STERIS Plc (STE) Walter M. Rosebrough on Q1 2017 Results - Earnings Call Transcript

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STERIS Plc (NYSE:STE)

Q1 2017 Earnings Call

August 09, 2016 10:00 am ET

Executives

Julie Winter - Director-Investor Relations

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

Walter M. Rosebrough - President, Chief Executive Officer & Director

Analysts

Lawrence Keusch - Raymond James & Associates, Inc.

Aubrey Tianello - KeyBanc Capital Markets, Inc.

David L. Turkaly - JMP Securities LLC

Jason A. Rodgers - Great Lakes Review

Chris Cooley - Stephens, Inc.

Operator

Welcome to the STERIS Fiscal 2017 First 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'd now like to introduce today's host, Julie Winter, Director of Investor Relations. Ma'am, you may begin.

Julie Winter - Director-Investor Relations

Thank you, Alice, and good morning everyone. Joining us on today's call as usual we have Walt Rosebrough, our President and CEO, and Mike Tokich, our Senior Vice President, CFO and Treasurer. I have a few words of caution as usual before we open for comments from management. This webcast contains time-sensitive information and is accurate only as of today. Any redistribution, retransmission or rebroadcast of this call without the expressed 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 results 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, constant currency, organic revenues 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 non-recurring items. We define free cash flow as cash flows 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 on today's release.

With those cautions, I will hand the call over to Mike.

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

Thank you, Julie, and good morning, everyone. It's my pleasure 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.

We had a good start to our fiscal year with 6% constant currency organic revenue growth along with contributions from acquisitions. Our revenue growth was almost entirely driven by volume as price was just slightly favorable and foreign currency was unfavorable to revenue by 40 basis points.

Legacy Synergy revenue in constant currency grew low-single-digits during the quarter, which is in line with our expectations. This number, however, is getting increasingly difficult to accurately estimate as we continue to move down the path of integrating our businesses. Gross margin as a percentage of revenue for the quarter decreased 370 basis points to 38.2%.

As expected, Synergy negatively impacted year-over-year gross margin by approximately 500 basis points. As we have stated before, we found that Synergy used a different policy to classify costs between COGS and SG&A as compared to legacy STERIS. Offsetting that, we had favorability from foreign currency of 50 basis points, a 40 basis point increase from the suspension of the medical device excise tax and a 30 basis point improvement from pricing and productivity.

SG&A expense as a percentage of revenue in the quarter declined 480 basis points to 20% of revenue, more than offsetting the change in gross margin as a percentage of revenue due mainly to Synergy Health.

EBIT margin at 15.9% of revenue represents a 200 basis point improvement as compared to the prior-year quarter. EBIT margin benefited from the impact of the positive contributors to gross margin as well as lower SG&A and R&D expenses as a percentage of revenue.

The effective tax rate was 24.5%, slightly below our anticipated full-year rate of 25% due to favorable discrete item adjustments. We continue to expect an effective tax rate of approximate 25% for the full year. Net income in the quarter increased to $68.4 million while earnings per diluted share for the quarter increased 27% to $0.79.

Moving on to our segment results, our Healthcare Products segment revenue grew 8% in the quarter, driven by 3% organic revenue growth and contributions from acquisitions. Consumable revenue increased 20%, of which 9 percentage points was attributable to organic growth. Capital equipment revenue in the quarter was flat. We are pleased with our order activity in healthcare capital equipment in the quarter and feel good about the year, as backlog ended the quarter at $149 million, an increase of 24% year-over-year. Similar to last quarter, we are seeing an uptick in project orders, which tend to have longer lead times than replacement orders.

Operating margins for Healthcare Products increased 110 basis points to 12.3% of revenue in the quarter. The increase is due primarily to higher volumes, favorable foreign currency, the suspension of the medical device excise tax, somewhat offset by higher R&D expenses.

Our Healthcare Specialty Services segment reported revenue for the quarter of $157.9 million, reflecting the addition of Synergy Health along with 5% organic revenue growth. Healthcare Specialty Services operating income decreased slightly in the quarter, due primarily to the lower than anticipated performance in our IMS business, which Walt will discuss in more detail in a moment.

Applied Sterilization Technologies had a good quarter with $116.6 million in revenue. The increase in revenue was driven by the addition of Synergy Health and solid organic revenue growth of 7% for the quarter. Applied Sterilization Technologies operating margin increased to 34% of revenue, due primarily to the increase in volume and the addition of Synergy.

Life Sciences revenue grew 43% in the first quarter, driven by 18% organic revenue growth and contributions from acquisitions. Capital equipment revenue was strong in the quarter, although we had somewhat easy comparisons with the first quarter of last year. And backlog in Life Sciences ended the quarter at $41.3 million.

Consumable revenue grew 62%, partly due to the acquisition of GEPCO and partly due to mid-teens organic revenue growth. Service revenue grew 20%, due to low single-digit organic revenue growth plus the addition of new service offerings.

Life Sciences' first quarter operating margin increased to 30.1% of revenue, due to a favorable mix shift towards consumables, an increase in volume and lower operating expenses as a percentage of revenue.

In terms of the balance sheet, we ended the quarter with $242.4 million of cash and approximately $1.55 billion in total debt. We continue to reduce our debt to EBITDA leverage, which was about 2.6 times at quarter end. Our DSO was 62 days at quarter end, an increase of five days as it compared to last year. As we have said before, the increase is based on the fact that we include 100% of an acquisition's accounts receivable balance but only include the revenue since we've acquired them in our calculation. Our DSO would be materially the same taking the acquisitions' relevant revenue into account.

Free cash flow for the first three months of $49.5 million, a substantial increase from the prior year and a solid start to the fiscal year. Included in free cash flow for the quarter is approximately $4 million of cash expenses related to the integration of acquisitions. Capital spending was $35.4 million in the quarter while depreciation and amortization was $53.8 million.

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

Walter M. Rosebrough - President, Chief Executive Officer & Director

Thanks, Mike, and good morning, everyone. Michael has covered the quarter, so I will focus on our recent transactions and our outlook for the year. We've had a strong and busy start to the year, executing on the strategies we put in place while working to meet the needs of our customers.

Let me recap a few highlights. On the 1st of July we completed the sale of our UK Linen business for approximately £50 million. For fiscal 2017 that business was expected to generate approximately $40 million in revenue for the balance of the year. We used some of the proceeds from that sale just a few weeks later when we paid about £27 million to buy Medisafe Holdings.

Medisafe is a UK manufacturer of washer disinfector equipment and it also markets related consumables and services. We paid about two times revenue for the business, which carries operating margins in line with our Healthcare Products segment. We are pleased to welcome Medisafe to STERIS as their products and services complement our global healthcare offering by providing washer R&D and production in the UK.

Now of course both of these transactions occurred after the recent Brexit vote. Although we have exited UK linens, we are not backing away from our plans to grow in the UK. We are watching the UK Brexit politics like everyone else but our initial belief is that the result of Brexit on our business in the near term is likely to be primarily currency fluctuations. We are obviously impacted by changes in the pound when translated to U.S. dollars.

As we've described in the past, the UK is about 10% of our revenue. Given the nature of the business that we have in the UK, most of the revenue and cost is UK in-country. So we have a natural cost hedge to help offset the impact of fluctuations in the British pound. As a reminder, the Synergy combination itself was also a natural hedge to the legacy STERIS currency position in terms of overall company profitability.

Our profitability now generally benefits from a strong euro and a strong British pound and a weak peso and a weak Canadian dollar when compared to the U.S. dollar.

As a result of these two business development actions, and reflecting the updated forward currency rates, we are adjusting our revenue outlook for fiscal 2017. Let me break down the pieces a bit as we do have a few moving parts.

Total company revenue growth is now expected to be in the range of 22% to 23%. Compared to our original outlook, we are reducing our revenue growth expectations by 300 basis points to reflect the UK Linen and Medisafe transactions we have completed this fiscal year, anticipated changes in foreign currency and a reduction in revenue growth expectations for our IMS business.

Since the UK Linen business divestiture, Medisafe acquisition and the exchange rate impacts are fairly straightforward, let me spend some time on IMS. We had a second consecutive nice growth year in IMS in fiscal 2016, ending the year with double-digit organic revenue growth. We plan to continue to grow at a similar level in FY17.

Our first quarter started slower than anticipated in IMS with mid-single-digit organic revenue growth and we are tempering our IMS expectations for the full year as a result. As Mike mentioned, this also impacted IMS profitability somewhat in Q1 as our investments were aligned with a faster-growth business plan. We will reduce the growth rate of IMS spending for the balance of the year. So we now expect to see an improvement in that unit's profitability compared with Q1 levels in the second half of the fiscal year.

The combination of all these moving pieces results in an expectation of approximately 6% organic revenue growth for the year compared with our original 7% growth outlook. To be clear, for your modeling purposes we have stripped the UK Linen business out of all relevant periods in our current estimate of organic growth.

Although we have reduced our revenue growth expectations, our adjusted EPS range is unchanged at $3.85 to $4 per diluted share. As we mentioned before, the addition of Synergy to legacy STERIS has somewhat increased revenue volatility to foreign exchange fluctuations in U.S. dollar terms. However, the impact on profitability is more naturally hedged than it was before the combination.

So the total impact of changes in foreign currency, the sale of the UK Linen business and the acquisition of Medisafe all combined is anticipated to create about $0.05 of dilution in adjusted EPS, which can be absorbed in the EPS outlook range. We currently anticipate that the previously discussed IMS earnings shortfall will be made up by improvements in the rest of the business as we continue to see strength in our North American healthcare, our global AST and global Life Science businesses.

As we said last quarter, we continue to review our portfolio of products and services to determine what to invest in going forward. We are working on a number of possible actions, including both disposal of non-core assets and tuck-in acquisitions, which may be completed this fiscal year.

We will update you on our actions and the relevant impact to our outlook on quarterly earnings calls as appropriate. While this may create some minor short-term modeling and forecasting challenges, we are working to redeploy our capital in order to generate greater value over the longer term.

Our FY17 outlook for the remaining financial measures – free cash flow, the effective tax rate, capital expenditures and cost synergies from the combination with Synergy Health, which continues to go nicely – remain unchanged for the fiscal year, as do our capital allocation priorities.

With that, I will turn the call over to Julie to begin Q&A.

Julie Winter - Director-Investor Relations

Thank you, Walt and Mike, for your comments. Alice, will you please give the instructions and we will get started with Q&A.

Question-and-Answer Session

Operator

Thank you. Our first question is from Mr. Larry Keusch with Raymond James. Your line is open.

Lawrence Keusch - Raymond James & Associates, Inc.

Thank you. Good morning, everyone.

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

Hey, Larry.

Walter M. Rosebrough - President, Chief Executive Officer & Director

Good morning, Larry.

Lawrence Keusch - Raymond James & Associates, Inc.

So Walt, I was hoping we'd get started on IMS and maybe give us some help understanding, you know, what you are seeing out there that led to the lower performance starting out the year. And then how are you thinking about, again, more from a revenue perspective through the year – I understand obviously that you are going to readjust your cost to be more consistent, but just any thoughts around that would be helpful.

Walter M. Rosebrough - President, Chief Executive Officer & Director

Sure, Larry. We see this as a temporal issue, not any kind of a permanent issue, if you will. We have a natural growth rate. I mean the general growth rate of that business in total is roughly in line with healthcare. The question is how much business moves from hospitals doing it themselves or from the OEMs moving to third-party participants. And there we've seen double-digit kind of numbers. We expect to continue to see double-digit kind of numbers. But within that there's always some churn, some going to us from us to us from us. We actually ended last year stronger than we expected and so we had quite positive churn. We probably got a little more optimistic than we should about that. So we've had some negative churn now in this current timeframe. But in terms – and so it take some times to work through that because we had invested presuming we would hold all that business and continue to take some.

So we are a little bit behind our current forecast. In that kind of business it doesn't – it's not like capital where you get a big order and then you lose a big order; it is an ongoing business. So the long term we don't expect it to be any different than our previous thinking. It's just a short-term aberration in our view.

Lawrence Keusch - Raymond James & Associates, Inc.

Okay. That's helpful. And then two other ones, I guess one for you, Walt, and then for Mike. For you, again you know obviously saw that you increased the dividend. That's again consistent with your focus on maintaining and actually growing the dividend. You also announced a $300 million share repurchase, which is about 5% of the current market cap, so nice size. And I recognize that that will be tapped into over time. But could you just talk a little bit again about where you see sort of deleveraging and share repurchase priorities, call it over the next couple years?

And then the second question is just on the HSS margins, which were 2%. Again, I assume a lot of that has to do with IMS, but well below that kind of double-digit bogey that you always talk about. And again wanted to take your temperature on what's driving the 2%, which is down sequentially, and what drives it up.

Walter M. Rosebrough - President, Chief Executive Officer & Director

Sure. I guess I'll break, two basic questions. One's a capital allocation question, let's call it, and the other one is the profitability in that business segment.

Lawrence Keusch - Raymond James & Associates, Inc.

Yeah.

Walter M. Rosebrough - President, Chief Executive Officer & Director

On the capital allocation question, we don't feel any differently. We've moved down nicely already. Mike mentioned we were down to 2.6. You know, someplace in the 2.2 to 2.3 range, around 2-ish if you will, is kind of what we think the sweet spot is. And so we will be working our way down. And we continue to plan to work our way down. So that still is the priority. In terms of the rest of the capital allocation, we're going to invest in our current businesses. We'll invest in the tuck-in type of acquisitions to add on to our businesses. And then stock buybacks is a third. I should mention that we had I think about $100 million left, Mike?

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

About $80 million.

Walter M. Rosebrough - President, Chief Executive Officer & Director

Thank you. About $80 million left in our previous authorization when we moved to Synergy Plc and in that process we needed to get a reauthorization from shareholders to do anything, so we actually had zero authorization going into this quarter. So this is just, I'll call it for lack of better terms, a re-up of our normal type of authorization. We've done this over the last seven or eight years. This is the third $300 million authorization. So it's not a change in philosophy or change in thinking.

And generally speaking, unless we see a dearth of acquisition-type opportunities or tuck-in opportunities, we would expect to be purchasing shares only to offset dilution. That's kind of our general thinking. So that I think answers that one, and that's really no change from what we've been talking about now since we announced the Synergy deal.

The second thing is, as you know, I don't like anything that's making single-digit ROS. There are differences in businesses. Our AST business has a much higher capital requirement, so it has to make higher ROS to make appropriate ROIC, and that's in the long run we create value by growing things and having ROIC above our cost of capital. That's what we want to do and to the extent we can even get higher ROIC the better.

So we do, there are different ROS criteria for the businesses to get to the appropriate ROIC, but clearly those are not where we would want them to be or would like them to be. We do expect them to see double digits. But part of that is we've got a combination of some businesses that are relatively low ROIC like the Linen business combined with – or ROS or ROIC for that matter – like the Linen businesses as well as businesses where we are investing because we believe the long term they will have good profitability because we've seen that model in the UK. So it's a combination of those things.

As you know, I don't put real targets on an end-point profitability but I definitely like to see double digits. And I don't see us feeling any differently about that than we did a year ago or two years ago or three years ago. But we do see investment opportunities here and growth opportunities and we anticipate doing that.

Lawrence Keusch - Raymond James & Associates, Inc.

Okay, very good. Thank you very much.

Operator

Thank you. Our next question is from Mr. Matt Mishan from KeyBanc. Your line is open.

Aubrey Tianello - KeyBanc Capital Markets, Inc.

Hey, guys. This is actually Aubrey on for Matt. Can you hear me okay?

Walter M. Rosebrough - President, Chief Executive Officer & Director

Yes certainly, Aubrey.

Aubrey Tianello - KeyBanc Capital Markets, Inc.

Great. Thanks for taking the questions. First, I was hoping maybe you could talk a little bit about what else is going on in the rest of the HSS segment outside of IMS. I know you still have the Netherlands and UK-based linens business there as well as the outsourced central sterile processing. Are there any changes in what you're seeing across those businesses?

Walter M. Rosebrough - President, Chief Executive Officer & Director

No. I think you may have meant the U.S. linens business because the UK business we sold. We do both have the U.S. and the Netherlands businesses. As we've mentioned in the past, those are relatively low-margin businesses. And so we haven't seen a significant change. As you noticed, they are still relatively low-margin, low-growth businesses and we haven't seen a change there.

In the HSS business, again, that business is a profitable business in the UK and we're investing in other parts of the world to grow that business to duplicate the UK model, so again no change. We still have a lot of interest from customers who are talking to us about potential outsourcing in the U.S. But again, as we've said many, many times, it's going to take time for that to come to fruition and we do see it as a nascent business.

We don't anticipate any significant revenue profitability in that business certainly in this year, and it's going to be a while before it becomes a material part of the total STERIS profitability map.

Aubrey Tianello - KeyBanc Capital Markets, Inc.

Okay, got it. And then just last one, if you'd be able to just give a little bit more detail on how you're going to be offsetting that $0.05 headwind that you called out from a combination of the Linen sale, IMS, FX, etcetera, why you have confidence in reiterating your EPS guidance?

Walter M. Rosebrough - President, Chief Executive Officer & Director

Yeah, well, first of all it's a range, not a number, and so we have a $0.15 range and it's a $0.05 headwind. So that certainly is encompassed in that kind of range. And obviously we didn't have our point forecast at where we are at the bottom of that range, the bottom number of that range. So that's one answer.

And then the second answer is we do see strength in the North American capital – well, the North American operation in general in healthcare and in the global operations in both Life Science and AST. So we have some very strong positive feelings about that. The rest of the globe for healthcare is a little tough. And so we are just mixing and matching all those components. And at this point in time in the year we did not see it appropriate to change the range.

Aubrey Tianello - KeyBanc Capital Markets, Inc.

Got it. Thanks.

Operator

Thank you. Our next question comes from Mr. David Turkaly with JMP Securities. Your line is open.

David L. Turkaly - JMP Securities LLC

Thanks. I know you mentioned on the Healthcare Products side the project again and obviously we see the increase in the backlog. I'm just curious do you expect that trend to continue throughout the year? And if so, yeah, just any color on why you think that is the case now.

Walter M. Rosebrough - President, Chief Executive Officer & Director

The short answer is we're seeing real strength and we're not alone in that. The other guys in the capital business in North America are seeing real strength there in both orders and generally speaking in backlog. And we also have visibility in pipeline as we mentioned several times; usually three to six months of pretty clear visibility. Our pipeline looks the same as our orders, it's just strong in North America right now. That can always change, but at this point in time we're seeing real strength. And it's been double-digit kind of strength now for six or nine months and so – and it looks like the same kind of strength out in the future, so out in the future meaning six months out or nine months out. So it's a combination of replacement orders are staying strong and projects are increasing, and you put those together and you get some nice increases.

David L. Turkaly - JMP Securities LLC

And then on the Life Science side I know you mentioned some easy comps but mid-teens organic growth. I guess just any color on sort of what your expectations are there and what's driving sort of that mid-teens organic growth. I know in the past there were some times in the past where that was a little slower. But I guess what are you seeing that can give you comfort that that can continue?

Walter M. Rosebrough - President, Chief Executive Officer & Director

Yeah, I'm going to separate the capital piece from the rest, the consumables and service parts. On the capital side, that business has now been steady for five years maybe and our backlog is balanced between $40 million and $45 million roughly for five years. So I don't see any material long-term change there. Mix has changed and our willingness to accept no-profit business has changed. And so the profitability from that business has changed significantly for the good.

Now when we look at the consumable side there are a couple pieces that make that up. First of all, our chemistry business has just been quite strong and we have a nice set of chemistries and we've mentioned that we've also added some chemistries to our portfolio. And so those are just picking up speed. So it's pure organic, growing business. We do think we're targeted at good spots, we're targeted at vaccines and biologics, which are nice growing pieces of the pharmaceutical business. So we're just targeting in the right spots and we have some nice products. So we have had good organic growth and we see that continuing.

And then the acquisition of our barrier products, which was the company called GEPCO, which is also a consumable product in Life Science, have also been strong. They had good growth but we also have the ability to – they were essentially a U.S. company and so we have a global footprint in the sales force so we have the ability to move those products to global customers outside the United States. So it's a real opportunity for us to grow. So we just see very nice positive movement in Life Science and we continue to expect that on the consumables side of the business.

David L. Turkaly - JMP Securities LLC

Thank you very much.

Walter M. Rosebrough - President, Chief Executive Officer & Director

You bet.

Operator

Thank you. Our next question comes from Mr. Jason Rodgers with Great Lakes Review. Your line is open.

Jason A. Rodgers - Great Lakes Review

Yes, just wanted to follow up on the Life Science question. Didn't know that you are facing some tougher comps in the next few quarters here. Would you expect the growth rate to slow a little due to that or do you think some of the positive factors you mentioned will more than offset the comps?

Walter M. Rosebrough - President, Chief Executive Officer & Director

On the consumable side, I think the comps are fine and the growth rates are fine. On the capital side, we had some really nice shipments I want to say in the mid part of last year. And so we will clearly not see these kind of growth rates going forward. I think to say the capital business is flat to slightly increasing is the right kind of general way to think about it for the year and for longer term. So it's not – I mean it's a 40% growth for this quarter but that was just because of easy comps and a strong quarter; that a long-term change.

Jason A. Rodgers - Great Lakes Review

And the Linen business that was sold, what was the expected operating profit for fiscal 2017 of that business?

Julie Winter - Director-Investor Relations

We really haven't disclosed that, Jason. I mean we've disclosed the size of the business and been clear that the margins were better than segment average, kind of high-single-digits, and left it at that.

Jason A. Rodgers - Great Lakes Review

All right. And looking at your Healthcare Product revenue, what percent of that is outside the U.S. and how do the margins compare?

Walter M. Rosebrough - President, Chief Executive Officer & Director

Well, Healthcare Products, again, it's more dominated in the U.S. because I don't know the number off the top of my head but it's small, so in the 15% to 20% kind of range. Mike is looking for it as we speak. And part of that is because there's a piece of that business that came from Synergy. I just don't happen – and it is predominately O-U.S., so I don't happen to have that number in my head.

But the margins O-U.S. are somewhat different because we go through distributors. So we generally do not get the "sales" margin or distributor margin, but we do get the design and manufacturing margins, so that's the predominant difference. Now pricing outside the U.S. is typically a little bit higher because transportation and the distribution cost. I'll call it the end customer's price is typically higher because of those things. But we don't get the distribution margin and we often don't get the service that goes along with it like the installation; some of the services the distributor tends to do that. So at a high level that's the case on capital. On consumables they are roughly similar.

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

And about 70% of our Healthcare Products revenues come outside the U.S.

Jason A. Rodgers - Great Lakes Review

All right. That's helpful. And finally...

Walter M. Rosebrough - President, Chief Executive Officer & Director

No, inside the U.S.

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

Sorry, the other way. Inside, yes sorry.

Walter M. Rosebrough - President, Chief Executive Officer & Director

Inside the U.S.

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

Inside the U.S., yes.

Jason A. Rodgers - Great Lakes Review

That's what I thought. And finally, any material change in anything outside the U.S. generally from hospitals, any improvements or deterioration in any regions of note?

Walter M. Rosebrough - President, Chief Executive Officer & Director

I mean, all you have to do is ask what countries are experiencing fiscal difficulty because most countries outside the U.S. are, for lack of better terms, are largely national healthcare programs with government budgets. So all of the countries that are mineral-based or oil-based – all is a big word – but generally speaking those that are mineral-based or oil-based are having difficulty in their government budgets and as a result having difficulty in their healthcare budgets.

So kind of off the top of my head in Latin America, Venezuela is just really, really challenged. Brazil is quite challenged. Moving to the Middle East, a big part of the Middle East, which was a very strong healthcare business, has slowed down significantly. And Saudi Arabia in particular, which was a very good healthcare business, has the dual challenge of the weaker oil prices as well as having to fund some war issues at the same time.

So Saudi is particularly challenged, but much of the Middle East, the oil-based economies are challenged. We have seen actually a bit of a pick-up in Asia; not China per se, although we've actually kind of done nicely in China. It's a small business for us. But not so much China but the areas outside, so Southeast Asia has clearly been picking up for us but it's still challenged. In Australia, again, a mineral-based economy has been challenged for the last 12 or 18 months.

Jason A. Rodgers - Great Lakes Review

Thanks a lot.

Walter M. Rosebrough - President, Chief Executive Officer & Director

You bet.

Operator

Thank you. Our next question comes from Mr. Chris Cooley with Stephens. Your line is open.

Chris Cooley - Stephens, Inc.

Good morning and thanks for taking the questions.

Julie Winter - Director-Investor Relations

Good morning, Chris.

Chris Cooley - Stephens, Inc.

Hey, good morning. Could we start, Mike, just going back and looking at AST profit here in the quarter, a little bit stronger than what we were modeling there, in fact about 400 basis points stronger. I just want to get a better understanding. Is that as you're starting to get greater utilization of the increase that you've done in capacity, primarily in the U.S., margins are improving? Are you seeing any kind of cut to your raw material or I should say cobalt-60 costs? Or is it just maybe mix? I'm just trying to get a little bit better understanding of what's driving that level of profitability, and then I have a couple of quick follow-ups.

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

Yes certainly, Chris. So the 34% operating margin that you mentioned with AST, I mean a lot of that is, and then we've talked about this before, is we have a high fixed cost base and we did see exceptional volume increases this quarter. So that volume, once we cover the fixed costs, is extremely profitable for us and that is the major driver. On top of that, the integration with Synergy Health is actually moving along very nicely. So we probably get a little bit of a benefit there as we integrate our businesses, but I would say first and foremost it's the volume piece that is driving the large increase.

Chris Cooley - Stephens, Inc.

Okay.

Walter M. Rosebrough - President, Chief Executive Officer & Director

And I would mention, Chris, we are bringing a number of plants online and when we're bringing plants online, it means the ones that are currently running are full. So we're running capacity-like numbers in a lot of places and that's a good time to be making some money. We would expect some averaging of that over time. We are trying to have them not come all at once, so we don't have this nice buildup and then a cliff, nice buildup and then a cliff. We are trying to even them out over periods of time. But there is some, if you look at a plant-by-plant basis, it does look like that. We're now getting to be good enough size. I mean we have 60 facilities roughly. So we are getting to be a large enough size that one or two facilities doesn't crush us, but you notice them when they come on board.

Chris Cooley - Stephens, Inc.

Understood. And then if you could just revisit healthcare capital, the growth in the backlog there again very briefly. Historically I think that's been about a 75%, 80% replacement, 20%, 25% new project build-type business. Could you just give us maybe a little bit more color there, and I apologize if I missed at the outset, in terms of that mix here the last several quarters? Because I know in your prepared remarks you mentioned greater growth in new project build. I am just trying to think about what that incremental growth is longer term potentially for both consumables and service as you pull out through the backlog.

Walter M. Rosebrough - President, Chief Executive Officer & Director

Yeah, Chris, just Mike's looking for the number. But while he does, consumables aren't really impacted by that. There are sometimes, because we go through distribution, sometimes our distributors stock a little more, stock a little less, or the hospitals don't quite catch their seasonality correct. But that tends to be minor fluctuations.

On the capital side, the 75-25 is roughly a good rule but we clearly – we had gone – it goes in cycles and we had been where replacement was the stronger piece a couple years ago. Projects have been picking up and they're continuing to pick up. So again, Mike's doing some math right now. I'll let him report it, but it's clearly picked up the last six months or eight months or so. And the outlook is also that way. There is more project kind of business out there.

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

Yeah, Chris, we've gone from roughly 70-30 replacement versus projects and we're more looking like closer to now 60-40. So we made a pretty substantial switch with the replacement versus the projects.

Chris Cooley - Stephens, Inc.

Okay. That's helpful. And then just lastly cash flow was strong, approximately $50 million in free here in the quarter. Can you just remind us if there's anything different in terms of the seasonality when we think about historically the way we saw corporate cash flow build through the course of the year now that this is going to be our first full year with Synergy? Thanks.

Michael J. Tokich - Chief Financial Officer, Treasurer & Senior Vice President

Yeah, Chris, I would say that from a cash flow standpoint the seasonality will be tracking to income. And for the most part legacy STERIS has typically been more second-half weighted. Legacy Synergy has been pretty much even throughout the year. So I don't think it'll be that much of a directional change from what we've seen historically.

Walter M. Rosebrough - President, Chief Executive Officer & Director

AST generally is a little, all things being equal, there's growth across, but all things being equal AST tends to be stronger in the first half and Synergy was more AST-oriented. And the rest of STERIS has tended to be a little more back half, particularly the capital side. So it kind of mixes and matches. I would still expect it to be, generally speaking, for seasonality to have a little stronger in the back half, A., just due to the growth in general, and B., because the back half tends to be a little more weighted, particularly on the capital side.

Chris Cooley - Stephens, Inc.

Understood. Thanks so much.

Operator

Thank you. Our next question comes from Mr. Larry Keusch with Raymond James. Your line is now open.

Lawrence Keusch - Raymond James & Associates, Inc.

Hi. Thanks. Just one more for you guys. Walt and Mike, you sort of alluded to some of this through your comments, but could you talk a little bit about just how the integration of Synergy is going as you put those two businesses together? And then there was a little bit of confusion in last quarter's conference call as it related to the outlook for the cost synergies. I noticed that you indicated that you are looking for and still expecting $15 million for this year. But again help us think about the $40 million that you kind of initially targeted.

Walter M. Rosebrough - President, Chief Executive Officer & Director

Sure, Larry. First, I would say there are basically three projects in this integration and each of the two major businesses that are integrated – the HSS/IMS business is one and the AST business from both sides, or formally Isomedix and AST business the other – the business integration for all intents and purposes is almost complete, that is the organization, structures and people and all those things.

Those integration teams are down to just a few items, with the exception of the classic IT where we were trying to get on common systems and all that stuff, which is much more like the central office integration functions. But in terms of what I'll call the business salesforce, those kinds of things, we are coming into the home stretch if not in the home stretch, and it's gone nicely, just full stop nicely.

The longer-term issues relate to systems, getting on common systems and getting on the back office people, whether that's human resources, IT, finance. Those systems take longer to integrate. And so those are I'll call it the long-tail systems, and that project team is still heavily working on their part of integration, not the least of which is things like legal, legal structure-type things because you know we had, I forgotten exactly, but 60 or 70 legal entities in our business and they had 60 or 70 legal entities in their business.

You know, we would like to get to 60 or 70 legal entities. And that just takes time of lawyers and accountants and those kind of things. And it saves us money in the long run because we don't have to do 140 statutory reports. We do 60 or 70. And so those kinds of things are taking the time and that was always expected. Now, to come down to the bottom-line side of it. We hit our $5 million that we expected last year. We are very comfortable with our $15 million forecast for this year and we are very comfortable with our $40 million or more now total forecast over the longer period of time. And whether $2 million or $3 million of it slides into 2019 instead of 2018, my own view is we'll probably hit 2018 and have a little extra that we get maybe slide into 2019. But at a high level, any way you want to look at it we are quite comfortable with the numbers that we have in place.

Lawrence Keusch - Raymond James & Associates, Inc.

Okay, terrific, thanks very much, appreciate it.

Operator

Thank you. I show no other question at this time. I'll turn the call back for any closing remarks.

Julie Winter - Director-Investor Relations

Thank you, Alice, and thank you everybody for joining us this morning. We'll talk to you again soon.

Operator

Thank you for participating. You may now disconnect.

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