STERIS - Earnings Call - Q2 2021

Transcript

Operator (participant)

Good morning, everyone, and welcome to the STERIS PLC second quarter 2021 Conference Call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please also note today's event is being recorded. At this time, I'd like to turn the conference call over to Julie Winter, Vice President of Investor Relations. Ma'am, please go ahead.

Julie Winter (VP of Investor Relations)

Thank you, Jamie, and good morning, everyone. On today's call, we have Walt Rosebrough, our President and CEO, Mike Tokich, our Senior Vice President and CFO, and Dan Carestio, our Chief Operating Officer. I do have 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' securities filings. 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' SEC filings are available through the company and on our website. In addition, on today's call, Non-GAAP financial measures, including adjusted earnings per diluted share, adjusted operating income, constant currency organic revenue growth, and free cash flow, will be used. Additional information regarding these measures, including definitions, is available in today's release with reconciliations between GAAP and Non-GAAP financial measures. 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. With those cautions, I will hand the call over to Mike.

Mike Tokich (CFO)

Thank you, Julie, and good morning, everyone. It is once again my pleasure to be with you this morning to review the highlights of our second quarter performance. For the quarter, constant currency organic revenue increased 2%, driven by 100 basis points of volume and 100 basis points of price. Constant currency organic revenue for the quarter includes a total of about $5 million from prior year tuck-in acquisitions, primarily in Healthcare, spread across capital equipment, consumables, and service. Gross margin for the quarter was up 140 basis points to 45% and benefited from mix, price and productivity. EBIT margin for the quarter was 22.5% of revenue, an increase of 220 basis points from the second quarter last year due to higher gross margin attainment and lower operating expenses, mainly for travel, sales and marketing, and compensation due in part from business disruption from COVID-19.

The adjusted tax rate in the quarter was 21.1% and includes the benefit of stock compensation offset by unfavorable discrete item adjustments. Net income in the quarter grew 13% to $127.3 million, and earnings increased to $1.48 per diluted share as compared to $1.32 per diluted share in the prior year. Our balance sheet is a continued source of strength for the company. Considering our cash position of $312 million, access to available credit lines, and a low leverage ratio, we are well-positioned from a liquidity standpoint. Even reflecting the anticipated additional leverage for the Key Surgical acquisition, our debt levels remained solidly in our comfort zone. During the second quarter, capital expenditures totaled $43.9 million, while depreciation and amortization was $54.4 million.

Free cash flow for the first half was $185.6 million, an increase of $23.6 million over the first half of last year, primarily due to improvements in net income and working capital somewhat offset by higher capital expenditures. With that, I will now turn the call over to Walt for his remarks.

Walt Rosebrough (CEO)

Thanks, Mike, and good morning, all. I hope you all have voted or will later today. We are pleased to be with you to report such encouraging results for our second quarter, which reflect the resilience of our business and the good work done by STERIS Associates. In total, constant currency organic revenue grew 2% year over year and improved substantially on a sequential basis. We benefited from the continued recovery in procedure volumes during the quarter, as well as continued strength in segments with exposure to COVID-19-related products and services. Our release walks through the details, but I will touch on a few highlights of the quarter. Life Sciences grew 16% in the second quarter, continuing its strong performance, in particular for consumables.

While it's difficult to dissect the 31% consumables growth in the quarter, we believe the underlying growth rate remained in the lower teens, and the balance of the growth is due to COVID-19 pre-buying in anticipation of vaccine production demand. As we've said all year, we do not anticipate maintaining these growth percentage levels in perpetuity. In particular, our fourth quarter has difficult comparisons, as last year's fourth quarter was the beginning of the Life Science consumables' significant COVID-19-related revenue uptake. Rebounding from first quarter levels, our AST segment grew 9% year over year in the quarter, benefiting from continued demand for COVID-19 product sterilization, as well as a significant recovery of procedure-related medical device sterilization volumes. As we've said in prior quarters, we continue to invest aggressively in capacity expansions at AST, reflecting our long-term expectations for the growth in this business.

As anticipated, our Healthcare segment continued to be impacted by some disruption in procedures in the quarter, declining 3% year over year, but improving nicely on a sequential basis. Both consumables and service rebounded from first quarter levels, with consumables revenue growing 6% year over year, while service revenue was flat. Capital equipment shipments in the segment declined as we anticipated. Those shipments were down 14% versus the second quarter of last year. As we break our capital business into either large projects or replacements. We were pleasantly surprised to see replacement orders rebounding sequentially in the quarter, reflecting a return to more normal procedure volumes. Capital equipment orders have grown sequentially through October from the low point in May and have returned to about last year's levels.

Like most in our space, while we are pleased to see the sequential improvements in revenue from procedures to date, there is significant uncertainty in the coming months as the COVID-19 pandemic appears to be escalating in many areas around the world. We have seen recent procedure declines in parts of Europe. It is too soon to tell what we will experience going forward in Europe and in the U.S. in the next six months. That said, we are not planning a significant disruption of procedure volumes in the second half of our year. As a result, we're planning for sequential revenue growth in the second half to result in about flat year-over-year revenue, excluding any impact from the anticipated Key Surgical acquisition. While we are quite pleased with recent trends, the situation is fluid and difficult to predict.

We still consider our Healthcare capital equipment portfolio to have the greatest downside risk in the near term. If procedures continue to improve and the pandemic subsides, we will expect some costs in our operation to start coming back to more normal levels in the second half of the year, which will limit our bottom-line percentage growth somewhat. As we said all along, we manage this business for the long haul. Our actions during this pandemic reflect that approach, including our decision to avoid unpaid layoffs or furloughs related to COVID-19. We've worked hard to maintain jobs and compensation for our people, putting programs in place to take care of those who need extra support and providing paid furlough for those people in operations that were impacted by declining the business due to the pandemic.

Total costs for COVID-19 programs and expenses were $4.5 million in our second fiscal quarter, about half of what we saw in first quarter. Similarly, our approach to investments has not changed. We continue to expand our AST footprint and to invest in R&D. We have introduced a full suite of surgical products this year, including new operating room lights, several new surgical tables, and a next-generation OR integration system. On the infection prevention side of our business, recently launched products include our new smaller-footprint steam sterilizers and more rapid biological indicators, among others. We do not expect a consequential slowdown in our new product development efforts or in spending for R&D as a result of the pandemic. Before we open to Q&A, I would like to again thank STERIS people for their commitment to our customers, who have continued to be the heroes on the front lines of this pandemic.

While there is uncertainty in the near term given the COVID-19 situation, we like the positioning of our global portfolio during the pandemic as well as when we come out of it. We are working toward completing the previously announced acquisition of Key Surgical by calendar year-end and look forward to welcoming Key's people to the STERIS family. We stand ready to capture additional opportunity and continue to believe that the long-term future for STERIS is bright. With that, I will turn the call over to Julie to open for Q&A.

Julie Winter (VP of Investor Relations)

Thank you, Mike and Walt, for your comments. Jamie, would you please give the instructions, and we'll get started on Q&A.

Operator (participant)

Ladies and gentlemen, at this time, we'll begin the question-and-answer session. To ask a question, you may press Star and then One using a touch-tone telephone. If you are using a speakerphone, we ask that you please pick up the handset before pressing the keys to ensure the best sound quality. Once again, that is Star and then One to ask a question. We'll pause momentarily to assemble the roster, and our first question today comes from David Turkaly from JMP Securities. Please go ahead with your question.

David Turkaly (Equity Research Analyst)

Great. Good morning. For Mike, maybe the 100 basis points you talked about in price, I know, you may not want to get into super detail about that, but that's a little better than what you've seen of late, and I was wondering if you just might comment on where you're gaining that, and particularly in this environment?

Mike Tokich (CFO)

Yeah, Dave. Yeah, 100 basis points. Typically, we are somewhere between 50 and 100 basis points this quarter. Obviously, we're at that 100 basis points level, and we are actually seeing price across all three of our segments in the second quarter. So I would not point out one individual one, but just across each of our segments.

David Turkaly (Equity Research Analyst)

Great. And as a quick follow-up you mentioned you called out some working capital improvements. I'm just curious if we should view some of those as permanent or as sort of a one-time or how are you looking at some of those improvements and how should we look at them moving forward? Thank you.

Mike Tokich (CFO)

Yeah, Dave. I would say that from a working capital improvement standpoint, we've actually been successful in reducing our days sales outstanding, pretty significantly, this year, although that is a little bit of math, if you will, because as EBIT does drop, the days sales outstanding do increase or decrease year over year, and we have been offsetting inventory. Inventory is on the rise. We continue to have higher inventory levels because we are maintaining both surety of supply and we are level loading. So I would say that DSO is favorable couple days, we should be able to continue to drive that at least the remainder of this fiscal year. I don't know about next fiscal year.

I would also say that inventory, our projection is inventory would still be elevated by the end of the fiscal year. So I would say those two will pretty much naturally offset, and we will continue to see as long as we see net income growth, we will continue to see free cash flow generation. In addition, our capital expenditures are also up, and we as we've spoken about many times, we do anticipate spending over $100 million in expansion capital growth for AST. So don't be surprised if you see year-over-year growth in CapEx by the end of the fiscal year. We were up $13 million in the first half, and we project to be more than that, up for the full year.

Walt Rosebrough (CEO)

I would add, another temporal one is government tax payments have been deferred, related to the pandemic act.

David Turkaly (Equity Research Analyst)

Got it. Thank you.

Walt Rosebrough (CEO)

There's a mixed bag there. I would say, obviously, the government payments are temporary. Capital spending is more longer term. As Mike has said, then if you look at a bit longer term, the inventory and receivables will probably reverse back to their more normal levels over time.

Operator (participant)

Our next question comes from Matthew Mishan from KeyBanc. Please go ahead with your question.

Matthew Mishan (Equity Research Analyst)

Hey, good morning, guys. I didn't quite catch all of the guidance for the back half. Did you say you're going to be year-over-year flat for the full year on organic growth basis? And what are you implying for the second half versus the first half? I just didn't catch it all. I just wanted to clarify.

Operator (participant)

Good morning, everyone, and welcome to the STERIS PLC second quarter 2021 Conference Call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please also note today's event is being recorded. At this time, I'd like to turn the conference call over to Julie Winter, Vice President of Investor Relations. Ma'am, please go ahead.

Julie Winter (VP of Investor Relations)

Thank you, Jamie, and good morning, everyone. On today's call, we have Walt Rosebrough, our President and CEO, Mike Tokich, our Senior Vice President and CFO, and Dan Carestio, our Chief Operating Officer. I do have 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' securities filings. 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' SEC filings are available through the company and on our website. In addition, on today's call, Non-GAAP financial measures, including adjusted earnings per diluted share, adjusted operating income, constant currency organic revenue growth, and free cash flow, will be used. Additional information regarding these measures, including definitions, is available in today's release with reconciliations between GAAP and Non-GAAP financial measures. 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. With those cautions, I will hand the call over to Mike.

Mike Tokich (CFO)

Thank you, Julie, and good morning, everyone. It is once again my pleasure to be with you this morning to review the highlights of our second quarter performance. For the quarter, constant currency organic revenue increased 2%, driven by 100 basis points of volume and 100 basis points of price. Constant currency organic revenue for the quarter includes a total of about $5 million from prior year tuck-in acquisitions, primarily in Healthcare, spread across capital equipment, consumables, and service. Gross margin for the quarter was up 140 basis points to 45% and benefited from mix, price and productivity. EBIT margin for the quarter was 22.5% of revenue, an increase of 220 basis points from the second quarter last year due to higher gross margin attainment and lower operating expenses, mainly for travel, sales and marketing, and compensation due in part from business disruption from COVID-19.

The adjusted tax rate in the quarter was 21.1% and includes the benefit of stock compensation offset by unfavorable discrete item adjustments. Net income in the quarter grew 13% to $127.3 million, and earnings increased to $1.48 per diluted share as compared to $1.32 per diluted share in the prior year. Our balance sheet is a continued source of strength for the company. Considering our cash position of $312 million, access to available credit lines, and a low leverage ratio, we are well-positioned from a liquidity standpoint. Even reflecting the anticipated additional leverage for the Key Surgical acquisition, our debt levels remained solidly in our comfort zone. During the second quarter, capital expenditures totaled $43.9 million, while depreciation and amortization was $54.4 million.

Free cash flow for the first half was $185.6 million, an increase of $23.6 million over the first half of last year, primarily due to improvements in net income and working capital somewhat offset by higher capital expenditures. With that, I will now turn the call over to Walt for his remarks.

Walt Rosebrough (CEO)

Thanks, Mike, and good morning, all. I hope you all have voted or will later today. We are pleased to be with you to report such encouraging results for our second quarter, which reflect the resilience of our business and the good work done by STERIS Associates. In total, constant currency organic revenue grew 2% year over year and improved substantially on a sequential basis. We benefited from the continued recovery in procedure volumes during the quarter, as well as continued strength in segments with exposure to COVID-19-related products and services. Our release walks through the details, but I will touch on a few highlights of the quarter. Life Sciences grew 16% in the second quarter, continuing its strong performance, in particular for consumables.

While it's difficult to dissect the 31% consumables growth in the quarter, we believe the underlying growth rate remained in the lower teens, and the balance of the growth is due to COVID-19 pre-buying in anticipation of vaccine production demand. As we've said all year, we do not anticipate maintaining these growth percentage levels in perpetuity. In particular, our fourth quarter has difficult comparisons, as last year's fourth quarter was the beginning of the Life Science consumables' significant COVID-19-related revenue uptake. Rebounding from first quarter levels, our AST segment grew 9% year over year in the quarter, benefiting from continued demand for COVID-19 product sterilization, as well as a significant recovery of procedure-related medical device sterilization volumes. As we've said in prior quarters, we continue to invest aggressively in capacity expansions at AST, reflecting our long-term expectations for the growth in this business.

As anticipated, our Healthcare segment continued to be impacted by some disruption in procedures in the quarter, declining 3% year over year, but improving nicely on a sequential basis. Both consumables and service rebounded from first quarter levels, with consumables revenue growing 6% year over year, while service revenue was flat. Capital equipment shipments in the segment declined as we anticipated. Those shipments were down 14% versus the second quarter of last year. As we break our capital business into either large projects or replacements. We were pleasantly surprised to see replacement orders rebounding sequentially in the quarter, reflecting a return to more normal procedure volumes. Capital equipment orders have grown sequentially through October from the low point in May and have returned to about last year's levels.

Like most in our space, while we are pleased to see the sequential improvements in revenue from procedures to date, there is significant uncertainty in the coming months as the COVID-19 pandemic appears to be escalating in many areas around the world. We have seen recent procedure declines in parts of Europe. It is too soon to tell what we will experience going forward in Europe and in the U.S. in the next six months. That said, we are not planning a significant disruption of procedure volumes in the second half of our year. As a result, we're planning for sequential revenue growth in the second half to result in about flat year-over-year revenue, excluding any impact from the anticipated Key Surgical acquisition. While we are quite pleased with recent trends, the situation is fluid and difficult to predict.

We still consider our Healthcare capital equipment portfolio to have the greatest downside risk in the near term. If procedures continue to improve and the pandemic subsides, we will expect some costs in our operation to start coming back to more normal levels in the second half of the year, which will limit our bottom-line percentage growth somewhat. As we said all along, we manage this business for the long haul. Our actions during this pandemic reflect that approach, including our decision to avoid unpaid layoffs or furloughs related to COVID-19. We've worked hard to maintain jobs and compensation for our people, putting programs in place to take care of those who need extra support and providing paid furlough for those people in operations that were impacted by declining the business due to the pandemic.

Total costs for COVID-19 programs and expenses were $4.5 million in our second fiscal quarter, about half of what we saw in first quarter. Similarly, our approach to investments has not changed. We continue to expand our AST footprint and to invest in R&D. We have introduced a full suite of surgical products this year, including new operating room lights, several new surgical tables, and a next-generation OR integration system. On the infection prevention side of our business, recently launched products include our new smaller-footprint steam sterilizers and more rapid biological indicators, among others. We do not expect a consequential slowdown in our new product development efforts or in spending for R&D as a result of the pandemic. Before we open to Q&A, I would like to again thank STERIS people for their commitment to our customers, who have continued to be the heroes on the front lines of this pandemic.

While there is uncertainty in the near term given the COVID-19 situation, we like the positioning of our global portfolio during the pandemic as well as when we come out of it. We are working toward completing the previously announced acquisition of Key Surgical by calendar year-end and look forward to welcoming Key's people to the STERIS family. We stand ready to capture additional opportunity and continue to believe that the long-term future for STERIS is bright. With that, I will turn the call over to Julie to open for Q&A.

Julie Winter (VP of Investor Relations)

Thank you, Mike and Walt, for your comments. Jamie, would you please give the instructions, and we'll get started on Q&A.

Operator (participant)

Ladies and gentlemen, at this time, we'll begin the question-and-answer session. To ask a question, you may press Star and then One using a touch-tone telephone. If you are using a speakerphone, we ask that you please pick up the handset before pressing the keys to ensure the best sound quality. Once again, that is Star and then One to ask a question. We'll pause momentarily to assemble the roster, and our first question today comes from Dave Turkaly from JMP Securities. Please go ahead with your question.

David Turkaly (Equity Research Analyst)

Great. Good morning. For Mike, maybe the 100 basis points you talked about in price, I know, you may not want to get into super detail about that, but that's a little better than what you've seen of late, and I was wondering if you just might comment on, where you're gaining that, and particularly in this environment?

Mike Tokich (CFO)

Yeah, Dave. Yeah, 100 basis points. Typically, we are somewhere between 50 and 100 basis points this quarter. Obviously, we're at that 100 basis points level, and we are actually seeing price across all three of our segments in the second quarter. So I would not point out one individual one, but just across each of our segments.

David Turkaly (Equity Research Analyst)

Great. And as a quick follow-up, you mentioned you called out some working capital improvements. I'm just curious if we should view some of those as permanent or as sort of a one-time or how are you looking at some of those improvements and how should we look at them moving forward? Thank you.

Mike Tokich (CFO)

Yeah, Dave. I would say that from a working capital improvement standpoint, we've actually been successful in reducing our days sales outstanding, pretty significantly, this year, although that is a little bit of math, if you will, because as EBIT does drop, the days sales outstanding do increase or decrease year over year, and we have been offsetting inventory. Inventory is on the rise. We continue to have higher inventory levels because we are maintaining both surety of supply and we are level loading. So I would say that, DSO's favorable couple days, we should be able to continue to drive that at least the remainder of this fiscal year. I don't know about next fiscal year.

I would also say that inventory, our projection is inventory would still be elevated by the end of the fiscal year. So I would say those two will pretty much naturally offset, and we will continue to see as long as we see net income growth, we will continue to see free cash flow generation. In addition, our capital expenditures are also up, and we as we've spoken about many times, we do anticipate spending over $100 million in expansion capital growth for AST. So don't be surprised if you see year-over-year growth in CapEx by the end of the fiscal year. We were up $13 million in the first half, and we project to be more than that, up for the full year.

Walt Rosebrough (CEO)

I would add, another temporal one is government tax payments have been deferred, related to the pandemic act.

David Turkaly (Equity Research Analyst)

Got it. Thank you.

Walt Rosebrough (CEO)

There's a mixed bag there. I would say the government payments are temporary. Capital spending is more longer term. As Mike has said, then if you look at a bit longer term, the inventory and receivables will probably reverse back to their more normal levels over time.

Operator (participant)

Our next question comes from Matthew Mishan from KeyBanc. Please go ahead with your question.

Matthew Mishan (Equity Research Analyst)

Hey, good morning, guys. I didn't quite catch, all of the guidance for the back half. Did you say you're going to be year-over-year flat for the full year on organic growth basis? And what are you implying for the second half versus the first half? I just didn't catch it all. I just wanted to clarify.

Walt Rosebrough (CEO)

Yeah, Matt. First of all, well, first of all, good morning. But after good morning, we're not guiding, just to be clear, but we have to plan even independent of the fair amount of uncertainty that's going on. And so we're planning roughly flat year-over-year revenue. And that's largely speaking kind of all the same constant currency, not constant currency. There's essentially no, in fact, no, or inorganic growth in the back half of the year. So that's an irrelevancy unless Key comes in place, and we're not talking about Key. But orders of magnitude, we're kind of thinking flattish, and it's our consumables business or recurring revenue business that's continuing to grow with some, I'll call it conservatism on what capital is going to do for the back half of the year.

Matthew Mishan (Equity Research Analyst)

Okay. Understood. And then the contribution, just for clarity purposes, the contribution from tuck-in and M&A over the next several quarters, I'm assuming that wanes a little bit as there's anniversary. What do you mean?

Walt Rosebrough (CEO)

Zero. It's tiny this quarter, Mike. It's about $5 million this quarter, Matt. And by the time we get to the Q3, I believe almost every one of those will anniversary. So it will be, if not zero, very, very close to zero. So, we won't even speak to it.

Operator (participant)

All right. I think everyone's happy about that.

Walt Rosebrough (CEO)

Well, we're unhappy. We'd like to have more, but we've got a significant one coming, so that's fine.

Matthew Mishan (Equity Research Analyst)

All right. And then the Life Sciences consumables business, maybe I'll ask it this way. What is the capacity? You're about a $200 million business right now, plus or minus. What is the capacity you could produce if customers said, "Just give me everything you got"? Are you kind of maxing it out at this point at plus 30%, or could you actually kind of flex that up even further?

Walt Rosebrough (CEO)

Yeah. We're not capacity constrained at this point, Matt, and barring the ability to get the components, which I'm not aware of anywhere we are struggling. So, but you always have to pay attention to supply chain issues. But barring some supply chain issue that I'm unaware of, we could go up a great deal. You have to remember that most of our work in this space in IPT and Life Science are sharing factories, and so the capacity of those shared factories is greater. Now, if everything goes up 50%, then that's a problem. But the capacity that we have in the combined Life Science AST facilities, I don't feel that we have a significant capacity issue.

Matthew Mishan (Equity Research Analyst)

All right. Excellent, and then I realize this last one. I realize it's a tough question given volatility and the overall breadth of your portfolio. But how much do you think you're outperforming your end markets by with share gains? It just seems like you're just well above where the market would be.

Walt Rosebrough (CEO)

I don't know about quantity and particularly in short terms, Matt. It's very difficult to have a feel for us versus everybody else, if you will. As everybody reports, it's helpful, but we have a lot of competitors that are not public, so it's still difficult to get that overall reach. But we are confident that we're getting more than our fair share of wallet in virtually all of our spots.

Matthew Mishan (Equity Research Analyst)

Thank you very much, Walt. Mike, Julie, Mike.

Operator (participant)

Our next question comes from Larry Keusch from Raymond James. Please go ahead with your question.

Larry Keusch (VP, Investor Relations and Strategy Development.)

Great. Thanks. Good morning, everyone. I guess first question here is, one of the really interesting things about the STERIS portfolio is that, you essentially have all these different businesses that can benefit and serve as hedges within during the pandemic. There are obviously supports of business that are impacted as well. So really, what I was just trying to understand for the quarter, is there any way to help quantify what you think the amount of tailwind was for revenue in the quarter and, conversely, what you think the amount of headwind was for the quarter?

Walt Rosebrough (CEO)

Larry, I guess, that's a tough question to answer, but the easiest way to quantify it overall is we're running flat, which is better than, again, the segments that we tend to work in, all things being equal, about flat in revenue. And we did not anticipate pre-COVID being flat. So we would have said we would plan on being up. Probably this year, we would have expected to be up high single to maybe even into the low double-digit numbers. And as a result, I would argue that we're probably about 10% negative headwind versus tailwind, plus or minus a little bit. So orders of magnitude, that would be our best answer. And it's the places are obvious, right?

In AST, where we're doing PPE, and in Life Science, where we're gearing up for the vaccines, we're getting a nice tailwind. But we're a procedural-based company in Healthcare, and procedures have gotten beat up. So that's been the opposite side of the equation.

Larry Keusch (VP, Investor Relations and Strategy Development.)

Okay. Very good. Two other ones on Life Sciences. So Walt, I guess I'm just trying to, again, understand, how we should think about the exposure there to vaccine production. So I'm wondering if you can talk a little bit about, are you exposed more to one type of vaccine technology versus another? Are you exposed to very specific customers that if they make it through, that's a positive?

And if they don't, that perhaps doesn't impact positively impact you as much. And I guess the other part of that question is, as you've seen the improvements in the business and the profits come through, how are you letting that drop to the bottom line, or are you investing that? Again, I'm just trying to think forward a little bit on this as to how you manage the margins as you come off the other side of this.

Dan Carestio (President and CEO)

Hey, Larry. This is Dan Carestio. Maybe I can give you a little information on the market in particular. With vaccines, that's really in STERIS's sweet spot in terms of our everything is by definition aseptic manufacturing. So it's manufactured in a sterile environment and near sterile clean rooms, and the products that we sell and the services that we have are used to ensure that those environments can operate in an aseptic manner. In addition to what we're selling into vaccine from Life Sciences, we've also seen a significant uptick in demand in AST in terms of bioprocessing consumables. These are bags or liners or tubing sets and things like that used in aseptic manufacturing specifically for vaccines.

And I wouldn't say that any one company or another in terms of the customers we serve is more has a higher demand or a lesser demand based on their methods. They're all basically very similar methods in vaccine production and all require an aseptic environment.

Walt Rosebrough (CEO)

And, Larry, I guess we're broadly enough across. Obviously, if all of our best customers happen to be the lucky ones, we're better. And if there's a couple that are not our best customers are the hot ones, that'll be a little worse. But we're pretty confident that the prebuys that we're seeing are a function of the people who are likely candidates. So we're pretty comfortable that we will see an ongoing effect. In the short to intermediate term, it's unlikely it's going to shrink.It's just, it can't keep growing 30% a year forever.

Larry Keusch (VP, Investor Relations and Strategy Development.)

Okay, and on the margin question around you're investing against the improved profitability there, how are you doing that?

Dan Carestio (President and CEO)

Yeah. Great question. Part of the margin expansion is strictly a function of mix. And some of that's, I'll call it just natural, but and secondly, as most companies, we were not at all clear how ugly this thing was going to get when it started. And so we shut down hiring in certain places. We kept spending in the R&D functions. I call it the long-term future. We kept spending. But on the short to intermediate term things, we kind of took a step back. And we'll pick some of that back up as we see the, I'll call it the long-term look going forward. We're increasingly comfortable, as you might expect. But there's still a lot of uncertainty out there.

We're watching it. Normally, we watch quarter to quarter. We're watching week to week right now. There are so many things going on, some of which could be very positive and some of which could not be so positive. We're just being careful. We'll lag the spending piece probably a little bit for a while, and then we'll catch up at the appropriate time.

Larry Keusch (VP, Investor Relations and Strategy Development.)

Got it. And then last one for me. AST, margins just continue to be very impressive and continue to move higher. How do we think about these kind of, do you think this is kind of peakish margins here? Are you, as some of this incremental volume comes in, whether it be around Life Sciences or other sterilization needed for the pandemic, is that coming in at higher price and that's influencing the margins higher? Just, again, trying to think about how we should really think about that the longer-term margin in that business.

Dan Carestio (President and CEO)

Sure. The AST business and we're very happy with the margins in that business, obviously, but that's ROS. When you're plowing $100 million or so every time you turn around to grow capacity, the ROIC is not extraordinary. It's good. We're not complaining about the ROIC in that space. It's a very good investment. We're putting a lot of money in place to make that money. I would not characterize it as over the top in terms of when you look at ROICs. We think there's room for improvement as those new facilities mature.

If you look back and you were with us quite some time ago when every time we added a plant, we had to knock off 50 to 100 basis points because each plant affected the overall ROS. Today, we have over 50 plants. So one plant doesn't make that much difference. But if you look plant by plant, those newer plants are not making the kind of money on an ROIC basis, well, on ROS or ROIC basis that than the older plants are. So, it's a function of those things.

Larry Keusch (VP, Investor Relations and Strategy Development.)

Okay. Very good. Thanks very much. Appreciate it.

Operator (participant)

Our next question comes from Chris Cooley from Stephens Inc. Please go ahead with your question.

Chris Cooley (Managing Director)

Good morning. Thanks for taking the questions. Well, maybe if we could start with a big picture one here this morning, and kind of following on what Larry was getting at there. You structurally have a lift with your Life Science and AST franchises, seeing accelerating growth. You've taken some costs out of the model. Clearly, there's planned investment going forward. But should we also see over the next 18 months as the business starts to normalize, hopefully from COVID, should we see a natural lift as well in cash flow in the business versus historical levels? Or how do we think about cash flow generation? Not so much for the back half of this fiscal year, but more so on kind of a go-forward basis. Should we see a natural lift there?

Are there uses of cash that will start to pick up there? And then I've just got a couple of follow-ups.

Dan Carestio (President and CEO)

Yeah, Chris. I would say both in cost and as a result in cash. There's a lot of, I'll call it sales and marketing expense that's not going on in the world right now. And it has a limited detrimental effect because none of our competitors are spending that money either. But when we return to the more real world, I suspect, strongly that we and our competitors are going to put boots on the street more and travel more and do a number of things more that we cannot do. So that will have some normalization effect on earnings, and cash will follow, naturally with that. So that's point one. Point two, though, your point's well taken.

As we grow in profitability and we have moved more toward some of those higher profit areas, then that profitability will flow through in cash completely. And then the only question is how much we're spending either in acquisition or for organic growth in order to use that cash. And we fully intend to spend as much as we can for those two things because that's what the future cash flow generations are. But if you pull out the investment side of it, yes, the cash will grow. Again, we would hope to be able to spend as much of that as possible to grow in the future, in a reasonable way, organically, and through acquisition.

Chris Cooley (Managing Director)

I appreciate that, Walt. And then maybe just two quick follow-ups from me too. The first, could you just remind us when the last time was that you had re-solidified your raw materials contracts, more specifically for Cobalt 60, on that front? A lot of discussion about that here as of late, as I'm sure you're aware. And just want to revisit when those were last revisited and kind of the terms of those agreements. And then one other quick follow-up. Thanks.

Dan Carestio (President and CEO)

Hey, Chris. Appreciate the question. We do not get into the details of our vendor contracts just like we don't get into the details of our customer contracts. Suffice it to say that we have visibility for a reasonable time. We tend to do both of those on a long-term basis, particularly in the AST business, and kind of everybody, the suppliers, the vendors, and the customers recognize that everyone's in a better spot if we all know what we can and cannot provide and what people are going to do and not do, so those tend to be intermediate to longer-term contracts. That's the case across the board.

Chris Cooley (Managing Director)

Understood. Appreciate that. And then lastly, something I'll get back into. Just want to make sure I'm squaring my assumptions correctly. So you're essentially flat directional planning for the full fiscal year, ex Key Surgical. You are not assuming, I guess, any incremental headwinds from COVID-19 in the back half of the year. Are you still assuming some incremental headwinds, maybe whether it's from procedure softness, as you cited, parts of Europe now are experiencing that, or maybe it's purchasing patterns. I know in prior conversations on these calls, we've talked about, hospitals carrying a little bit higher consumable inventory on site than what they had in the past.

Just wanted to make sure I fully understand what you're baking in when you're talking about getting a flat year-over-year, for the fiscal year, ex Key Surgical, appreciating there's a tough fourth quarter coming. Thank you.

Dan Carestio (President and CEO)

Yeah, Chris, again, I'm telling you, we're planning, and that plan could change next week or next month, so and that's why we're not giving guidance. There are so many uncertainties right now, both positive and negative, that we think it's uncharacteristically difficult time to forecast, but having said that, in general, we're not anticipating a huge reduction in procedures like we saw in April, May, June, or into March, April, May. We're not anticipating that level of reduction, which was pretty catastrophic, but we do expect temporal changes, kind of spot changes around. That's kind of built into our thinking. We again do expect, and part of that is one offsets the other a bit. If we have a little more of that, we have a little more PPE processing.

If we have a little less, we have a little less PPE and a little more of the procedural devices. So, we're balancing those issues. And our best view of that is that we come out about flat. Having said that, it is we still, given the history that we've seen to date, which is about the best thing we have to work off of, and how nice a job the facilities have done with the treatment protocols of COVID-19, that's kind of grossly misunderstood and underappreciated is, the facilities around the globe and the physicians and nurses around the globe have really improved their knowledge of how to deal with this disease. So even as it heats up some, they're a lot better and a lot better positioned to take care of patients.

And as a result, have done things to be able to continue to operate their procedural spaces. It would only be, in my view, unless it goes a lot worse than anticipated, it would only be patients deciding due to concern of COVID that would reduce the procedures a great deal, so we just have to wait that one out. But in general, we are expecting some spot issues around the globe, but not an overwhelming reduction like we saw before. We're expecting to see some additional PPE and processing as a result, and clearly we're anticipating good growth or good volume in the Life Sciences business for vaccine production, and so at a high level, I'd say that's pretty much it.

We are being a bit cautious in our view of capital, even though orders have come back quite a bit better than we expected. Being flattish recently is better than anticipation but capital can bounce a little bit so we're being a little cautious on our thinking about capital.

Chris Cooley (Managing Director)

Thank you.

Dan Carestio (President and CEO)

You bet.

Operator (participant)

Our next question comes from Mike Matson from Needham & Company. Please go ahead with your question.

Mike Matson (Senior Equity Research Analyst)

Yeah, thanks. I just want to ask about gross margins. They were up a fair bit, year over year. And it sounds like some of that was driven by mix. So, is that something that's sustainable? Is that something that could potentially go the other way if your growth rates kind of revert back to more normalized rates in the different businesses?

Dan Carestio (President and CEO)

Yeah. I would say the single biggest thing on the quarter is that you saw that Healthcare capital was down and kind of everything else was up. And so that is a mix effect. So if Healthcare capital comes back over a longer period, you'd expect that mix down. On the other hand, if it comes back and everything's still growing and we do see AST and Life Science growing faster in general than most of the Healthcare space, it's still a positive impact, kind of long-term temporal impact on margins in my view.

Operator (participant)

Okay. Thanks. And then just wanted to follow up on Larry's question about the Life Sciences business and the potential impact of the vaccine. So, how do we think about that business as the vaccines start to be launched? Does that mean that the demand for your consumables would then decline because there's been kind of these stocking orders, or would it can remain strong as the vaccines are rolled out? Thanks.

Dan Carestio (President and CEO)

Yeah. We don't have perfect visibility to that. If we did, we'd probably be giving strong, differential guidance than what we're giving. But that's a tough call. My experience is in this space that vaccine or I would call it the pharma folks who are running these facilities are the most conservative of our customers when it comes to supply chain. So my suspicion is they're going to hold a fair amount of inventory for a long time until they know that they are in good shape and have, know what they're running, know how much they're going to have to build, and know what their requirements are going to be. So I don't think in the short term there's going to be a huge reduction.

As we work through this, if indeed they're overstocked, they will slow it down. And if they're not, they won't. But generally speaking, they tend to be kind of conservative on supply chain, appropriately conservative. Those factories, you shut one of those things down, you're shutting down millions of dollars a day, not millions of dollars a year. So they're pretty careful about their supply chains. But again, we do not have perfect visibility, just like we don't have perfect visibility to who's going to be building when. I should also mention that another effect of this has been our capital in. I've talked about capital in Healthcare, being at risk. Our capital in Life Sciences is at all-time records, all-time record backlog, all-time record shipments. Everything you want to look at.

The capital equipment in Life Sciences is quite strong. We don't see that declining in the short- to intermediate-term.

Operator (participant)

Okay. Thanks. That was very helpful. And then, just on the, I heard your commentary around the orders, improving since they kind of bottomed in May. But it does look like the Healthcare backlog was down kind of double digits year over year. So is that just more of a lagging indicator or something? Is that why that's not showing, kind of better year-over-year change? Thanks.

Dan Carestio (President and CEO)

Yeah, it is. You may recall that in the first quarter, we had an accounting change that resulted in roughly $15 million of orders being recognized in the first quarter. That number for this quarter is probably more in the $10-$12 million range. But so if you looked at this based on a similar approach, you would see that the backlog is roughly the same plus or minus a little bit. But so it's down, but it's not down double digits. And so that's it in the short run. But capital has been under pressure, more pressure than many of the consumables. And we just have to see. It's nice to see that the replacement business seems to be returning, which is roughly 60% of capital orders.

So, yeah, we will see the next several months. It's been sequentially moving the right direction, and we hope it continues that way.

Operator (participant)

Okay. Great. Thank you.

Dan Carestio (President and CEO)

You bet.

Operator (participant)

Once again, if you would like to ask a question, please press star and then one. To withdraw your questions, you may press star and two. Our next question comes from Michael Polark from Baird. Please go ahead with your question.

Michael Polark (Senior Equity Research Analyst)

Hey, good morning. Thanks for taking the question. Just a couple here. Curious on PPE and AST. Well, do you have a view? Did volume from that category in total flat sequentially versus the June quarter up, down? I'm just curious how that piece is trending.

Mike Matson (Senior Equity Research Analyst)

Yeah. This is Dan. It's been more governed by supply than it has been, demand at this point. And as the suppliers have ramped up on the raw material, we're seeing similar levels that we saw in first quarter, maybe a slight uptick. We do believe there'll be sustained increased demand at some level for PPE onto the future as the requirements for those products for certain procedures have changed, even with or without the pandemic.

Michael Polark (Senior Equity Research Analyst)

As you fill back up, and PPE stays at these kind of elevated new norm levels, let's assume, and electives recover, and presumably your global network is quite tight, hence the significant amount of CapEx going into AST, are there ever issues that arise where preference is discussed between, where you make decisions about, who gets access to the facilities and when? Or is there enough capacity, such that those frictions don't arise? I'm just curious how that in a world over the next handful of quarters as we learn to live with this, electives recover, PPE stays elevated, is there a risk that your capacity gets very tight?

Mike Matson (Senior Equity Research Analyst)

One, there's a reason why we're building a number of plants right now across the globe in North America, Europe, and Asia. We have more builds going on in AST than ever in my lifetime right now, because we see long-term increased demand. In terms of customer, capacity constraints at a given site, it does happen from time to time. And we work with our customers to cross-validate or multiple methods of sterilization so that for some period of time, it may not be optimal for their supply chain, but we can get their product sterilized into the market.

Michael Polark (Senior Equity Research Analyst)

Helpful. Yeah. No, I would say, Mr. Carestio always tells me that it's like Jell-O. There's always room for Jell-O. So there's always room for one more customer.

Operator (participant)

I'm sure you're not, yeah, running facilities at every hour of the day, or is that?

Mike Matson (Senior Equity Research Analyst)

Oh, yeah. Yeah. No, no, we are. Except for essentially Christmas Day in the Western world, we run 24/7.

Operator (participant)

Got it. The other topic was SG&A. I just didn't know you're not putting a fine point on the back half. But in the context of an ex-Key Surgical revenue expectation of flat year on year, how would you frame SG&A dollars for fiscal 2021 in the context of that revenue outlook? Reasonable to expect those dollars are flat? Is there quite a bit of so such that the ratio is similar year on year for the full year? Or would you expect variance one way or the other?

Mike Matson (Senior Equity Research Analyst)

Yeah. Mike, for the first half, obviously, we saw a lot of favorability there. In the second half, we would say there's going to be favorability, but nearly not as much, and then obviously for the full year, we would expect to see a decline in total, and then obviously as we look to the future, we will give guidance, hopefully at that point in time when we know more. But definitely anticipate that we would be spending more operating expenses in the second half of the year versus the first half.

Operator (participant)

Thank you very much. Ladies and gentlemen, with that, we'll conclude today's conference call's question and answer session. I'd like to turn the conference back over to management for any closing remarks.

Thanks, everybody, for taking the time to join us this morning. Stay healthy.

Ladies and gentlemen, with that, we'll conclude today's conference call. We do thank you for joining. You may now disconnect your lines.