AGB 2021.23 - STERIS (STE)
Leader in Most Areas of Sterilization
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STERIS is the leading provider of sterilization equipment and services globally with 72% of revenues generated in the U.S. and 28% internationally. Across its four business segments: Healthcare, Advanced Sterilization Technologies (AST), Life Sciences and Dental, the company reaches customers in most industries within the healthcare sector including hospitals, surgery centers, dental practices, medical device manufacturers, biotechnology and pharmaceutical companies.
Sterilization is adopted by companies to prevent the occurrence and spread of infection. For healthcare customers, many of the tools used by doctors and technicians are typically used more than once. After a procedure is completed, these tools need to be washed, decontaminated, sterilized and then repackaged for future use. For medical device manufacturers, products need to be sterilized after they’ve been packaged so that they are ready for shipment to the end customer. And for pharmaceutical companies, vaccines and biologics need to be manufactured in a sterile environment to prevent contamination.
Because each customer’s sterilization needs are different, STERIS oftentimes works with each customer to assess and develop a sterilization process. And in that assessment, the company makes recommendations as to which equipment and consumables the customers would need to purchase.
Healthcare is the largest segment for STERIS at 63% of revenues. Hospitals and surgery centers are the main customers of this segment. Typically, a hospital has a central reprocessing area (usually in the basement) where used surgical instruments come down in case carts to be sterilized daily. If the unit is managed internally by the hospital, staff have to be trained to use the equipment. The largest competitors in this segment are Getinge and Belimed.
Customers make large capital equipment purchases during set up and then recurrently purchase chemicals to run the sterilizing machines. STERIS also sells certain medical equipment that are not directly used for sterilization in hospital operating rooms like surgical tables, lights and endoscopy related tools. Capital equipment make up 30% of the healthcare segment and consumables make up 25%.
The remaining 45% of the Healthcare segment is services. STERIS charges customers for installation, maintenance, upgrade and repair work done to capital equipment. The company also offers instrument repair services for customers that don’t want to service the parts themselves or work with the original device manufacturers to repair/maintain the equipment. This business was formed through a series of acquisitions and is a small part of the services segment.
One of the main growth initiatives within services is outsourced sterilization. STERIS acquired Synergy Health in 2014 and has tried to replicate the successful outsourced model from the U.K. to the U.S. The idea is to offer hospital and surgery center networks within major cities a more efficient method for sterilization. Instead of each location having a sterilization unit, STERIS would consolidate all of the sterilization work into one central location that the company would manage. The company generated ~$10M in outsourced revenues in FY19 and is targeting $50M in a few years.
AST is the second largest segment at 18% of revenues. STERIS owns and operates ~60 plants globally that sterilize finished and packaged medical devices (this process is called terminal sterilization) in different methods depending on the plant. These are large batch processes that either use radiation or gas for sterilization. Gas is mainly in the form of ethylene oxide (EO), which is able to permeate packaging without ruining it. The other large form is Gamma Irradiation which uses a compound called Cobalt-60.
AST is STERIS’ highest margin segment and likely its most defensible. The economic model of the plants are high fixed costs/low variable costs, so there is lots of operating leverage depending on the level of capacity utilization. Geographic proximity to the end customer is very important for this business. The cost of transportation from the customer to one of STERIS’ plants is oftentimes larger than the cost of sterilization.
Contracts are for the most part 3-5 years in length and because the sterilization process has to be tested and validated, it’s cumbersome to move work to a competitor. There are two main players in this space, AST and Sotera Health, each with ~1/3 market share. The remaining share is fragmented with some device manufacturers doing it themselves and small independent operations running one or a few plants.
The Life Science segment is 11% of revenues and the characteristics for this segment are similar to that of Healthcare. Pharma and biotech companies that make biologics and vaccines need to develop and produce these drugs in sterile environments. The machinery for these customers are typically larger and more complicated that for Healthcare customers. The cost for a machine is significantly more, ranging between $500k to $1.5M and are oftentimes the size of entire rooms.
The Dental segment is 8% of revenues. This business is new to STERIS as it was a part of the Cantel Medical acquisition completed in 2021. The business model is similar to the Healthcare segment but the customers are mainly dental practices and schools. STERIS offers sterilization equipment, consumables and services as well as certain dental instruments in this segment.
Each of the company’s segments has shown strong operating leverage over the past 10 years. The AST segment has the highest margins but is closely followed by Life Sciences. The AST business is capital intensive, so it makes sense that there is strong operating leverage there as demand in this segment has been very robust. Within Life Sciences, the capital equipment and consumables portion of the business leverages the spend in the Healthcare division, so margins are naturally higher. Also the mix within the segment favors the higher margin consumables business and has a smaller contribution from the lower margin services business.
Long-term drivers for this business (its organic growth profile) is the growth of medical and dental procedures and the development of new drug formularies. The company estimates that the market should grow mid-single digits going forward (4%-6% as of late) and STERIS should do better than that as a share gainer. Acquisitions add a couple more points to growth (though it’s been higher than that over the past 5 years). With operating leverage, the company expects to achieve double digit EPS growth.
In terms of capital allocation, STERIS believes in paying the dividend first, then investing back into the business (a lot of which has been for the AST business in recent years), then M&A and lastly buybacks.
Why is it a good business?
STERIS benefits from switching costs and scale advantages. The strengths of these advantages differ among the four segments but for the most part, switching costs are prevalent in each of the company’s segments. Sterilization processes are specifically designed and optimized for the type of sterilization that’s required for each type of customer. For example, a hospital has a very different process vs. a life sciences company due to the size and frequency of what’s being sterilized and the quantity of items being sterilized in one batch.
These individual processes and the knowledge of how to utilize the sterilizing equipment has to be learned by the customers’ staff. There is also the use of the machines themselves. STERIS equipment require company made consumables and any necessary servicing, replacement or updating of equipment usually has to be serviced by a STERIS technician.
The switching costs for customers of the AST segment may be the highest. Contracts are 3-5 years in length and the device sterilization process is integrated with the customer’s supply chain. Oftentimes, customers use multiple AST facilities around the world because shipments to the end consumer are also spread out geographically. This is where scale becomes an advantage. The fact that STERIS can sterilize in different geographies with the same standards and procedures means that the customer only has to test and validate the sterilization process once.
There are many barriers to entry for this segment as well. For new entrants, the cost to open a new plant is high and only then can they bid for contracts. Furthermore, the regulatory hoops the new entrant would have to jump through to open a new plant is also an added burden. And lastly, medical device manufacturers have to retest and revalidate the sterilization process if they elected to switch to a new entrant. Sotera Health estimates that testing and validating takes between 1-3 weeks to 6 months depending on the class of products.
Even if the new entrant offered lower pricing, customers wouldn’t switch that easily either. As we mentioned above, the cost of sterilization is a small part of the overall cost to finish and ship the medical device. Oftentimes the cost of transportation to the terminal sterilization plant is more than the cost to sterilize the equipment.
The tailwinds for STERIS’ business segments are: (1) an aging population around the world (similar to most other healthcare companies), (2) increased regulatory scrutiny around cleaning and sterilization processes, and (3) the continued shift from central hospital to ambulatory surgical procedures in the U.S.
The continued shift from inpatient to outpatient surgical procedures has resulted in more outpatient centers being built or acquired by larger hospital networks. While STERIS claims that it doesn’t make much difference where the surgical procedures are done (margins are the same), the buildout of these new ambulatory centers is a net positive for STERIS because there is just more total capex spend. This has also resulted in an increase in the total number of procedures and the complexity of these procedures in outpatient settings are moving higher, both a net positive for STERIS.
Specific to STERIS, the company has decreased its exposure to cyclical revenues over the past decade. Capital spending from healthcare companies are cyclical, especially in areas like sterilization equipment. And because many of these customers are not that profitable themselves, spending on capital equipment usually occurs when there is an urgent need (improper sterilization can result in a shut down of operations). Since FY12, STERIS has increased its service and consumables business as a % of revenues (both organically and through acquisitions) so that these two segments now make up almost 80% of the company’s revenues. This is compared to just over 55% in FY12.
Returns on incremental capital?
Over the past 10 years, STERIS has spent 57% of its capital on acquisitions, 34% on capex and 13% on R&D. Capex is mainly related to production of capital equipment and consumables and the buildout of new AST plants. R&D is mainly related to producing the next generation of sterilization equipment, usually resulting in faster and more efficient turn around times for customers.
Capex spend has been relatively consistent with overall revenue growth, but that’s decoupled over the past 3 years as the company has invested more into AST vs. the remaining segments. Capex investments for AST, whether it’s for new plants or existing plant expansions, almost lead to step function type increases to capacity. STERIS has stated that most of its AST plants are at full utilization, meaning these are running 24 hours per day, almost 365 days per year.
STERIS breaks out capex and asset values for the Healthcare + Life Sciences and AST segments. Healthcare and Life Sciences are grouped together because there is a lot of overlap in the assets that are used for both segments. As seen from the operating margin chart in the first section, margins for the AST segment are actually higher than both the Life Sciences and Healthcare segments. But when looking at return on assets (ROAs), because the AST segment is very capital intensive, the ROAs are actually higher for the Healthcare + Life Sciences segments.
From the chart above, it looks as if the ROA for AST saw a sharp decline in FY16. However, the ROA decline is mainly due to purchase accounting rules that require acquired assets be written-up on the balance sheet. The ROA decline was due to the Synergy Health acquisition that was completed in 2015. Prior to the deal, Synergy Health’s assets were valued at roughly $1B, however, the combined company’s assets increased by more than $2B by 2016. We estimate that the ROA for the AST segment would be closer to mid-teens% if it weren’t for the purchase accounting rules.
On the acquisition front, the company has made multiple acquisitions over the past 10 years, with most of them being small private company tuck-ins. The larger, more notable acquisitions include U.S. Endoscopy in 2012, Synergy Health in 2014, Key Surgical in 2020 and Cantel Medical in 2021 and the multiples paid for these deals are broadly inline to slightly below comparable transactions during that period.
The U.S. Endoscopy deal was for $270M, but due to a deferred tax benefit that number came down to $220M. U.S. Endoscopy was generating about $20M in EBITDA, which implies an EV/EBITDA of 11x, or 9% return if we assume EBITDA is a good enough proxy for cash flow. This acquisition has not lived up to initial expectations as the endoscopy business has struggled to gain much traction. However, it can be argued that the endoscopy business has helped STERIS get into more endoscopy suites and creates new sterilization opportunities.
The Synergy Health deal was for $1.9B and this was partially paid for in stock. STERIS shareholders represented 70% of the economic interest of the combined entity. The two most important asset gains with this deal was (1) expanding the AST business internationally + acquiring eBeam technology, (form of radiation sterilization), and (2) the outsourced reprocessing business model that Synergy successfully built in the U.K. The outsourced model has been met with mix results so far, but management is still bullish on the LT prospects of this business in the U.S. Synergies for this deal came in ahead of expectations at >$45M, so the EV/EBITDA ended up being close to 12x implying a return of 8%.
The Key Surgical deal was for $853M or $810M after a tax benefit. The projected synergies were between $10M-$15M. The EV/EBITDA multiple was 13x even after the tax benefit and synergies, implying a return of 8%. Key Surgical strengthened STERIS’ positioning within endoscopy suites and boosted the international business. Most of Key Surgical’s revenues are consumables and services which is more recurring in nature than capital equipment.
The Cantel Medical deal was for $4.6B and like the Synergy Health deal, this was partially paid for in stock. STERIS shareholders represented 85% of the economic interest of the combined entity. STERIS gained the dental business and strengthened its endoscopy business with this acquisition. Synergies are projected to be $110M, resulting in a EV/EBITDA of 12.8x, implying a return of 8%.
We estimate that STERIS has generated returns on incremental capital between 19%-26% over the past 5 years. Unlike other U.S. based companies, STERIS didn’t benefit as much from the Tax Cuts and Jobs Act because the company had become a U.K. based company in 2015 after acquiring Synergy Health. And after Brexit, the company redomiciled to Ireland in 2019.
In years where there are large acquisitions, the return profile does compress in the short run. These larger deals tend to run above 10x EV/EBITDA but they usually have strategic value or creates new business segments for STERIS. The company does do a lot of M&A, with over 70% of STERIS’ deals being private, tuck-in deals. These deals tend to be at much lower multiples and thus have higher returns but the larger deals account for much more of the total capital spent.
STERIS doesn’t discuss its TAM (at least not recently) and to be fair, it may be difficult to estimate that given the number of segments the company operates and the various businesses within each segment. But if we piece together at a high level, Healthcare + AST + Life Sciences, we can get to a rough estimate of the TAM for STERIS.
For Healthcare and Life Sciences, one of STERIS’ largest competitors is a Swedish company called Getinge. At that company’s 2018 Capital Markets Day, they gave estimates of TAM for the Healthcare and Life Sciences segments. While it’s not perfect, given that the products and services offered by Getinge do not 100% overlap with STERIS, it’s still a good estimate. In 2018, Getinge estimated that Healthcare sterilization was a $6B market. In 2017, STERIS had $1.8B in revenues in their Healthcare segment, which would imply 30% market share.
This is likely too high of an estimate as not all businesses within the Healthcare segment fall under Getinge’s $6B TAM estimate. STERIS has given out TAM estimates for certain parts of its Healthcare segment. Device repair services, which is very fragmented, is estimated to be a $1B TAM. Endoscopy is estimated to be a $2B TAM.
For Life Sciences, Getinge estimated that the company commands 15%-20% market share and for 2017 had $242M in revenues in this segment which would imply that market to be $1.2B-$1.6B. In 2017, STERIS had $340M in revenues in their Life Sciences segment, which would imply 21%-28% market share.
For the AST, Sotera Health is the largest competitor. Sotera estimates that the TAM for outsourced terminal sterilization is $2B. In 2020, STERIS generated $650M in revenues in their AST segment, which would imply 33% share.
Significant share gains in Healthcare, AST and Life sciences would be difficult given the relatively high market shares for STERIS. Going forward, most of the reinvestment likely will be in smaller tuck-in acquisitions within each of these main segments and larger horizontal acquisitions to expand overall TAM. STERIS’ acquisition engine may require going outside of core sterilization in the future if the company wants to keep up with the pace of its recent acquisition history.
With a reinvestment rate between 45%-80% and a return on incremental capital between 19%-26%, we estimate that STERIS has increased its intrinsic value between 12%-15% over the past 5 years. While the growth in intrinsic value has been good over the past 5 years, we have to remember that STERIS has made two large acquisitions partially using its stock. Dilution after the Synergy Health acquisition was more than ~40% and the dilution from the Cantel Medical acquisition will be ~17% in FY22.
What else is important?
The impact from Covid to the Healthcare segment was similar to that of most capital equipment providers and medical device manufacturers. Because surgical procedures (especially ones that were deferrable) slowed down in 2020, fewer capital equipment was purchased and medical devices were used.
However, offsetting the decline in the Healthcare segment, the increased demand for certain products that need terminal sterilization (like PPE) benefited AST. There was also more demand in the Life Sciences segment as pharma customers increased production of vaccines and biologics.
The quarterly combined organic growth profile for the company didn’t see much decline (just one quarter of negative growth in June 2020). Since the company has lapped the Covid impacted quarters, organic growth has come back strong in both the Healthcare and AST segments.
AST is the segment that could be subject to regulatory risks because of EO sterilization. In 2016, the EPA determined that EO is carcinogenic to humans. A lot of the EO gas used in the plants are actually recaptured but there is still some emission that goes out into the environment.
Having said that, EO sterilization is likely to stay because over half of all medical devices are sterilized using EO gas. This is because these devices are in their final packaged form so EO gas is one of the only sterilizing agents that can permeate the packaging.
Of the ~100 EO plants in the U.S., STERIS owns 9. EO is roughly 25% of AST revenues, implying that STERIS is actually under-indexed to EO vs. the rest of the industry. STERIS has more exposure to radiation plants due to the acquisition of Synergy Health, which was a leader in eBeam technology.
But to mitigate the regulatory risk, STERIS has already devised sterilization methods that use 50% less EO gas than the traditional method. There is no direct cost associated with moving the sterilization process to the 50% less EO gas program, but customers would need to retest and revalidate the process, which would take time. From the customer’s perspective, (as we saw from Sotera’s research) it’s unlikely that customers will revalidate their sterilization processes until environmental regulations require them to do so.
For STERIS, M&A will likely be the source of optionality in the future. M&A will allow the company to continue to expand in new geographies. This will be important as countries outside of the U.S. and Western Europe raise their standards for sterilization in healthcare settings. M&A should also provide entry into ancillary areas within healthcare that STERIS is currently not addressing. Even with the latest acquisition of Cantel Medical, STERIS was able to enter the dental market, which is a new market for the company.
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Why not buy SHC rather than Steris if AST is the best part? Lower multiple too