Description

Summary

• Too much street focus on near-term noise and not enough at the long-term picture which is that Steris is the best it's ever looked having finally shed its dental business (base margin uplift) and is now purely focused on sterilization services and products.
• Pending recovery of the life science sector should reinvigorate its historically high growth AST business.
• Further consolidation across US hospital systems should drive more equipment upgrades leading to both long-term equipment, services and consumables demand.
• Increasing regulatory scrutiny on EO emissions will only benefit Steris' positioning moving forward contrary to street concerns given the mess that peer Sotera has been in.
• Current CEO Dan Carestio has done a good job executing by pulling them through the supply chain issues over the past 2+ years reducing backlog and lead times and cleaning up the portfolio.
• Adj. operating margins expanded from 14% in FY15 to ~26% in FY24E, I expect this to continue aided by HSD organic revenue growth driving teens EPS growth. Given its leading position across the majority of its businesses, this should trade at or above its large cap MedTech peer group.

Steris Plc (STE) is a healthcare equipment and service vendor focused primarily on sterilization for hospitals, surgery & endoscopy centers, medical device and pharmaceutical manufacturing. This is predominantly a service and consumables driven model despite being known for sterilization equipment as consumables and services combine for nearly 80% of revenue. There are four core segments within the business including healthcare (~65%), Applied Sterilization Technologies also referred to as AST (~17%), Life Sciences (~10%).

This is an HSD organic revenue grower operating close to mid-40s gross margins, high-20s EBITDA margins and mid-20s operating margins. The business is capital light with ~5-6% CapEx intensity and ~2-3% working capital intensity resulting in a highly free cash flow generative business having low-teens conversion from revenue and 50%+ conversion from EBITDA.

The stock hasn't gone anywhere since 2021 largely because of two reasons:

1. Near-term volatility: The 14% down-move in March was most likely a derivatives trade due to new litigation in California against peer Sotera's Sterigenics business for their EO emissions causing cancer in near-by residents plus new EPA ruling signaling increased regulations and scrutiny over EO facilities. STE has rebounded since on a strong FQ424 print although still below its all time high of $248 in 2022.
2. Last 2-3 years: The stock had been a long-term compounder as it was a consistent beat and raise story but long-time CEO Walt Rosebrough who was highly regarded for building Steris to what it was up until that point suddenly retired. Initially, the timing was suspect given they had just made their biggest acquisition in history buying out endoscopy rival Cantel Medical, although nothing came of his retirement outside of just wanting to ride off into the sunset. What made things worse was current CEO Dan Carestio stepping into a rough first year having set 2022 guidance too high and missing as they were hit with major components shortages which led to record high backlog and lead times. Add to this increasing wage inflation, life science particularly biopharma momentum grinding to a halt in 2023 which impacted its outsourced sterilization business and increasing regulatory scrutiny on EO emissions.

Today, the majority of these issues have abated. Life science tools vendors have universally signaled the bottom with pending recovery in late 2024 or early 2025. Supply chain concerns are mostly over as backlog has been stepping down sequentially over the past year. Concerns over the financial health of major US hospital systems largely stepped down since 2022. Adding the cherry on top is Steris finally shedding its dreaded low growth low margin dental business this year.

Longer-term, I expect Steris to continue prudent capital allocation and execution with its diversified portfolio that is largely immune to economic cyclicality and leading position across its markets. Normalized, this is an HSD organic topline grower with steady but growing margins, healthy balance sheet (just under 2x leverage) and consistently growing dividend.

I see little to no reason why the stock over the medium term should continue to trade at a discount to its large cap MedTech peer group. Over the long run, this should trade at a premium.

Overview

Healthcare is by far its largest segment serving a primary customer base of hospitals (majority), surgery centers and endoscopy centers. They sell a breadth of sterilization machines (capital equipment) including steam and gas, liquid chemical, low temp as well as washing and decontamination systems which range anywhere from a few hundred thousand to a million plus. Along with this, they’ll often bundle consumables that include cleaning chemicals, sterilant and disinfectants, etc. and services which are primarily installation, repair, and maintenance as well as OEM parts.

Capital equipment is sold outright while consumables are pulled through after that. Service contracts are typically 1-3 years and are often sourced by hospitals (which often procure through group purchasing organizations – GPOs) through 3^rd party brokers. While incredibly sticky given their brand recognition, long history of relationships with major healthcare systems and superior service coverage, sterilization products & services of this nature generally commands very little pricing power with Steris typically only raising prices anywhere from 50 bps to 100 bps per year with the exception being the past 2+ years with material constraints and abnormal labor inflation, they’ve had to raise prices between 3% - 4%. 

Mix within Healthcare b/w capital equipment, consumables and services is ~30%/35%/35%.

The key competitions include Getinge (the biggest and most direct), 3M, Baxter, Boston Scientific, Fortiv, Karl Storz, Olympus, Stryker, Agiliti, and Owens & Minor.

Outside of general sterilization, Steris with their 2021 acquisition of Cantel now offers a massive portfolio of endoscopy products (liquid chemical sterilization equipment and automated endoscope reprocessors (AERs), reprocessing consumables, single-used clinical accessories and cabinets and storage equipment) and services (same as sterilization services – maintenance and repair).

Healthcare is primarily volume driven and overwhelmingly depends on hospital procedural volumes which has remained strong in the US (#1 factor for Steris healthcare). Globally, APAC and EMEA volumes are still behind with EMEA expected to take a few years to work through its existing backlog (industry-wide).

Aside from its healthcare segment, the shining star asset is Applied Sterilization Technologies (AST - 99% services mix) which provides contract sterilization and test services for medical device and pharma companies. Steris is contracted to open facilities near the customer’s manufacturing base to sterilize and assure these products pumped out of the factory. This is 100% recurring revenue with typically 3–5-year contracts with annual escalators (80% of customers). The range of sterilization methods include gamma, electron beam, X-ray and EO (ethylene oxide).

Services are highly regulated and spec'd into existing testing and manufacturing processes. This plays into another long-term trend of more outsourcing of lower-tech services by the life science sector. AST is the fastest growing and highest margin segment within the Steris portfolio commanding HSD organic growth and 45%+ operating margins. The largest and most director competitor for AST is Sterigenics owned by Sotera Health Co (SHC) who is little more than half the size of AST (~$1b vs. ~$670m revenue run rate).

Life Science primarily serves biopharma companies to support aseptic manufacturing but is similar to the healthcare segment of selling a mix of equipment, consumables and services (27/44/29 – equipment/consumables/services).

Lastly, up until q124, they operated a dental segment (Hu Fredy main brand) that sold sterilization equipment, consumables and reprocessing chemicals and solutions to dental offices and schools. This largely came from the Cantel acquisition and the main reason they haven’t divested is its margin profile (~60% in FY22 prior to the downturn in dental spending) and its 100% recurring revenue base.

What's attractive about Steris?

The market leader across majority of their businesses: Steris is #1 in every single market with the exception of surgical equipment (operating tables, lighting, etc.). Its sterilization market share across hospitals, ambulatory surgical centers, outpatient facilities, etc. range anywhere from 50% to 70%. Endoscopy, which is ~35% ($1.3b+ run rate) of its healthcare segment now controls over 40% of the market after taking out its primary competitor Cantel. Steris also controls ~25% to 30% of the sterilization consumables market and operates in a duopoly with Sotera’s Sterigenics in the contract sterilization services space for MedTech companies.

Premium quality products: Steris is widely known to produce best-in-class products and their ability to guarantee their consumables work with their equipment is key to their pricing, which is considered the most expensive.

Former Key Acct Manager at Steris (Tegus): I believe they have a really good brand for themselves on just the quality of the products. It's commonly known that they are the most expensive product in their category. That's obviously not to deal with contracts and discounting GPOs, pricing and things like that, but at the same time, you're getting really good long-lasting product that anyone needs to have a lot of service to it consistently.

Assistant Director of Surgery SC at Johns Hopkins Hospital (Tegus): Overall, you can tell we have a really good relationship with STERIS. They're really responsive. They might be a little bit more on the expensive side, but that's based on quality. I think quality is worth a little extra price as long as they're not gouging, because we also have lower fees on the back end if you don't have a high-quality product.                               

Best-in-class service coverage: The common theme across all its segments is its razor and blade model with the go-to-market strategy as leading with capital equipment sales bundled with top-tier maintenance and repair service and attached consumables. Given that the win-rate in consumables is much tougher as most of these solutions are largely commoditized, the key differentiator for Steris’ ongoing dominant market share really comes down to its equipment service capabilities. As their former Area VP of Service puts it:

Former Director, Clinical Services at Steris (Thirdbridge): I think there are five Steris reps for every Getinge rep. It’s the Intuitive model for looking at Da Vinci, you’re going to flood the field with several types of reps that represent different disciplines, and once you have the market share, you can then trim back your sales force. Getinge and Belimed have not flooded the market with people to help influence this change. It’s a very minimal amount, from my observation. Again, I fly all over the country every week and I mainly see Steris and Steris reps.

The key here is service coverage which is driven by fleet density. Steris commands by far the largest fleet of technicians of over 1,000 which is far more than rival competitors Getinge and Belimed. Particularly is the case for hospitals, having a service technician who can respond at a moment’s notice is critical to winning their wallet share on these service contracts. Service above all else is the reason why Steris continues to command premium pricing relative to peers.

Assistant Director of Surgery SC at Johns Hopkins Hospital (Tegus): The turnaround time for repairs is a lot quicker with STERIS than it is Getinge. For us, they have to fly in a technician and then look at it, figure out what's wrong and then fix it. So it could be weeks before its fixed where STERIS is like catching it almost before it happens. There’s probably a price for everything but I will say the service level is really important with this. We can’t afford to have anything down based on our volume. It’s just so high paced here. So a mom-and-pop, unless they live here, would probably not be the best option for us. We want an established company that has a great service line to assist us with anything that we need.          

Preferred outsourced partner: The stickiness within AST is incredibly high to which these contracts should be viewed as annuities given the challenge for any customer to move away from Steris once capital has been deployed and supply chain lines put into place near the customers’ own manufacturing base. Per Sterigenics, 80% of its customers use more than 1 facility with 50% using 5 or more which is likely a similar picture for Steris who owns over 60 facilities globally. Additionally, facility economics should fairly attractive with a typical facility costing ~$40m and earning on avg. $13m in sales and ~$5m in NOPAT implying ~13% return on tangible assets.

Largest portfolio coverage: Aside from consolidation within the hospital systems, hospitals are also consolidating their supplier base with many places looking for a one-stop-shop. This is the case across all customers but much more pronounced with hospital systems especially given the financial constraints experienced post-COVID.

Former Sr. Director of Marketing at Steris (Tegus): It's depth and breadth of product portfolio. I mean, they are truly a one-stop shop from the equipment to the chemistries, to the service, to device repair. I mean they log in through GHX or whoever it is as a vendor, a lot of STERIS guys go up and they have hospital ID badges, like that's how ingrained STERIS is in the day-to-day operation of their customers.

This is a key reason why Steris has been growing its surgical equipment business within hospital systems offering things like operating tables, lights, integrated operating rooms and ceiling management systems. This has put them in the crosshairs of the likes of Stryker and Medtronic but portfolio breadth where they can offer a bundle of sterilization equipment, attached consumables and services along with operating equipment is the reason why they’ve been successfully gaining share in these secondary businesses.

Former Area VP Service at Steris (Tegus): I don't want to necessarily say first, but when STERIS is in the market and just kind of dabbling in it a little bit in the surgical side and they might have only had 10% of the market. Now, I'd say that share of the market is probably up to closer to 30% or 40%. Yes. And that's because they got into getting what's driving the market. So what is, again, it's like, is it just stretchers, tables? Or is it lights and booms and is it high-definition cameras or is it plasma TVs and what are all the different things? And they realize that, "Hey, it's not just about people laying on a stretcher or bed in the OR room, it's all these other things, too." And that's what STERIS invested in and started getting behind and buying other companies that did this to build their portfolio.

Hospitals in general for obvious safety and liability concerns will not source from smaller mom & pops. Instead, they want to be associated with world-renowned suppliers and pay a premium rather than save $1m here or there and risk FDA-violation. Furthermore, consolidation across this space is driving a trend of upgrading acquiree facilities to that of the acquirer’s given the much larger budget which drives further share toward major suppliers like Steris.

Great management team and culture: All of the above plays into the hands of a top-tier management team who have consistently demonstrated superb prowess in making the right acquisitions at the right price while successfully integrating acquired targets seamlessly into their portfolio.

Previous CEO Walt Rosebrough had ran the business from 2007 to 2021 during which STE stock compounded 654% going from $28 to $211. I’d say current CEO Dan Carestio has executed fairly well navigating the company through the pandemic and growing the business organically by 13% and 7% over the past 2 years while expanding margins (adj. operating margins grew from 19.1% in FY22 to 23.2% in FY23) despite heavy wage inflation. Dan grew up through Steris having been there for over 25 years and had previously headed Steris’ AST business before becoming COO from 2018 to 2021.

Former Director, Clinical Services at Steris (Thirdbridge): When Walt retired? Easy hand-off because the other guys had been there decades, or a decade or plus, time that they’ve already been in. Even though Walt is a great guy, it was an easy hand -off, and they’re all under the same tutelage, from Walter, what direction to take the company.

Former Sr Director of Marketing at Steris (Tegus): He is an awesome guy. I mean, STERIS had a well-learned reputation of being a very stodgy, highly conservative company. STERIS very rarely, if ever, was first on the market with some type of new innovation. They always wanted to be a fast follower. And if you look at everything they've done outside of SYSTEM 1 or low-temp sterilization, they've never been a leader. So whenever they had lost business in the past, the big knock on them was you guys just aren't innovative. Dan looks at it completely differently. Dan is investing more in R&D. He's a, I believe, in speeding tickets, not parking tickets kind of guy. He's huge into culture. Everybody loves Dan. He doesn't have any error about him even as he ascended to the CEO office. So he's a great guy. The only real kind of risk on Dan is that he's not a health care guy. He was in the contract sterilization business, which is all contract-driven. So if there's any challenge to Dan, it's a pretty steep learning curve that he's going to have to understand, like just how GPOs work, things of that nature.

Dan is a huge lean and process guy, and he is far more open to kind of be more sales-driven and sales focused in conjunction with engineering. So he's created far more opportunity for sales leaders and marketing leaders to have input on where they want to take their product portfolios, what they need to do to be more competitively successful, all those types of things. People really love him. If you walked into STERIS three years ago, it was a very, very quiet place. People came to work and went home, and that's it. Dan he's beginning to change that culture, making it a little bit more fun, making it more attractive to younger folks to want to stay and attracting younger folks to want to join the organization.

Key Points Supporting the Thesis

Clear path to expanding leadership across endoscopy sterilization:

Steris highly accretive acquisition of Cantel solidified Steris’ dominance and differentiation of having by far the most comprehensive portfolio of products and services. Steris acquired Cantel Medical in June of 2021, their largest acquisition to date for $4.6b (5x sales, 17x EBITDA). The prized asset in this deal was Cantel’s Medivator endoscopy system which has ~90% market share and is the go-to-endoscope reprocessor on the market (endoscopy is one of the fastest-growing healthcare segments currently and a space that Steris hadn’t previously played in).

Cantel's portfolio largely expanded Steris' presence in endoscopy with its full suite of high level disinfection chemistries, equipment and services while filling gaps in their portfolio for single use accessories in the endoscopy space.

There are two methods to reprocess an endoscope for reuse; sterilize (Steris) and high-level disinfectant (Cantel). The hole that Steris filled by buying Cantel was capturing the large customer base who believed in the disinfectant method. Customer acquisition is further enhanced by requiring customers to use its consumables with its equipment. Furthermore, Steris works with major medical device OEMs to ensure its products are recommended in the OEM’s usage instructions which is vital for hospitals to comply with audit standards. Steris’ ability to conduct its own compatibility tests without 3^rd party assistance is another key advantage.

Lastly, further portfolio coverage strengthens Steris’ bargaining power with hospitals who are putting more pressure on medical device suppliers to either offer more bundling of products and services to match Steris, introduce more technology neutral equipment that are interoperable with Steris consumables and/or offer more discounts. In other words, Steris is raising the bar further for its competitors as they continue taking wallet share across hospital systems.

Major supply chain constraints are largely over: As we are now a few quarters past the supply chain constraints particularly within electronic components that hammered the company’s ability to meet demand over the past 2 years and with 2 straight quarters of backlog reduction, Steris’ ability to meet demand and hit their organic topline growth target of HSD will improve and re-instill street confidence. As of FQ424, backlog was back to "normal" although still high vs historical ~$350m range.

Pending recovery of the life science sector: Recovery of the biopharma sector expected H2 of this year and/or H1 of 2025 will drive corresponding recovery across both Steris’ AST and Life Science segments both of which have bottomed to HSD and LSD topline growth respectively. After 7 consecutive quarters, Life Science finally returned to 40%+ operating margins.

Steris’ life science segment is tied more to biologics producers (e.g., large molecules, vaccines, and cell and gene therapies) who are the fastest growing piece of the biopharma pipeline by far (10% - 15% vs. small molecules at 3% -4%). The biologics space is expected to grow DD (look at biologics CDMOs like Lonza or Samsung Biologics). Additionally innovation growth from GLP-1 and biosimilars will continue to drive market penetration outside of the US.

Crisis within hospitals is entirely priced in, any sliver of positive news should deliver upside: The financial issues experienced by the overall US hospital system post-COVID is already priced in so any incremental improvements should help reinstate investor confidence on the trajectory of future hospital spending. Per Morgan Stanley’s 2024 hospital capital spending outlook, over 100 executives expected ~4% y/y growth in spend with hospitals continuing to experience pent-up demand with ~50% overall pent-up demand remaining. Additionally 2/3 of hospitals expect to increase investment in ambulatory surgery centers (ASCs) which should spell positive tailwinds for increased outsourcing sterilization services for Steris.

The trend of more procedures shifting to outpatient centers provide potentially a major tailwind for Steris’ outsourced sterilization model given the decreasing footprint as well as smaller capital budgets across these facilities. They’ve already piloted and opened several reprocessing centers which I expect facility economics to be similar to that of AST. And similar to AST, Steris enters into lengthy contracts with healthcare systems to build a nearby off-site facility which would handle more than 80% of their instrument sterilization. Moving this process off-site provides more space for hospitals to build more rooms leading to more procedural volume resulting in additional revenue opportunities.

Former Sr. Director of Marketing at Steris (Tegus): Well, the one way to go to ensure growth that STERIS is you look at synergy and you look at some of the other acquisitions that STERIS has is, STERIS is opening up offsite reprocessing centers. So if you're located in Minnesota, right, Mayo Clinic is all over the place, right? Instead of every Mayo Clinic spending millions of dollars every year on new equipment and the people. I mean, think how difficult it is to hire people these days and to manage that cost center, not a profit center within your hospital. Wouldn't it be easier to just pay STERIS a couple of dollars for every instrument that you have to clean? STERIS comes once a day, they make their rounds picks up all the dirty stuff, takes it back to the off-site reprocessing center, processes it, and brings it back.

The trend of further consolidation across US hospital systems should drive more equipment upgrades (and related attached services/consumables) as Steris is already heavily penetrated across the largest hospital groups who generally prefer to upgrade acquired facilities to the latest and greatest equipment systems.

Increasing regulatory scrutiny backed by ESG pressure on ethylene oxide (EO) emission (AST segment) should benefit Steris’ positioning moving forward contrary to street concerns as this helps weed out smaller competitors as increased compliance requirements forces higher CapEx spend to upgrade facilities. EO is increasingly becoming a headline topic for medical devices where ~50% of devices are sterilized with ethylene oxide gas. Increasing stringent regulation will inevitably drive more capital spending for both medical device manufacturers and sterilization service vendors which should lead to more outsourcing from MedTech to the likes of Steris and strengthen its market positioning in AST given its outsized capital budget relative to peers.

EO concerns have largely been the driving force between the volatility in the stock the past few months as peer Sterigenics (SHC) was sued again (they were previously sued in Illinois which resulted in a $400m settlement) for claims of cancer-causing EO emissions. Although this has been top of mind for the buyside who follow the name, the potential risk of litigation against Steris' although a wildcard is really nothing more than a short-term blip. Management has been fine with the updated EPA regulations and confident in their ability to stay compliant.

Growing antimicrobial resistance driven by global overuse of antibiotics (both in healthcare and agriculture) has seen a huge increase in the number of bacteria resistant to multiple or all forms of treatment. The only practical response outside of continuing antibiotics development is sterilization prevention for which Steris would be the clear beneficiary.

Concerns of GLP-1’s impact on reduced bariatric volumes across hospitals systems and its potential impact on Steris is largely overhyped as bariatric procedures make up LSD % of overall hospital procedural volumes and the fact that Steris is 2 derivatives removed from any GLP-1 impact.

Management team’s history of successful acquisitions and related integrations into their core segments will continue to drive both revenue and cost synergies as portfolio breadth remains one of its key differentiators.

Our base case scenario should land us in the upper $12 of EPS and close to $10 of FCF per share by spring 2027.

This implies shares trading at ~23.5x FY25E EPS and under 16x EBITDA.

Where should they trade? STE is trading 2.7 turns below its peer comp group (large cap MedTech) on an EV/EBITDA basis and 1.8 turns on P/E basis.

Given everything discussed including Steris’ history of first-class execution and capital management, its business diversification largely immune from economic cyclicality and clear dominance across its markets, I see little to no reason why the stock over the medium term shouldn’t trade at least in line its large cap MedTech peer group. Over the long run, this should trade at a premium.

Ignoring the justification for a premium multiple, if this even re-rates to the peer group average, we’d have 40%+ upside on both a P/E and EV/EBITDA basis.

Catalyst

Medium-term upside catalysts:

• Stronger than expected hospital capital spending driven by higher-than-expected procedural volumes.
• Increased EO regulation driving incremental outsourcing for AST growth.
• Stronger than expected bounce back and stronger growth from the biopharma sector.
• Increased spend driven by antimicrobial resistance trend, hospital consolidation and outpatient procedures.
• Decline in wage inflation pressure on margins.
• Accretive M&A

Longer-term downside catalysts:

• Increased single-use scopes within endoscopy procedures: this has been a trend ongoing for years with single use scopes having lower infection rates. Morgan Stanley did a thoughtful analysis on the potential impact and concluded no more than 50 bps hit to topline growth.

Source: Morgan Stanley

• Wildcard: Litigation against Steris on EO emissions
• Dampened FCF from abnormally larger than expected CapEx requirements for AST facilities and healthcare outsourced sterilization facilities as a result of heavy EO regulations.