STE curve too steep relative to peers
admin | April 9, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The 10s/30s curve of STERIS Plc (STE) (Baa2/BBB-/BBB) is steeper than that of similarly rated peers who also recently tapped the bond market, including PerkinElmer Inc (PKI – Baa3/BBB/BBB). STE trades roughly 13 bp behind PKI in the 10-year part of the curve, but nearly 25 bp back in the 30-year. While PKI has a slightly larger capital structure it only has three index-eligible USD bonds outstanding totaling $1.65 billion versus two at STE totaling $1.35 billion; so the case for PKI being more liquid is not necessarily valid. PKI’s stronger margin profile (EBITDA margin ~35%) and better leverage (net leverage ~1.5x) is reflected in the current 10-year spread differential, but it does not account for the additional steepness. Given that STE’s deal priced with a 35 bp 10s/30s curve while PKI’s priced at 30 bp, the STE 30-year bonds have upside potential of 7-10 bp.
Exhibit 1. BBB Healthcare 10/30s Curve
Source: Bloomberg TRACE; Amherst Pierpont Securities
Recurring Revenue Supports Revenue and EBITDA Stability
STE provides sterilization products and services to a host of customers including hospitals and health care centers which tend to be recurring in nature. Products such as chemical sterilizers and washers as well as services like microbial reduction of medical devices keep STE’s recurring revenue percentage in the 70%-80% range. In fact, STE’s Applied Sterilization Technologies (AST) business, which represents 20% of the company’s top line, is a contracted business with the majority of its customers in three-to-five year contracts with a very high renewal rate, as the business is highly regulated and STE is a leading player. Customers in this unit include healthcare product manufacturers and life science companies. While STE posted 1% organic (ex fx) growth in its last fiscal quarter, AST witnessed strong double digit revenue growth, largely fueled by COVID related demand of single-use products including COVID testing materials and components used in vaccine manufacturing and packaging. While demand has increased due to the pandemic, STE’s core medical device customers have also been showing steady demand which is expected to continue post pandemic.
Use of Equity to Fund Acquisition a Positive for Ratings
STE announced the acquisition of Cantel Medical Corporation for $4.6 billion earlier this year. While the deal came close on the heels of its acquisition of Key Surgical LLC, that acquisition was much smaller ($850 million). Furthermore, management plans to fund the majority of Cantel acquisition with equity. We note that STE will use $2.9 billion of equity to help fund the purchase as well as cash on hand and the $1.35 billion they just raised in the debt market. Management’s willingness to use equity to help fund the acquisition resonated well with the rating agencies as they all affirmed the ratings with a stable outlook subsequent to the announcement. Additionally, net leverage is only expected to increase to the 3.0x area but is forecast to be reduced back to management’s target range of 2.0x-2.5x within 12 to 24 months post close. The deal is expected to close by the end of June 2021. Management has noted that they do not plan on repurchasing shares or participating in significant M&A activity until it returns to its leverage target.
EBITDA Margin Growth Expected to Continue
STE has been posting EBITDA margin growth on an annual basis since 2014. Over that time period, margins have grown from 18.3% to approximately 25.7%. Street estimates are looking for the EBITDA margin to be up over 350bps in fiscal 2021, to the 29% area. With the acquisition of Cantel, STE is expecting to tap into cost synergies primarily through redundant public company and back-office overhead, as well as product manufacturing and service operations. STE believes it can capture roughly $110 million of cost synergies within the first four years post combination, with roughly 50% of the total expected in the first two years. Synergies will further add to margin growth. That said, consensus estimates have STE’s EBITDA margin 200 bp higher than PKI’s by fiscal 2022.
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