Guido Mieth

Investment Summary

We revised our rating from buy to hold on shares of STERIS plc (NYSE:STE) after the market punished the stock on news of the Sotera Health lawsuit. Despite a positive fiscal Q3, the The market has outperformed the latest growth estimates and STE’s rating has been heavily on the downside since September. Price visibility in the medium term is now weaker. Alas, the market has some work to do before it reaches a consensus on STE’s share price in our estimation.

Our last publications on STE [newest to oldest]:

  1. Steris: Supports non-GAAP valuations
  2. Steris: Deleveraging a mainstream undercurrent

Net clean, revise to hold until market data shows more buying support for STE.

Q3 marked by revenue growth, Cantel synergies

STE produced another mixed quarter, with YoY and non-GAAP EPS ahead of consensus by $0.01. It recorded $1.2Bn in quarterly revenue and posted core EBITDA of $325mm. It has now maintained a run rate of >$300m in core EBITDA for the last 4 consecutive quarters. Meanwhile, the revenue split was 44%/56% in service and product revenue respectively, similar to last year.

We note the c.$500mm backlog in STE’s healthcare division as confirmation of a strong cycle in hospital capital budgeting matters. The order breakdown of 60%/40% replacement/major projects is further evidence in our view. Looking ahead, this is beneficial for STE.

Cantel Medical integration continues to track well in Q3 with $15mm in realized cost synergies for the quarter, $35mm for the full H1. Project management ~$50mm in total synergies for FY23, and still confident of this route. It also expects a drag on revenue in the coming quarters from ~$60mm in capital shipment delays due in Q3 to finally settle.

Our key operating takeaways from the quarter include:

(1). The main driver of medium-term growth is capital shipments from the healthcare sector in our estimate. Management also expects this to be the key lever to lift organic revenue growth to ~10% for FY23/24′. Therefore, STE’s priority is to ensure that its ramp for capital shipments is as flat as possible.

(2). Gross margin compressed by ~140bps YoY as productivity, material costs led margin growth. Despite this, it maintained a 50bps upside in cash EBIT as a result of the Cantel Medical synergies. We have been looking for this kind of data from language in our previous analyses [listed earlier].

(3). STE recognized a net loss of $333mm for the quarter, down from a net profit of $69.6mm a year ago. However, this is on a GAAP basis, and needs to be resolved. The year-over-year discrepancy arises from a non-cash charge of $490.6mm related to the impairment of goodwill in its dental segment. It recorded the impairment after reviewing its estimates of future cash flows and marked down the fair value of the dental item below its carrying value. Hence, the resulting impairment of goodwill. Removing this non-cash charge resolves Q3 OpEx to $348.2mm from $838.75mm. After all adjustments, STE reported non-GAAP net income of $199mm or $1.99 per share. OpEx reconciliation is shown in Exhibit 1.

Exhibit 1. Reconcile GAAP OpEx to remove a non-cash goodwill impairment charge

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Details: HB Insights, STE 10-Q Q3 FY22

Highlights of the critical segment:

The healthcare division grew 700bps YoY [constant currency]and management note shipments increased during the quarter.

Based on the backlog, capital shipments are seen to remain strong over the next 6 months.

Applied sterilization technologies (“AST”) achieved 13% YoY growth in turnover to $232mm and $110mm in segment EBITDA, reflected by strong demand in its biopharmaceutical and medical device markets.

Another standout was the 12% decline in capital equipment revenue from the segment and another 700bps YoY decline in consumables.

It booked $48.6mm in core EBITDA against $57.5mm the previous year.

Finally, dental revenue was the laggard with a 500bps YoY decline driven by reduced volumes and supply chain headwinds.

Growth outlook maintained despite a challenging macro landscape

Management kept its FY22 revenue forecast for 10% growth at the top in constant currency terms but revised down its print number to 8%.

It forecasts FX headwinds of $150mm in revenue and ~$0.15 dilution to EPS for the full year.

We found that it’s important to look at the non-GAAP EPS number for EPS, and management expects $8.40-$8.60 at the bottom line this year after adjustments.

We forecast $8.40 in EPS for the company this year and we see this extending up to $9.32 by FY24, a 10.6% gain.

Our adjusted EPS forecasts with corresponding growth percentages appear in Exhibit 2.

Exhibit 2. Forward EPS estimates, adjusted from GAAP to non-GAAP forecasts

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Note: STE defines adjusted/non-GAAP net income as net income that excludes amortization of intangible assets acquired in business combinations, transaction costs related to acquisitions and divestitures, integration costs related to acquisitions, tax restructuring costs, and unusual or non-recurring items -certain other reflexes. The same reconciliation is done for our projections. (Data: HB Insights Estimates)

The technical picture

Chart studies also suggest that the stock is under pressure to recapture gains. It fell to a 2-year low following the Sotera Health lawsuit, where Sotera was ordered to pay $363mm to a plaintiff [more details here] in late September.

Just before, it had formed a strong base and was testing the 50DMA after facing resistance at this level for 7 weeks.

After the deal was done, it had evaporated a large chunk of STE’s market cap.

The stock is supporting and filling its 7-week setup in September and is now retesting the 50DMA.

However, as seen, the volume trend is significantly decreasing. The sideways action is evidence of heavy resistance to downsizing, in our view.

The point is, the market data is not there to suggest that investors are creating support for buying the stock.

We are happy to see a change in this arrangement but for now this confirms our neutral view.

Exhibit 3. STE 2 year weekly price evolution [log scale shown]. Note a major re-rating after the Sotera Health lawsuit in September.

444

Details: Update

In short

Despite a positive overall quarter, we’re looking for bigger earnings growth percentages than are on the table for STE. The stock has some work to do before the market can reach a consensus on its share price. We were strongly convinced of STE prior to the Sotera Health lawsuit, however, the market is likely to continue to penalize the company until more clarity is achieved on the matter. Clean-clean, keep the rate.



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