Steris: Dental divestiture, acquisition of surgical instruments, but overvalued (STE)

I assigned a “Hold” rating to Steris (NYSE:STE) in my article published in February 2024, highlighting their strong growth in health care products alongside weakness in the Applied Sterilization Technologies (AST) business. I think the company did the right move by divesting their dental business and acquiring the surgical instruments business. Because I believe the stock price is overvalued, I reiterate a “Hold” rating with a fair value of $220 per share.

Divestment of dental business and purchase of surgical instruments

In June 2023, Steris announced that it would acquire the surgical instruments, laparoscopic instruments and sterilization container assets of Becton, Dickinson and Company (BDX) for $540 million.

In April 2024, Steris announced that it would divest its dental business to Peak Rock Capital for $787.5 million. Proceeds will be used to repay debt and invest in AST’s healthcare, life science and business.

I believe the acquisition and divestiture could benefit shareholders for the following reasons:

• As illustrated in the chart below, the dental business has become a growth burden for Steris in recent quarters. Steris’ dental business emerged from the acquisition of Cantel Medical in 2021. As discussed in my previous article, the dental business is very competitive with several large, established players including Dentsply Sirona (XRAY) and Henry Schein (HSIC). As a small player, Steris does not have strong relationships with dentists in the dental supplier market; making it difficult for the company to expand its dental business.

• Divestment of the dental business could allow Steris to focus on their core healthcare products, AST and life science businesses. Because dental customers have a different customer profile, there are limited synergies between the sales forces of different business units.
• The acquisition of the surgical business could expand Steris’ presence in the operating room and sterile processing markets. As the Surgical business shares a similar customer profile, Steris can more easily leverage its sales force, leading to potential revenue synergies.

Recent Result and Outlook

Steris published its Q1 FY25 result on 6 August^threporting organic revenue growth of 5.4% and adjusted EPS growth of 7%. Due to the divestiture, Steris classified its dental business as discontinued operations.

The biggest takeaway this quarter is the solid growth of the AST business, which grew organically by 7.2%. As I indicated in my previous article, Steris has built a large scale of applied sterilization facilities in recent years, allowing products to be sterilized close to end customers’ manufacturing plants. During the earnings call, management expressed strong confidence in a turnaround in bioprocessing marketing in the second half of this year.

For FY25, Steris is targeting 6.5-7.5% growth in reported revenue from continuing operations. I consider the following for their short-term growth:

• Healthcare: Without the dental business, the healthcare business will account for 70% of total revenue. The segment offers products for hospitals, surgery centers and endoscopy centers with 70% exposure to services and supplies. Segment growth will be driven by increased healthcare procedure volume and market share gains. We estimate the segment to grow 7%, assuming volume growth of 5% and share gains of 2%.
• Life Sciences: Consumables and services account for nearly 75% of the segment’s total revenue. We estimate the segment to grow by 6%, in line with the historical average growth rate.
• AST: I anticipate that AST will be a primary growth driver for Steris in the coming years. Steris provides contract sterilization and testing services for single-use products to pharmaceutical and medical companies, and Steris’ network of sterilization facilities gives the company a tremendous competitive advantage over smaller players. We estimate that the business will grow by 12% annually.

Overall, total revenues are expected to grow organically by 8%. Additionally, I assume the company will allocate 7% of total revenue to acquisitions, contributing an additional 2.3% to total growth.

ASSESSMENT

As I have previously analyzed, I estimate that Steris will grow its revenue by 10.3% annually. I model 50 bps margin expansion driven by 20 basis points from pricing and gross margins and 30 basis points from SG&A optimization. With these parameters, the DCF can be summarized as follows:

The WACC is calculated to be 10.2% as follows:

I discount all future free cash flows and adjust their net cash position, and the fair value is calculated to be $220 per share.

Key risks

During the earnings call, management indicated that healthcare capital equipment revenue declined during the quarter as hospitals tightened capital equipment spending. Steris is guiding for single-digit revenue growth in their capital equipment business for FY25, reflecting a cautious outlook on overall healthcare capital equipment spending. I think the current spending pattern is largely driven by the high interest rate environment and is more likely to pick up once the Fed starts cutting interest rates.

Conclusion

I believe Steris made the right strategic decision to optimize their business portfolio and the dental divestiture could accelerate their overall organic growth. Due to the high valuation, I reiterate a “Hold” rating with a fair value of $220 per share.