STERIS' (STE) CEO Walt Rosebrough on Q4 2016 Results - Earnings Call Transcript

| About: Steris Corporation (STE)


Q4 2016 Earnings Conference Call

May 18, 2016, 10:00 ET


Julie Winter - Director, IR

Michael Tokich - SVP, CFO & Treasurer

Walt Rosebrough - President & CEO


Jason Rodgers - Great Lakes Review

Matt Mishan - KeyBanc

Chris Cooley - Stephens

Mit Ramgopal - Sidoti


Welcome to the STERIS Fiscal 2016 Fourth Quarter Conference Call. [Operator Instructions]. I would now like to introduce today's host, Julie Winter, Director of Investor Relations. Ma'am, you may begin.

Julie Winter

Thank you, Danica and good morning, everyone. On today's call as usual we have Walt Rosebrough, our President and CEO and Michael Tokich, our Senior Vice President, CFO and Treasurer. I have just a few words of caution before we open for comments from management. 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. Some of the statements made during this review are or may be considered forward-looking statements. Many important factors could cause actual results to differ materially from those in the forward-looking statements including without limitation those risk factors described in STERIS Plc's, STERIS Corporation's and Synergy's previous securities filings.

Many of these important factors are outside of STERIS' control. No assurances can be provided as to any result or the timing of any outcome regarding matters described in this webcast or otherwise. The Company does not undertake to update or revise any forward-looking statements as a result of new information or future events or developments. STERIS plc and STERIS Corporation SEC filings are available through the Company and on our website.

Adjusted earnings per diluted share, segment operating income and free cash flow are non-GAAP measures that may be used from time to time during this call and should not be considered replacements for GAAP results. Non-GAAP financial measures are presented during this call with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. STERIS' adjusted earnings per diluted share and segment operating income exclude the amortization of intangible assets acquired in business combinations, acquisition-related transaction costs, integration costs related to acquisitions and certain other unusual or nonrecurring items.

We defined free cash flow as cash flow from operating activities less purchases of property, plant, equipment and intangibles, net capital expenditures plus proceeds from the sale of property, plant, equipment and intangibles. Additional information regarding adjusted earnings per diluted share, segment operating income and free cash flow is available in today's release.

With those cautions, I will hand the call over to Walt. To Mike, excuse me.

Michael Tokich

Thank you, Julie and good morning everyone. It is my pleasure once again to be with you this morning to review our adjusted financial results. Before I get into the numbers, let me remind you that all prior-year comparisons are to legacy STERIS unless otherwise noted in both mine and Walt's remarks. We're pleased to report revenue growth of 38% for the quarter. The increase in revenue was driven by the acquisition of Synergy Health, Black Diamond Video and GEPCO in addition to solid organic revenue growth. Constant currency organic revenue growth was 5% and was entirely driven by volume as price was neutral during the quarter.

Foreign currency negatively impacted revenue by 1%. I want to spend some time this morning addressing gross margin as we have received a number of questions since reporting third quarter results. The addition of Synergy Health has caused overall STERIS gross margins to be lower than they were pre-deal. As we began to integrate Synergy, we found that they used a different policy to classify costs between cost of goods sold and SG&A as compared to legacy STERIS. We have applied the legacy STERIS four-walls approach which reports all costs directly and indirectly related to the delivery of products or services as cost of goods sold. This four-walls approach causes STERIS to include costs in our facilities that other companies may include in SG&A instead of cost of goods sold, for example, human resource personnel in a factory. As a result, some costs that Synergy would have previously reported as SG&A are now included in COGS and will be going forward. As integration continues, we may find that some additional costs need to be reassigned but believe we're generally consistent at these levels.

Importantly, these expense classifications have no impact on the overall bottom line profitability of our business. Gross margin as a percent of revenue for the quarter decreased 320 basis points as compared to last year to 39.3% which was about flat sequentially, year-over-year, Synergy negatively impacted gross margin by 500 basis points in the fourth quarter. Offsetting that, we had 90 basis points improvement from currency, 50 basis points improvement from the suspension of the Medical Device Excise Tax and 30 basis points of improvement from lower material costs. SG&A as a percentage of revenue in the quarter declined 350 basis points to 18.4% of revenue, more than offsetting the change in gross margin as a percentage of revenue due mainly to Synergy Health. Now let's focus on EBIT margin. EBIT margin in the quarter increased 100 basis points to 18.8% of revenue. Revenue volume, favorable foreign currency, the suspension of the Medical Device Excise Tax and lower R&D expenses as a percentage of revenue drove the improvement in EBIT margin.

While we delivered an operationally sound quarter there was quite a bit of noise in our effective tax rate. The effective tax rate in the quarter was 34%. During the quarter we had a greater than anticipated percentage of our income earned in higher tax rate jurisdictions like the U.S. which as you know has a higher effective tax rate as compared to the rest of the world. In addition, the quarterly tax rate was negatively impacted by the timing of discrete item adjustments primarily relating to the acquisition of Synergy Health. Both of these items more than offset the tax benefit received from the combination with Synergy. One example of a discrete item which negatively impacted the fourth quarter would be the establishment of FIN 48 tax reserves specifically for Synergy.

FIN 48 tax reserves are reserves established for tax positions which are less than certain. During the quarter, we had to establish several FIN 48 reserves related to the activity associated with certain tax positions for which Synergy had taken prior to and after the close of the combination. Synergy appropriately followed IFRS accounting guidelines but not U.S. GAAP. U.S. GAAP specifically requires the establishment of these reserves for certain tax positions. As we look forward, we fully expect to achieve an effective tax rate of approximately 25% for the full fiscal year. Like always, this rate is subject to unforeseen changes in mix and discrete item adjustments.

Net income for the quarter increased to $77.9 million or $0.90 per diluted share with 86.2 million weighted average shares outstanding. Moving on to segment results, our healthcare products segment revenue grew 5% in the quarter contributing to the revenue growth, consumable revenue increased 25% of which half was attributable to organic revenue growth. Our maintenance and installation service revenue grew 6% in the quarter. Capital equipment revenue declined 6% in the quarter with flat performance in the U.S. and declines in most other regions. We believe the performance of capital equipment revenue is a matter of timing as backlog ended the quarter at $119.4 million, an increase of 22% year-over-year. We have also begun to see an uptick in project orders which tend to have longer lead times than replacement orders.

Operating margins for healthcare products were 18.1% of revenue in the quarter, an increase of 30 basis points year-over-year due primarily to the increase in volume, favorable foreign currency and the suspension of the Medical Device Excise Tax. Our healthcare specialty services segment reported revenue for the quarter of $157.9 million reflecting the addition of Synergy Health along with 10% organic revenue growth. Healthcare specialty services operating income increased to $6.5 million in the quarter due primarily to the increased volume. As anticipated, the addition of Synergy Health's hospital sterilization services and linen management businesses reduced the operating margins within this segment compared to the prior year. Applied Sterilization Technologies had a good quarter with $110.4 million of revenue.

The increase in revenue was driven by the addition of Synergy Health and increased demand from our core medical device customers. Organic revenue in this segment was 8% for the quarter. Applied Sterilization Technologies operating margin was 34.8% of revenue, a meaningful increase compared to the prior year due primarily to the increase in volume, the addition of Synergy Health and a reduction in our asset retirement obligation. Life Sciences revenue grew 31% in the fourth quarter. Supporting that growth, consumable revenue grew 51% partly due to the acquisition of GEPCO and partly due to mid-teens organic revenue growth.

In addition, Life Sciences service revenue grew 34% due to mid-teens organic revenue growth plus the addition of new service offerings. Last but not least, capital equipment revenue increased 8% in the quarter. Life Sciences total organic revenue growth was 11% in the fourth quarter. Backlog in Life Sciences ended the quarter at $45.3 million, about flat compared with the prior year. Life Sciences fourth quarter operating margin increased to 31.6% of revenue due to favorable mix shift towards consumables, an increase in volume and favorable currency. In terms of the balance sheet, we ended the quarter with $249 million of cash and approximately $1.6 billion in total debt.

As we have previously stated, now that we have completed the combination with Synergy, we have added debt repayment to our list of capital allocation priorities. Barring no further M&A activity, we expect to reduce our debt to EBITDA over the next 18 to 24 months from approximately 2.7 to a level more consistent with STERIS' history. Our DSO is at 73 days at quarter one, an increase of nine days compared to last year. This increase is largely due to the impact of incorporating Synergy and other acquisitions we made over the past year into our DSO calculation. Our calculation includes 100% of in an acquisitions accounts receivable balance but only includes revenue since we have acquired them which somewhat overstates this measure. There is no material change in our AR exposure. Our free cash flow for fiscal 2016 exceeded our expectations. Free cash flow finished the year at $129.1 million.

As we discussed last quarter, we had approximately $100 million of one-time cash expenses related to the combination with Synergy and other acquisitions as well as a pension contribution. So we generated approximately $229 million before paying these one-time expenses. Our free cash flow outlook of $250 million for fiscal 2017 includes approximately $50 million in additional cash expenses for the integration of Synergy Health mainly to capture the $15 million of cost synergies we have included in fiscal 2017. That leaves us with about $20 million in cost synergies remaining to capture beyond next year. Capital spending was $44.3 million in the quarter while depreciation and amortization was $55.2 million. Going forward, we anticipate that D&A will be approximately $145 million for the combined business and we would assume that our maintenance CapEx is at or slightly below that level.

For fiscal 2017 specifically, we anticipate approximately $190 million of capital spending of which $50 million is for investment projects. We have a number of significant projects planned in fiscal 2017 including expansion projects or our AST business, an upgrade of our ERP system to the Oracle R12 platform and investments in R&D. Before I turn the call over to Walt, I want to spend a few moments on currency. When providing FX guidance, we utilize the average forward rates for our key currencies. Based on the 12-month forward rates as of March 31, 2016, we do not expect FX to have a net material financial impact on revenue or EBIT in fiscal 2017. In particular, the forward rates indicate that the U.S. dollar will strengthen versus both the pound and peso and weaken versus both the euro and Canadian dollar. As a combined company, we tend to like a strong euro and pound and a weak peso and Canadian dollar as compared to the U.S. dollar.

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

Walt Rosebrough

Thanks, Michael and good morning, everyone. Fiscal 2016 was an extraordinary year for STERIS and we're pleased to be with you discussing another record performance as a result of the collective contributions of our people. Even in the face of currency and market headwinds outside the United States, our business grew both organically and through strategic acquisitions to deliver 21% growth in revenue and record adjusted earnings per share of $3.39. Topping the year's achievements was the landmark completion of the Synergy Health combination in addition to closing two other strategic acquisitions, General Econopak and Black Diamond. At the same time, we grew organically as a result of our continued investment in product development and in manufacturing and service operations that enable us to bring improved products and services to our customers and the people whose health and safety they improve.

Full-year 2016 organic revenue growth for legacy STERIS was 5%, 6% in constant currency with growth in all four segments. In particular, our IMS business which is the legacy STERIS component of our new HSS segment delivered double-digit growth even as they settled into new combined sales territories. We also saw solid mid-single digit organic growth in our life science and AST segments which I will discuss in more detail shortly. Our healthcare products segment organic revenue grew 3% for the year with strong growth in the United States offsetting weakness outside the U.S. Synergy Health was a meaningful contributor to our overall growth in FY '16. On a constant currency basis, Synergy revenue grew 4% for the full year and adjusted operating profit grew 9%. Of course the impact of currency has had a negative impact on a U.S. dollar basis which made the U.S. dollar reported revenue decline low single digits and profit about flat for the year.

As is always the case, some parts of the business are doing better than others. We're particularly pleased with the strength of the AST portion of the Company and believe the HSS business in the UK and Europe have good opportunity for continued growth and profitability. As we have said all along, the U.S. HSS business which is a long term growth opportunity for STERIS is a nascent business and will take time and investment to develop. While we continue to engage in conversations with customers about potential outsourcing opportunities, we believe there is substantial lead time before significant contracts will materially impact our business. The Northwell joint venture continues to experience project delays which have pushed back the anticipated opening.

As a result, Northwell has not generated any significant revenue during the year and we have not included any revenue from Northwell in our fiscal 2017 outlook. We have a continuing strategic review of the company's businesses consistent with our ongoing review and determine the level of resources we will allocate to each of the businesses. Naturally we will discuss that with you further at the appropriate times. On the cost side related to the Synergy combination, we have generated approximately $5 million of Synergy in fiscal 2016 as planned and continue to expect that we will save an additional $15 million in fiscal 2017 and $20 million thereafter. As Mike mentioned, we will incur some additional costs as planned during this fiscal year to accomplish those overall synergies. Diving into the segments a bit further, healthcare products grew 6% for the year in total with contributions from Black Diamond and Synergy Health and a low single-digit organic revenue growth.

Capital equipment in healthcare products increased low single digits for the year driven by double-digit growth in the U.S. which was offset by declines in all other regions. Newer capital products that contributed to the year include a new AMSCO washer line, Harmony lights and booms or the Vision tables and V-PRO 60. Healthcare product consumable revenue climbed low double digits with organic revenue making up more than half of that growth. We saw healthy increases for consumables in the major geographic regions other than the EMEA. The Middle East in particular reflects lower revenue due to the current macroeconomic issues in the region and follows particularly strong consumable orders in the prior year. Our instrument cleaning chemistries, V-PRO dedicated chemistries and new product portfolio for U.S. endoscopy all saw solid improvements this year.

Service revenue grew mid-single digits driven by the strength in the U.S. and Latin America. The healthcare specialty service segment grew 70% in the year with strong organic growth bolstered by the addition of the two businesses from Synergy, hospital sterilization services and linen management services. Our strong organic revenue growth was produced by IMS, our instrument repair business. IMS's double-digit revenue growth was fueled by several large contract wins as well as our ability to capitalize on shorter term engagements that arose during the year. Moving on to our life science business, this business just had an outstanding year with 18% revenue growth, about one-third of which was organic.

We completed the purchase of GEPCO last summer and that has been a strategic addition to our portfolio which capitalized on our global field support of our pharmaceutical customers. We believe the addition of these product lines strengthen our position around the globe. Even in the face of economic headwinds outside the U.S., all three life science product areas capital, consumables and service experienced organic growth last year and all life science geographic regions grew as well. Operating margins for life science continued to expand benefiting from the increase in volume and favorable mix. AST grew 51% for the year with 7% organic revenue growth and the previously discussed contribution from Synergy. The integration of our people, Synergy and STERIS is complete and the business is being run by the appropriate STERIS and Synergy people. Combined, we have a network of 59 facilities in 16 countries around the globe in which our customers rely on us to sterilize over 1 billion medical products each year.

We continue to be excited about the opportunities ahead of this combined organization and if anything, we have been conservative in our original thinking. We're working on a number of facility expansions that will facilitate our ability to meet anticipated customer demand. In the United States, we're extending radiation in Southern California and Chester, New York and recently opened an additional facility in Northern California. We're also modifying our plant in Temecula, California to allow small volume ETO processing which better matches the demand in that region. In Europe, we're expanding radiation capacity in Ireland and the UK and ethylene oxide in the Netherlands. Our European expansions will begin to impact growth in fiscal year 2018.

Switching gears now to profitability, total company EBIT improved 30% year-over-year due to the inclusion of our new businesses, our organic volume growth, favorable currency and our cost reduction efforts. We did have increased interest expense and a higher share count impacting earnings per share, some of which was offset by the lower tax rate for the year. All in all, we're pleased with our organic achievements as well as the businesses that have joined the STERIS family which allowed us to post another year of record results in fiscal 2016 and more importantly, provides a springboard for an anticipated fifth consecutive year of record performance in fiscal 2017.

Last week we held our beginning of the year business meetings with our newly combined field sales and operations forces in healthcare, life sciences and AST. I have to say I have never seen the STERIS field organization more excited about what lies ahead in both the near term and long term future for STERIS. They understand the powerful combination of products and services we can bring to our customers in hospitals, pharma and medical devices. We expect fiscal 2017 revenue growth to be in the range of 25% to 26% with growth in all four segments. Of that, approximately 7% will be organic revenue growth. For your modeling purposes, we expect revenue for the legacy Synergy business in the range of $640 million to $650 million for the year reflecting low single-digit growth over the course of the year.

We're clearly looking for expansion of EBIT margins year-over-year for the total Company even with an increase in R&D as we plan to reinvest the Medical Device Excise Tax savings in FY '17 in product development and production predominantly in the United States. Adjusted net earnings per diluted share are anticipated to be in the range of $3.85 to $4.00 for the full fiscal year. For your modeling purposes, we expect our first half, second half split to be approximately the same as this past year at about 44% in the first half and 56% in the second half. As we said in the release, our forecast presumes that changes in foreign currency do not have a material impact on fiscal 2017 financial results. We anticipate that the effective tax rate on adjusted earnings will be approximately 25% next year. We ended the year with a solid balance sheet having secured favorable refinancing of our debt in conjunction with closing the Synergy Health deal.

Our leverage is higher than it has been in the past but well within ranges we're comfortable with and dropping. We remain committed to our capital allocation priorities, maintaining and growing our dividend, investing for organic growth, targeting acquisitions in adjacent product and market areas, reducing our leverage and finally, share repurchases if other uses of cash are lower than our desires and do not offset dilution.

To be clear, our guidance for fiscal 2017 assumes no EPS dilution due to share count increase as well as no M&A activity. We have made meaningful progress in achieving our strategic goals over the past several years and it is remarkable to look back at all our people have achieved in just this past year, expanding strategically through acquisition while performing well organically. We have been and will continue to look across our business portfolio for opportunities to continue to optimize our products and services. We believe the future for STERIS is bright indeed.

As always, we appreciate your continued support and your time this morning. I will hand the call back over to Julie for Q&A.

Julie Winter

Thank you, Walt and Mike, for your comments. Danica, would you please give the instructions for Q&A?

Question-and-Answer Session


[Operator Instructions]. Our first question is from Lawrence Keusch of Raymond James. Your line is open.

Unidentified Analyst

This is [indiscernible] in for Larry. Just a couple of quick questions, first I guess on the EPS guidance, could you walk us through some of the key puts and takes from fiscal 2016 bridging to fiscal 2017? Obviously I think the key buckets would be cost synergies which you have called out, BDV and GEPCO accretion which you had talked about previously and then incremental sales for Synergy. So could you help kind of walk us through those different pieces? So that is my first question.

Walt Rosebrough

We don't get in that level of detail on the specific components. But you are absolutely correct that I will call it the big buckets and it is largely driven by both the revenue and profitability we bring over with the acquisition. So we have significant increase in profitability as a result of bringing Synergy over for a full year instead of half year. GEPCO also, we have not a full-year in last year's earnings so we bring across those buckets. The synergies from Synergy or the increased profitability due to Synergy on the cost side alone we do expect another roughly $15 million of earnings as a result of those cost reductions. And I think those are probably the biggest pieces other than the natural growth in the business which we have said we have about 7% organic growth then we typically and will this year grow our profitability more than our organic growth rates as a result of that growth.

Having said that, there are some places that we're clearly investing, we're investing more in R&D. That largely is offset by the Medical Device Excise Tax this year. We're clearly growing some nascent businesses so we're investing in those businesses. And then you have to take into account last year we did not have a full-year impact of the total share count that we had this year and of course, we have a greater interest rate as a result of bringing those businesses on. I think if we think through those buckets that way, that is the big chunks.

Unidentified Analyst

And then just turning to the healthcare products segment, capital did come in a little bit lighter than we would have anticipated so I guess number one, how would you characterize the current utilization environment as it relates to capital purchasing in surgical volumes? Number two, could you help us break apart the comments around the impact of level loading of shipments and then perhaps some areas where you have seen international weakness? Thank you.

Walt Rosebrough

Good questions and I think there are two or three questions embedded. I will try to answer them one at a time. Generally speaking, capital came in about where we expected it to for the year and it was offset if you will, the U.S. business came in quite strong and double-digit and maybe even pretty strong double-digit increases across those areas. And then of course with the acquisition of Blank Diamond, even more. So we like our capital business in the U.S. Globally, capital has shrunk for us and almost everybody that is in the business and you guys look at the other people as well.

So we have a difficult year globally both as a result of the economic, the general economies which push the governments then which push their spending on healthcare as well as the currency, the dollar strengthening vis-a-vis almost every major currency. And then we had particular weak spots and one that comes to mind is the Middle East which has struggled mightily just as a result of the collapse of oil pricing as well as them having to fund more based activity. As a result, they have less funding for healthcare-based activity. So that at a high level, that is pretty much it. What is different and we think it is better, an improvement, is we were able this year to much better match our production planning and shipping activities such that our business was more level loaded if you will across the year.

Now you saw some of that, we did with inventory so we increased our inventory over the course of the year anticipating some significant shipments in the third and fourth quarter. We did see those in the third and fourth quarter but we did not have nearly the quote unquote spike in the fourth quarter that we have had some times and we like not having that spike that allows our operations to run more effectively and efficiently. We're hopeful we can continue down that path keeping it at least at the level we did this year and maybe even better. So you didn't see a fourth quarter spike and that is also reflected in the backlog. If you would look at our backlog, you will see that our backlog is greater at the end of this year than it was at the end of last year, significantly greater, I think something on the order of $20 million and that is a function of two things.

One us level loading that and not shipping as much of the backlog during the fourth quarter and having more in the second and third. And the second is we have seen an increase in our project, major project kind of work and that tends to fluctuate. We talk about that all of the time. It kind of fluctuates up and down. Right now we have more project work as a percent of the total and project work has longer leadtimes than does routine replacement and so that tends to lengthen the backlog. I think I have answered most of that in terms of most of the questions you've ask and that one good question. And in that, the last component is our outlook and we still see in the U.S. significant positive outlook. I wouldn't call it high growth rates but on the other hand, it is not shrinking and in fact we have had now several months in a row, maybe now even several quarters in a row where we have seen increased activity in the field so the pipeline looks good and our orders have reflected that.

And that again is why you saw the increased backlog at the end of the year. So we feel comfortable with the go forward look in the U.S. Outside the U.S., it is a much more difficult environment and we do not believe we have seen significant change. There are difficulties in much of the economies in Latin America, all the mineral based or oil-based economies are having difficulty in the Middle East is difficult. We have actually seen improvement in our business in mainland Europe and so there have been some improvement there for us. And then Asia-Pacific seems to be coming back some but again they face struggles in those economies that are dominated by either oil or by minerals.


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

Jason Rodgers

Very strong performance in life sciences and especially with the margins and just wondering how we should think about that segment going forward given the margins are well above your longer term target of 20%?

Walt Rosebrough

As I have expressed on many occasions, I don't have really what I would call a margin target per se. I generally speaking do not like seeing things that are under 15% and over 20%, I start thinking about whether or not we're investing appropriately or working appropriately. But we don't have a cap on margin and we don't have a minimum. Our job is to try to improve them and create the margins we can create. We have tremendous value creation capabilities in the life science space and those margins are reflecting that. They are also reflecting a mix shift, another mix shift which we have been shifting over the years significantly which is why the margins have improved to the consumable business.

And then of course, GEPCO is an entirely consumable business so we saw another step function up in that mix shift. So I would not characterize that we're trying to move our margins down to 20%. So we will continue to do the best we can on the production side, the operations side and develop new products that are good for our customers and charge the appropriate prices for that and as a result create value for them which creates value for us. We do, I mentioned earlier on our cost reductions and on product development, we do always try to pass some portion of that back to our customers because we think that is the appropriate thing to do for the long term.

So it is not like every dollar we save we put in our pockets, every dollar we say we either put back into R&D, put it into price, get value creation in price for ourselves or value creation and price reduction for our customers. It is a combination of those things.

Jason Rodgers

And was there anything one-time in nature that drove that mid-teens organic growth rate in life sciences?

Walt Rosebrough

The only thing I would say different, obviously you have the GEPCO acquisition so you have to put the acquisition into the mix but the balances of the -- so there is an organic, inorganic component. So the inorganic component popped it up significantly, but they just had good, strong growth and you know that we have historically struggled in capital and capital also grew so we had I will call it the normal growth I will use the word normal loosely because they had good growth in both service and in consumables. But we also saw growth in capital which does not always happen.

Jason Rodgers

And then finally looking at the HSS segment with the margins off year-over-year to the low single digits, how should we be thinking about that segment as far as margin improvement for the upcoming fiscal year?

Walt Rosebrough

Obviously that is an area of opportunity for us in terms of margin improvement. And since I have already told you I don't like things necessarily under 15 and I start thinking about them over 20, we will be working to improve those margins. But that is a mixed business, there is laundry in that or the historic linen business and synergies in there. There is historic business that was purchased in the U.S. and there is a nascent business we're trying to grow in the U.S. So it is a mixed bag.

We do anticipate improving those margins over the course of time but part of that is we want to make sure we don't under invest in the growth parts of that business. So it is a mixed bag. I will call it ongoing businesses have objectives to improve their margins, some of which is volume, some of which is growth, cost improvement that comes along with growth but we're also making investments in those businesses as we go forward.


Our next question is from Matthew Mishan of KeyBanc. Your line is open.

Matt Mishan

Let's just start off with you did a 5% underlying constant currency growth for core STERIS but what was the pro forma constant currency growth including Synergy Health? And then you also said that Synergy Health us plus 4% on a constant currency basis for the full-year. What was it in the quarter?

Michael Tokich

We're not going to get into that much detail in Synergy. We gave the year because in total we had a lot of pressure in the fourth quarter to provide a number and we felt that giving the year was probably the best perspective that we could get. So I would say the quarter would be no more or less than the year so it would be similar in that regards.

Walt Rosebrough

And pro forma is a difficult term because as you know, in the last five months we have been mixing and matching STERIS and Synergy and it is difficult enough for us to determine what is Old Synergy and Old STERIS that we changed our bonus program in the last three months of the year because we don't feel like we can make those determinations cleanly enough and when there is a cost reduction as a result of Synergy, is that Old Synergy or Old STERIS? When there is revenue growth as a result of us working together, is that Old Synergy, Old STERIS? The answer is we don't know. But orders of magnitude as best we can give you, we have given you the STERIS legacy business and orders of magnitude, we have given you the Synergy legacy business growth rates, total sizes in growth rates and the number for next year, legacy Synergy although there are two reasons there is a range there. One is there is always a range in forecasting and the other is it is getting harder and harder for us to tell what is Synergy and what is STERIS which is a good thing, that is the power of putting the businesses together.

Matt Mishan

I think that is fair. Maybe I will try to ask it in a different way. It looks like AST was exceptional in the quarter and then it also looks like IMS as part of your HSS Group now is doing really well. Is something going on with the other pieces of HSS, the linens business, the hospital sterilization services that is maybe driving some lower growth? Can you talk a little bit about that?

Walt Rosebrough

Sure. I think you correctly captured the general direction that we have tried to lay out for you for the business as you described. On the HSS business as I said, we do think -- I'm going to separate HSS Europe which is largely UK but also has some European component and the HSS business U.S. So the HSS business in Europe is a well-established, strong growing business. We think there is good upside opportunity for both growth and profit growth in a strong business. There is always some trade-offs in timing and current right now -- currency is not helping us because since that is an all inside the UK or inside Europe or largely inside the UK Europe business and the pound has been strong for those two, that has hurt us on a reported basis.

But we do think there is opportunity for growth in both those businesses and it is more routine type of work. In the U.S. there is an acquisition, acquired businesses in the U.S. and those businesses are some pieces that we think are good and some pieces that are clearly not having the kind of returns that we would want them to have and we will work to improve those. And then we have this, for lack of a better term, nascent business that is just getting started and we're investing more into that than we're getting back out of it. And that is normal in a startup kind of a business. So when you put all of that together, I think that is a good description of those businesses and we do anticipate improving the profitability of those businesses and growing revenue in those businesses probably more in later years than in earlier years, but that is our thinking at that point in time. I think in the linen businesses are also in this segment and as is often the case, that is a tale of two cities.

And Dr. Steeves, if you look back at his comments over the course of the years, it seems like one year or two or three, the UK business was stronger. And one year, two or three, the Netherlands business was stronger. And clearly in this case, the UK business had a strong year and the Netherlands business had a tough year and as you have heard from Dr. Steeves, I think the last year or two, the Netherlands business there is overcapacity in the space and we're working to reduce our costs appropriately and manage that appropriately but that is a tough business right now.

Matt Mishan

And just a follow-up to that and then I will have one more on tax and then I will jump off. We heard a couple of companies talk about delays in the UK specifically around their National Health Services and some funding there. Did you seeing any of that in the quarter, is there anything UK specific around that business that may be impacting growth in the near term?

Walt Rosebrough

We didn't see any significant change in our business model or businesses if you will in the UK in the Synergy space and because that tends to be a turn business if you will, it is a consumable kind of a business, you don't tend to have as much fluctuation in that as you might some other things. Now we have seen some delays in timing in terms of working on new projects and signing up projects as there have been changes in NHS so there has been that kind of a delay. But that does not really affect us on a routine basis so in the quarter we didn't see anything significant.

Matt Mishan

And then just lastly on the tax rate, can you provide some additional detail or quantify a little bit how you get to 34 from 25? Was this a surprise for you and what gives you confidence that you are going to be able to do the 25% in FY '17 especially with the U.S. remaining very strong and the international being kind of weak?

Michael Tokich

Matt, as it turns out we were somewhat optimistic in our forecast as we had anticipated that the favorability in the tax rate that we were experiencing through the third quarter would continue and obviously you know that it did not. In addition, we had the geographic mix and the negative impact of discrete item adjustments or the timing of the discrete item adjustments which we had underestimated their impact on the rate for the quarter. Part of those discrete items as I gave you an example earlier about the FIN 48, I mean that was just a natural process we were going through in integrating Synergy as we were doing balance sheet, detailed balance sheet reviews. And obviously with them being on IFRS and now transitioning to U.S. GAAP, there were some variances in the tax rate reserves that we needed to record and needed to record when we had discovered those.

So we really didn't have any opportunity to move those out. It was really recognize those and put the reserves on when they were discovered. I can tell you that since November 2, we have obtained the tax benefits from the combination with Synergy and these items that we talked about, the discrete items specifically and also the geographic mix having a full-year of Synergy and understanding their tax positions going into the full-year, we're as confident as ever that the 25% rate will be withstood in fiscal year 2017.

Walt Rosebrough

Matt, I would argue we will see a bit more variability in our tax rate over the course of the year because these things don't -- just the way taxes are recognized, we may get some variation quarter to quarter. And as a result both of what you are asking the mix issues because we're much better at forecasting what we will sell in general geographic regions or in countries for a year than for a quarter and we're terrible at forecasting it for a month. It gets harder and harder as you move down because again, our turn business tends to be more stable but our capital business can move pretty significantly.

What we do is when if we're building product it is pretty easy to shift if we're a little light in I will just say the UK and we have shipments for the UK but we can ship that to the U.S. or vice versa, we do that. And so even though that hits our total numbers correctly on an operating profit, it will shift our tax rates from quarter to quarter or month to month. But on an annual basis, we will be much better at that than we -- where we don't have to phase it, time it and all those things we did this past year.

Matt Mishan

And I'm just as sorry to all of the people behind me but can you quantify what the impact of the discrete tax adjustments were, like what the dollar amount was so people can back those out? Then I'm done.

Michael Tokich

The problem with that, Matt, is we have discrete item adjustments almost every quarter and we're not going to get into that level of detail. I mean they are not always negative. In Q2 this year we had a large positive discrete item adjustment which favorably impacted the tax rate. We're not going to book keep those, we're going to book keep the total adjusted tax rate on an external basis only.


Our next question is from Chris Cooley of Stephens. Your line is open.

Chris Cooley

Walt and Mike, could you maybe help us out? When we think about the capital component in healthcare products during the quarter, you saw a 6% decline. Could you maybe help us characterize the differences that you see in not only the size of the average order quantity but also in the lead time when you see this shift from basically a replacement to a new build or a major product? And help us think about how that played into the fourth quarter and also maybe then been bracket that with international softness and just or maybe weakness in general. Just want to make sure we fully understand what we saw in the fourth quarter and then how that plays through here in the first part of 2017. Then I've got a couple of follow-ups as well.

Walt Rosebrough

Sure. First of all, Chris, hopefully I tried to at least answer a portion of that question. We saw our backlog increase roughly $20 million in the quarter year-over-year quarter so that gives you an order of magnitude of the change. So obviously our orders grew $20 million more than our shipments for the year so for a yearly change that gives you that view.

Secondly, as Mike mentioned or Mike or I both I think mentioned, we have seen somewhat of a shift and this shift happens, it is not an infrequent happening, it happens all the time between major projects, things where we're selling $0.5 million or bigger projects at a time versus individual orders. I would not say that those orders independently have changed size significantly. That is the project orders are staying roughly the same size and the replacement orders are staying roughly the same size. It is just we have seen a shift to more of those project orders. And Mike, I think you may have the details on that.

Michael Tokich

We started seeing that about -- this is the second quarter in a row we have actually seen that shift which is obviously one of the reasons we're actually seeing the increase in backlog in addition to the level loading. So we're on about a two quarter trajectory at this point in time and that we made the note of it because it is at this point a change that we have not seen for probably the last year or so.

Walt Rosebrough

And then a follow-on on the international things, we're actually seeing some improvement in the pipeline in international but we think it is a little early to call it success so we're being cautious there. But it at least seems that we have hit the bottom in international in general and now so we're seeing some positive things in the pipeline but we're not ready to declare victory there yet. We do have some increases in our international business in our plan but they are modest in scope.

Chris Cooley

On the guidance for fiscal 2017, I think you stated you expect Synergy to contribute between $640 million to $650 million or low single-digit growth in the fiscal year. Can you maybe just walk us through what is behind that low single-digit growth when we think about Synergy? It seems just a little bit softer than what historically we have seen from that business and just want to make sure I understand how much is a function of the merger and then how much maybe softer international in-market demand. Just walk us through kind of why we should think about low single-digit growth for the coming year?

Walt Rosebrough

There is obviously currency effect. I want to hold that aside, it is not a big, big number but there is a currency effect. The second component is we're continuing to see the kind of growth rates we have and would expect to see in the AST business in the high single-digit kind of numbers both on the Synergy side and on the STERIS side or now you really have to characterize it as both on the U.S. business and the O-U.S. business.

So we're seeing that kind of growth and expect to continue to see that for the long term which is why we're investing in growth capacity in those businesses. In the linen business, we're not seeing that, we're seeing growth in the UK and actually shrinkage in the Netherlands side of the business so that is not a trivial piece of the business. And then in the HSS business again, there is the growth in the UK international piece. We have seen a bit of a slowdown, we do not think that in any way is integration related. We think it is just the nature of the business at this point in time. We do expect to see that growth rate pick up over time back to more traditional levels. When you go to in the U.S., we're clearly going to be sorting between some of those businesses that is not as that is not as profitable as we would like and the businesses that are more profitable than we would like.

And so just like we have in the past for example in life science, sometimes it is better to shrink a little to grow your profit a little and we're going to be doing that so we can invest appropriately for the growth business that we see as a possibility on the U.S. side. I think at a high level that is the answer. I don't think there is any significant disruption if you will as a result of the integration going forward. I think it is absolutely fair to say for both companies that the 15 months we spent trying to figure out if we would get to come together clearly created -- we were both running two plans, what if we do and what if we don't? And so in those businesses where there is more interaction both the AST business and the HSS businesses, there was some slow down or you had to do two things instead of one thing and so that 15 months we might have lost a little bit of ground on both sides of the business but I don't think it is significant and I don't think it will play significantly going forward. So it is not something that gives me great concern.

Chris Cooley

Just one more if I may, then I will get back into the queue. When we look at the guidance for fiscal 2017 in the aggregate, definitely some strong topline implications there, 7% organic growth, cash flow of 250 inclusive of the incremental spend also very encouraging. You are roughly 5-ish plus months into the merger now. Could you just give us maybe a quick state of the union as to how you see the opportunity with Synergy Health? What is there that you thought was there at the time of the proposed merger and maybe what incrementally have you discovered from both maybe a growth and a cost standpoint now that you have had a chance to get a little bit more aggressively into the merger itself? Thank you.

Walt Rosebrough

Maybe I will walk three steps, try to break it into three questions. One, the cost synergies. Two, what we see in the major chunks of the business and three, any differences in our views. First, on the cost synergies, they always come out different from where they are than what we think but they are still coming out to the same number. So whether it is this department or that department or this item or that item, we continue to feel that the $40 million is achievable. I personally feel that may even be a little light if you give us a little longer time but we feel the $40 million is achievable. Timing may not be exactly perfect and I will come back to the why on that a little bit. The $20 million from this year and from last year let's call it and this year in total we fully expect that we will achieve that so we're not concerned about that at all. The next years' worth, if some of it slid a little bit, it wouldn't surprise us.

We're getting into finding out that more and more, as is often the case a lot of central office type stuff is IT related and you can only do so many IT things at once. And so we may have some delay in 2018 or 2019 but we're not talking significant numbers in our view at this point in time so we're not concerned about that at all. Again, we do feel that we achieved the $40 million -- my personal expectation is we do a little better.

So now moving on to that topic in terms of the three big buckets of integration, the first is I will call it the central office kind of stuff, the relatively easy things that we have done and it is behind us and that is quick. The longer term central office things are clearly more IT related and it is just work and they were anticipated taking longer time, they were all put out in the 2018 time period and they were predominantly put out any 2018 time period. But there is a lot of work and we're going to work through it. We think we will get there, no big surprises, no big deal but it might take us a little bit longer than we anticipated.

I will call it the two major business components, quite clearly the AST business that I have already indicated it was in my view and always has been my view that it was the easier integration in that basically you had a U.S. business and an O-U.S. business. The people in the businesses have known each other, we have not been competitors and so they've known each other for a long time, they go to the same conferences, they do the same things. So many of our people knew many of their people fairly well and we have a long term leader in that business, Dan Carestio, who has been in our business for a long, long time, 15 to 16 years. I may not be quite right but I'm close and so that is going I think very well. I think the upside there is even greater than we anticipated.

On the HSS business, clearly the laundry issues in the Netherlands that Richard Steeves has talked about now for a year or two is clearly there and we think it will continue and we have work to do to improve that. And then in the U.S. business, I have always felt that there is different people's views on how that is going to go. I have always talked the nascent business I have always felt it is going to take time and I do still believe it is going to take time to have a material impact on the business, but I think it is a very, very nice potential long term opportunity so I don't know that there is a change there but clearly in terms of my view, it is very similar. I'm trying to think through if there is anything else of significance in those three. So if I were a betting person, the AST business probably gets a little quicker start than we might have thought and does a little better in the long term.

The HSS business I think will do as well as we thought but it is going to take a little longer than we thought. But orders of magnitude hopefully it will be in the same ranges. And then the currency, probably the biggest issue is currency changed on us. It was 18 months or now almost two years ago when we were putting this thing together and when we did the deal, the currency clearly changed on us. The good news is that the deal was constructed in such a way that we paid a cash portion in pounds so we had a partial hedge against that currency change but that has clearly had an effect when you go through the operating segment. But high-level, that is it. I think as large integration goes, this one is going about as well as one should expect.


[Operator Instructions]. Our next question is from Mit Ramgopal of Sidoti. Your line is open.

Mit Ramgopal

Most of my questions have been answered but I just have two quick ones. Mike, I know you talked about maybe deleveraging the balance sheet a little. I just wanted to get a sense in terms of the priorities for cash load if it is debt reduction and is it safe to roll out potential acquisitions?

Michael Tokich

Yes, I would say that our priorities for cash remain the same as Walt talked about earlier; dividends, reinvesting in our organic business, M&A if the opportunity does exist or does come forthright. Obviously we have had a little hiatus on doing any type of M&A activity but the pipeline is still strong and we're probably getting a little more active as we have Synergy under our belt now for the last five months. And then debt repayment, as we have talked about, we have added that into our prioritization and again as I spoke earlier, we're at about 2.7 times debt to EBITDA and barring any other large M&A opportunities or acquisitions, we would think that over the next 18 to 24 months we would get that back down to more of a STERIS historic level. And then obviously since we have included no dilution and assume no dilution and our FY '17 plan, if nothing else we would try and recoup some of that dilution by potentially repurchasing some shares.

Mit Ramgopal

Quickly on the CapEx, your $190 million now for fiscal 2017, I don't if you have a sense as to what we should expect going forward in terms of a more normalized CapEx?

Michael Tokich

I would say that our combined depreciation and amortization is around $145 million, $150 million. Obviously we have a significant amount of investments this year. Those investments as you know and you have followed us for quite some time, we tend to over invest one year, under invest the next. So I would say again for modeling purposes, I would still use that $150 million-ish as a good guide in total.


Thank you. I show no other questions at this time. I will turn the call back for any closing remarks.

Julie Winter

Great. Thanks everybody for joining us. Have a great day and go Cavs.


Thank you for participating. You may now disconnect.

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