By Robert Gold
In the health-care and other industries, a number of trends are driving increased demand for products, services, and technologies used to prevent infection and contamination. That's good news for Steris (STE ), a leading manufacturer and service provider in this market. The stock carries S&P's highest investment ranking of 5 STARS (buy).
Steris' principal market is health care, which accounts for 70% of its revenues in fiscal 2002 (ended March). It sells both heat-sterilization systems that use saturated steam as well as low-temperature ethylene oxide (EO) gas sterilizers used for heat-sensitive medical devices.
It also sells consumable supplies (items that are used, disposed of, and reordered) such as surgical scrubs and those used for skin care and instrument cleaning. Surgical tables, examination lights, and other products for hospitals and other health-care facilities are also on its product list.
Standard & Poor's believes that the domestic hospital industry's continued financial strength bodes well for capital-equipment purchases in Steris' health-care division. Indications are strong that the unit will generate significant growth during fiscal 2003. In the fourth quarter of fiscal 2002, this division posted surprising 12% revenue growth -- well beyond our expectation of 8% -- which partially reflected Steris' working through a high order backlog.
And for the future, management has indicated that underlying sales growth in health care is approximately 7% to 8%, a range we view as reasonable, if not conservative. Sales to some of the large for-profit health-care providers such as Tenet Healthcare and Healthsouth remain particularly strong, and S&P believes it's likely that the only thing preventing Steris' health-care division from realizing a double-digit sales gain in fiscal 2003 is a lack of manufacturing capacity.
Scientific and industrial markets account for about 30% of annual sales. Within those markets, Steris is capitalizing on rising demand from pharmaceutical, biotechnology, medical-device, food, and other manufacturers. These customers must adhere to stricter guidelines for the validation and control of their antimicrobial processes demanded by the U.S. Food & Drug Administration and worldwide regulatory agencies.
An increased emphasis on food safety, supported by multiple U.S. government initiatives, presents new business opportunities for Steris. In addition, it has had discussions with the feds about transferring its sterilization technology to postal applications, where it could prove useful in neutralizing bioterrorist threats such as anthrax. So, in conjunction with Versar Inc., Steris is seeking to develop a comprehensive approach to combating bioterrorism by linking its infection-prevention and decontamination capabilities with the specialized services offered by Versar's Homeland Defense unit.
Steris' scientific and industrial segment posted revenue growth of 13% in the fourth quarter of fiscal 2002, but we're expecting some moderation to the 9% level in the first half of fiscal 2003. During the second half, however, we see faster growth because of an expected expansion of manufacturing capacity. We're forecasting revenues from this segment to grow at 10% to 11% for all of fiscal 2003.
Overall, S&P believes that Steris is poised for a revenue gain of about 8% in fiscal 2003, which would be driven by high single-digit growth in sales of capital equipment (health-care, scientific, and industrial) and consistent growth in consumables and services. Additional revenues from the sale of products to combat bioterrorism are not presently built into our sales model, but developments in that business could provide some upside to our estimate.
Assuming that plant closings and head-count reductions are completed by the end of the first quarter, we look for gross margins to expand to 42%, vs. 41% in fiscal 2002, while selling, general, and administrative costs should consume about 28% of sales. Research and development outlays are seen rising 20%, partially reflecting the bio-decontamination opportunity. Including an approximate five-cent per share benefit from the elimination of goodwill in accordance with new accounting rules, we see Steris' fiscal 2003 earnings per share rising 21%, to 85 cents, from a comparable 70 cents in fiscal 2002.
With a projected three-year EPS growth target of 19%, we believe the stock is underpriced with a p-e-to-growth ratio (PEG) of 1.4, well below our medical-device group average of 1.9. We believe Steris doesn't deserve such a discount and feel that a PEG of 1.5 times estimated growth is reasonable. On that basis, we have a 12-month stock-price objective of $30.
During fiscal 2002, Steris generated a 39% rise in operating cash flow, to $142 million, while free cash flow (operating cash flow less capital expenditures) surged 53%, to $78.5 million. It anticipates that free cash flow in fiscal 2003 will decline to about $50 million, reflecting increased working capital requirements and $70 million of budgeted capital expenditures.
S&P believes, however, that free cash flow growth in fiscal 2004 and beyond will more closely mirror the increase in net earnings. On that basis, and assuming gradually declining growth over the next 15 years with a perpetuity growth rate of 4%, our discounted cash flow model indicates that the stock carries an intrinsic value of about $28 a share.
What's the opportunity here for investors? Based on its May 10 closing price of $21.92, by either measure, Steris shares present considerable upside.
Analyst Gold follows health care equipment stocks for Standard & Poor’s