitability front again. I just had a couple of questions here. First, you guys mentioned some restructuring, European restructuring, the $4 million annualized savings. You guys have been doing a lot obviously, on the cost save front. Is it safe to assume that that's sort of a new program, that's not something you've announced before?

Walt Rosebrough

This brand new program Josh, we just made decisions on in the fourth quarter.

Joshua Zable – Natixis

Okay, great. And then just – you made a comment about H1N1 difficult comps. Obviously, it makes sense. I'm just kind of wondering, was there any benefit from H1N1 this quarter? Or was it nothing?

Walt Rosebrough

Actually, from our standpoint, it was actually a negative benefit because we saw in our third quarter, some timing of purchases where they purchased a larger volume in the third quarter as compared to what they would normally purchase in the fourth quarter.

Joshua Zable – Natixis

Okay, great. And then just looking out at the guidance here, specifically, the top line guidance, I'm just trying to go through and think about equipment versus consumables. You obviously get a boost, if you will, from those SYSTEM 1E sales depending on obviously how the warranties work out or the rebates et cetera. So, I'm just trying to think about to really think about that healthcare number going forward because that's obviously going to be the key driver of revenue. So, any color around consumables and equipment would be helpful. Thanks.

Walt Rosebrough

We're anticipating if you include the transition from SYSTEM 1 to 1E, that we will see positive increases in capital consumables and service. So all of components will show growth year-over-year.

Joshua Zable – Natixis

Okay. And that's pretty much it. Thanks, guys. Appreciate it.

Walt Rosebrough

Thanks Josh.

Operator

Our next question is from Brad Evans with Heartland. Your line is open.

Brad Evans – Heartland Funds

Hi. Good morning, everybody. Thank you for taking the question.

Walt Rosebrough

Hey, Brad. How are you?

Brad Evans – Heartland Funds

I'm doing well, thanks. Again, thanks for the question – for the opportunity. I'm just curious with respect to the – 2011 obviously will have the SYSTEM 1 transition costs, which takes you off of the trend that you had been exhibiting from a margin expansion perspective and I'm just curious, Walt, if you maybe could help us understand or Mike, where you see the operating margin goals for the business over the next two or three years as we start to anniversary the transitional costs of the SYSTEM 1E transition?

Walt Rosebrough

I think as a general statement, we'd say we're continuing to look for efficiencies both in the gross margin line and in the operating expense lines. But one of the things that we also look at is how we trade that off in price to our customers. So I don't see a radical change in that theory. That is, we will continue to be looking to get more and more efficient. But a piece of that efficiency, we will clearly pass off to our customers in less aggressive pricing if you will. And a piece of that we would intend to take into the profitability of the corporation.

Brad Evans – Heartland Funds

Okay. Just looking back to the third quarter of this year, you had an 18% operating margin. Is that a type of number you think – as we get into 2012 or 2013; is that a type of number that we could think about achieving on a more sustainable basis?

Walt Rosebrough

I would not say that those numbers are out of the question. The numbers in the mid teens are respectable numbers if we see volume growth.

Brad Evans – Heartland Funds

Understood. Okay. That's helpful. Just another follow-up then in terms of – Walt, you've spoken a lot about level loading the factories to provide more efficiency and that's been an ongoing effort for you. Does that relegate backlog for the healthcare division to be less meaningful? Does that give your customers greater confidence of your ability to ship with shorter lead times that might have the effect of diminishing the importance of backlog going forward as a measurement?

Walt Rosebrough

I don't think our customers care about our backlog. They just care whom we can deliver. And so it is true. One of the things that we do when we do that is by definition, we work to be even more reliability in our delivery metrics. So that does. But backlog is literally just a function of how much orders we have and how much we shift. I do think you'll see, in some respects you may see even more variation in the backlog because it will be customer demand issue.

The customer, if they're building a new operating room and they're building it six months from now and they want to get their equipment all figured out and purchased, it doesn't make a difference to them what our backlog is. They want the stuff six months from now, not today. And they may place the order today. And so backlog really is largely a function of when the customers want the equipment versus when they want to place the order and so I don't think we'll see a meaningful change in backlog as a result of this work.

Brad Evans – Heartland Funds

Okay. That's helpful. And then, just one last question. Your balance sheet is in outstanding shape and obviously, the outlook for strong free cash flow, which has been a hallmark of the company for some time. I'm just curious how you view the prioritization of deployment of free cash flow going forward?

Walt Rosebrough

Sure and we've talked about that. We see no difference. We do like cash and we think it's a great measure of the business. But I'm talking about creation cash flow creation. In terms of use of cash, our first use is always going to be to invest it internally to improve the business and we will do that judiciously but as we see fit to improve the business. The second use is clearly to look for ways to grow the business, either by internal means or external means and the third and fourth are different ways to return that cash to shareholders, either dividends or through stock buybacks and we try to balance those based on the situations at hand we will continue to do it that way.

Brad Evans – Heartland Funds

Okay. Thanks and good luck. Congratulations.

Walt Rosebrough

Thank you.

Operator

Our next question is from Jose Haresco with Brean Murray. Your line is open.

Jose Haresco – Brean Murray

Good morning and thanks for taking the question.

Walt Rosebrough

Good morning.

Jose Haresco – Brean Murray

Good morning. A couple of questions. Really on a two year time span, you mentioned that we should think about gross margins being down for 2011. You also mentioned that operating expenses – and correct me if I'm wrong here – operating expenses on a dollar value should be flat to down. So, as we look beyond 2011, as you work through this transition with SYSTEM 1E, should we expect or can we expect gross margins to kind of snap back up to perhaps where they were in the early part of fiscal 2010 or even for all of 2010? And should operating expenses still have a very de minimis level of growth, say over 2012 – 2013 or do you expect the spend to ramp back up at that period?

Walt Rosebrough

Again, we really are not giving 2012 and beyond guidance. But I'll just say the general statement. First of all on the OpEx side, we're clearly looking for ways to leverage OpEx. You can't keep OpEx going down forever and you can't keep it flat forever. But relative to the revenue generation, generally speaking we're going to see OpEx grow more slowly than revenue. There are some exceptions. Some of our OpEx components are almost a function. They're for example. They are variable, for example the commission rates for sales people, the charges for group purchase fees.

So, though we do have some variable components but generally speaking they are not variable. We have generally speaking were to limit the OpEx outside of areas like R&D sales service folks in the field and in our quality and regulatory area, those areas we have invested money the past couple of years when we expected to invest in those areas, but generally speaking other areas we expect them to remain constant or fall if we can.

I think that's a general comment about OpEx. In terms of the margins we will see these two years, 2011 and 2012. It will be mix issues between the SYSTEM 1E and other products in the company. So, there will be mix issues going on and then in 2011 we have the start-up cost issues, I would expect the start-up cost issues to be largely behind us in 2012.

It is way too early for us to forecast 2012 mix issues in those products. And then I would say by 2013 that should all pretty much be dissipated.

Jose Haresco – Brean Murray

Okay. Just following up on that, then. The decline in the gross margins is primarily tied to product trend, the service margins shouldn't change all that much or am I wrong about that?

Walt Rosebrough

The service margins in general don't change but again we are being on the system or rather SYSTEM 1E, we are just as we did in SYSTEM 1 sales we are clearly giving our customers a good deal as we entered this business.

Jose Haresco – Brean Murray

Okay. And I'm sorry if I missed this. What was the actual dollar figure for cost of product and cost of service in the quarter?

Julie Winter

I don't have that broken out in front of me. Jose, can I circle back on that?

Jose Haresco – Brean Murray

Yes. That's fine. Thanks.

Operator

Our next question is from Shawn Fitz with Stephens Incorporated. Your line is open.

Shawn Fitz – Stephens Inc.

Yes, thanks. Walt, in your prepared comments, you gave us a number that you all internally expect about a 50% of your historical base will go to other technologies. And I'm talking about SYSTEM 1. Could you maybe, as we think about I guess your current install base of about 20,000 units and your capacity to manufacture, could you kind of walk us through the logic in a broad sense that gets you to that number.

Walt Rosebrough

First of all that 50% would include SYSTEM 1E not the exclusive of SYSTEM 1E. So, we are – when I tell alternative technologies, I mean alternative technologies including SYSTEM 1E. So, that's a good point of clarification because I am not sure I made that clear. The second, in general as we said we are thinking about 4000 to 6000 units in the fiscal year production. You mentioned there is about 20,000 in total and of course we do have ramp up period during this fiscal year. So, that is kind of the logic to it. Now it's worth mentioning, we have said before that roughly 15% to 20% Sterilant sales are down roughly15% to 20% as of the end of March.

And so, the 15% to 20% of Sterilant sales that has already converted to something, some of it may convert back but again that is 15% to 20% in some senses already gone and then the balance. It is obvious that like most things this fits a bit Pareto like small number of the units or a large amount of the Sterilants. So, it is not and we will see customers as they move some of their or as they move their non-heat sensitive devices to other technologies generally speaking. As they move those away they won't need as many SYSTEM 1s to do the work because they will only be doing work on the heat sensitive devices.

So, it's a combination of those three factors that come together and that's just our best view of how far along they will be in the transition to both SYSTEM 1E and/or other technologies we sell and/or other technologies that others sell.

Shawn Fitz – Stephens Inc.

Okay, thanks, Walt. And then, just as we think about turnaround time on SYSTEM 1E versus SYSTEM 1 are they similar turnaround times for the two technologies?

Walt Rosebrough

The turnaround time mean processing?

Shawn Fitz – Stephens Inc.

Yes, processing and then how quickly the unit can be basically turned around and ready for another round of processing.

Walt Rosebrough

Yes in fact it's about 20% faster; it's one of nice features of the device. Couple of other very nice features is there is less affluent or more environmentally friendly I will call it affluent but turnaround time is clearly one of the nice features of this device. It is already a very fast device, the SYSTEM 1, this one is even faster.

Shawn Fitz – Stephens Inc.

And so just as we – you said there's the law of maldistribution at play here in terms of certain units being a disproportionate amount of you cycle times. Should we be thinking that, that will grow in terms of will you see, basically, a higher utilization of the SYSTEM 1E units in the market or in your install base of customers?

Walt Rosebrough

That's not clear yet and it depends on how they convert, there is a complete opposite side of the story that I just told you. There are some customers that are very, very dependent on this device that use relatively small amount of Sterilant but they are just small customers and so this device is very important to them. So, I think we will still see a distribution not unlike the distribution we have seen before and the question on what the – I will it what the Sterilant per unit will eventually look like, is a combination of the two factors. One hospitals have and other users have; they might have a number of these units and they are 15 to 18 years old. They may say, let's we are going to move this set of goods out to out to steam sterilization, and as a result we will need a little less and we can file these units and use them more practically. So, they may purchase less units and then do more clicks per unit if you will.

And then that will be somewhat offset by the fact that some of the devices that are currently been done in SYSTEM 1 will be done in steam. And how that all works out, we are not 100% sure, we don't see it being radically different. It's not like we don't expect that 50% drop or increase in Sterilant per unit out there.

Shawn Fitz – Stephens Inc.

Okay, Walt. Last question. Could you help us understand why the cost of producing S40 is meaningfully higher than S20?

Walt Rosebrough

Sure, it's purely a volume issue. It is a startup in volume issue purely. In terms of – so that's why I said as you go out in time as the volumes of S40 cross into the relative order of magnitude volume levels S20. We don't expect it to be any cost differential. So, overtime we don't see that being an issue but in the short-run we are making two skews instead of one and so there is always a little cost of complexity and it's just purely the volumes and the way we set-up the lines to run those. We have a very efficient high volume line for S20. We will be starting with low volume lines in the beginning and then those will cross over and then we would expect to see very similar margins.

Shawn Fitz – Stephens Inc.

Okay. Walt thanks for the help.

Walt Rosebrough

You bet.

Operator

Our next question is from Heidi Lawrence with George Weiss Associates. Your line is open.

Heidi Lawrence – George Weiss Associates

Hi Walt, how are you doing?

Walt Rosebrough

Good, you?

Heidi Lawrence – George Weiss Associates

Good, thanks. Just a quick question. Are you anticipating any pushback from the price increase you'll be taking on the 1E?

Walt Rosebrough

I think our price is very reasonable, I expect push back from customers on every price that we ever quote on every product we ever quote because there job is to do that for their institutions but I think when they look at the value that they are receiving for these products vis-à-vis anything else on the market. I think pricing is very, very reasonably.

Heidi Lawrence – George Weiss Associates

Okay. Great. And then, the guidance is obviously wide because there's so many variables. But maybe if you could just help us understand what's incorporated into the low end of guidance, what's incorporated into the high end of guidance, and what is the major swing factor there?

Walt Rosebrough

Well I have mentioned the factors and it's a mix and match of all those when we look at – we don't expect all the bad things to happen. We don't expect all the good things to happen. So, it is a mix and match but the major factors I have think have laid out pretty clearly in the discussion.

Heidi Lawrence – George Weiss Associates

Okay. And just quickly, on the $100 million charge that you broke out on the last call, you talked about this matrix you did. And is there any way you can give us insight into your estimates a little bit further into that matrix in terms of how many customers you assume take Tier 1 rebate versus Tier 2. Any metrics on that would be great?

Walt Rosebrough

Yes, I think at this point we won't be doing that and I am not sure we actually will be going forward. But let us consider that and – but as we get more clarity in terms of the way our customers are moving across the metric. We can discuss that better with I think.

Heidi Lawrence – George Weiss Associates

Okay, great. And one last question. So, is there any way you can help us quantify the impact on your margins that you had from a lower percentage of lower margin capital equipment on the overall margin?

Walt Rosebrough

We don't give product specific margins but I think what the statement I made earlier about what our kind of gross margins would have been and what our EBIT would have been. I think we will stick that, I would make one comment and it may help clarify some extent on the metric. We do think the SYSTEM 1E is the best single one to one replacement for this device. And there is no device on the market in our view including anything else we sell. That is a straight one to one placement for SYSTEM 1 and system something else. But SYSTEM 1E we think is the closest thing to a straight one to one replacement and we believe that our customers will see that and we think it is very capital cost effective approach.

So, we are expecting significant one to one conversion and the 1E is the highest total rebate in the equation. So, that does set some of that $100 million.

Heidi Lawrence – George Weiss Associates

Okay. Great. Thanks, guys.

Walt Rosebrough

Thanks Heidi

Operator

(Operator Instructions) Our next question is from Joshua Zable, Natixis. Your line is open.

Joshua Zable – Natixis

Thanks for taking my follow-ups here.

Walt Rosebrough

No problems.

Joshua Zable – Natixis

Just some housekeeping, more housekeeping, just on the R&D side, you talked about this quarter, obviously, a big step up because of stuff going on quarter specific. As we think about next year, it seems like the $8 million a quarter is the right run rate. Is that the right way to think about it? Or should it step up or step down?

Walt Rosebrough

R&D is lumpy, so and this quarter just happened. We had some projects that came to fruition and those kinds of things. So, and lot of times it is a function for building prototype units that gets lumped in there those kind of things. So, it can't be lumpy but as a general statement I think you are pretty much of target.

Joshua Zable – Natixis

Okay. And in conjunction with that, because I know you gave us SG&A. On the GM, is there going to be some sort of – obviously we understand the components, why it's taking a hit. But is there going to be a progression over the year? I'm just trying to think about – because I know you guys have done a really good job of flattening earnings, for lack of a better word over the year. I am just wondering if SG&A is flat and R&D is generally where it's going to be, if we have a big hit in the early part of the year, are we going to offset that with SG&A, or is the gross margin hit going to be pretty evenly distributed over the course of the year.

Mike Tokich

Josh, as Walt mentioned earlier the distribution of our earnings will be 4% – 50% in first half remaining and the second half. So basically almost following where we were for fiscal ‘10 is our best estimate at this point in time.

Joshua Zable – Natixis

And that's primarily gross margin movement? Or is the SG&A going to coincide with that?

Mike Tokich

Little bit of both here and there. Margin for sure is definitely going to degrade and it all depends on fast customer's transition to away from SYSTEM 1to another product. So, really has to do with timing more than anything but our best guess at this point in time is the relationship will be following 10 and all of the degradation will be in gross margin. We will have some favorability in OP expenses.

Joshua Zable – Natixis

But if customers pick it up faster, then the gross margin takes a hit earlier?

Mike Tokich

Correct. If they transition quicker, the gross margins will take a hit quicker if they transition longer in the year it will end up in the third or fourth quarter.

Joshua Zable – Natixis

Okay great.

Mike Tokich

Or potentially next year depending on again the timing of this transition of the customers.

Joshua Zable – Natixis

Very, very helpful. And I just want to follow-up to Shawn's question. Walt, I know we really appreciate all the level of detail, here and I know it does get confusing. And so, I just want to push a little bit more. You talked about 50% basically loss of SYSTEM 1. That's SYSTEM 1 and then you said that excludes SYSTEM 1E. So, in other words, I think it's safe to assume that you're going to get at least one customer to do SYSTEM 1 to SYSTEM 1E, probably a lot more.

So, you obviously believe that there's less than 50% loss on that SYSTEM 1 revenue stream, and again getting back to sort of the number of devices, is what you're trying to say is that even if you put the 6,000 maximum devices out and you obviously have 20,000 out there. The makeup there with the numbers would be higher utilization on lower devices. Is that what you're saying? Even if customers transition from SYSTEM 1 to steam, you still lose that on the SYSTEM 1 revenue side. So, I'm just trying to reconcile those numbers. Thanks.

Walt Rosebrough

Exactly and Josh I would say let me re-characterize. When we talked about the SYSTEM 1 reduction being 50% greater, we are talking about the S20 Sterilant on its own. Not anything else and then we would expect the S1E capital and in the Sterilant that it will go along with, the S40 Sterilant that will go along with that to make up some portion of that and so that is – I will call that a gross number for a lack of better term as we close to a net number.

And you are absolutely correct we do expect there to be significant number of customers that convert to S1E. It's our expectation that we will be capacity constrained certainly through fiscal '11. So, we think those customer conversions, our best estimate now is that those customer conversions will be capacity constraint and not order constraint.

Joshua Zable – Natixis

Okay. That's very helpful. Thanks, guys. Appreciate it.

Walt Rosebrough

Thank you, Josh.

Operator

Bob Goldman, CL King. Your line is open, sir.

Bob Goldman – CL King

Thank you, again. I just decided to jump back in queue rather than due it off line. On the assumption that you're booking revenue when you ship a piece of capital equipment –

Walt Rosebrough

Absolutely. That's a good assumption.

Bob Goldman – CL King

And I assume that customers, when they put in an order, want the product yesterday?

Walt Rosebrough

That depends on their specific situation, but it is a general statement that's not the case. Generally they have things; it's a capital equipment; they have to plumb it. They have to get their system set for capital equipment. So, it varies, so some customers would want it yesterday and some would want it in three months of six months or nine months.

Bob Goldman – CL King

Okay, and this statement that the Company has worked to reduce the seasonal variability of capital shipments, which you're stating as impacting sales. It suggests to me that there were some products that perhaps could have been shipped at the end of the quarter that for whatever reason instead are going to be shipped in the first quarter.

Walt Rosebrough

Or that historically, we would work hard to ship everything we had at the end of quarters or end of years and we are not working so hard. That is if the customer didn't care, if the customer didn't care within a two or three week window, that we may have worked harder to get things shipped one day earlier if you will if they were indifferent. Now we are working to meet our customer demand and then to keep our volume as steady as we possibly can and still meet that customer demand. That's it in a nutshell.

Bob Goldman – CL King

So, the obvious follow-up then, Walt, is if you worked equally hard in the fourth quarter of 2010 that you did in the prior year, how much more sales would you have had on capital equipment in the fourth quarter?

Walt Rosebrough

I have no idea what that number would be, but, you are correct to assume that it would have been more and it wouldn't be – I basically I try to look at what the order rates, what the shipments are and overtime you would expect those to be the same or roughly the same and in fact overtime they will be the same. Our backlog grew about 7% year-over-year. So, I would not expect if all of that would have been shipped. I don't know the details enough around the numbers to know but clearly we are working to level our factories and meet customer demand.

Bob Goldman – CL King

Okay, thank you.

Walt Rosebrough

Thanks Bob.

Operator

At this time I am not showing any further questions at this time. I'll turn the call back to our presenters for any closing remarks.

Julie Winter

This concludes our fiscal 2010 fourth quarter conference call. Thank you for joining us and have a great day.

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Source: Steris Corporation F4Q10 (Qtr End 03/31/10) Earnings Call Transcript
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