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Morningstar | Fiscal Third-Quarter Results Meet Our Expectations, but Steris Looks Expensive at Current Levels

Steris reported another characteristically strong quarter, with organic constant currency revenue up nearly 7% in the period. We'll make some adjustments to our model but anticipate only a modest increase to our $101 fair value estimate. We saw impressive performance across the narrow-moat enterprise, although the comparable growth of 8% in its applied sterilization segment and 10% in healthcare services stood out to us in particular. Our valuation implies 19.9 times and 13.4 times our updated estimates for adjusted earnings and EBITDA in fiscal 2020.

While the equity looks to be on the more expensive side of fair value today, there are reasons to be optimistic. Management revised its revenue outlook higher by 50 basis points for its fiscal full year after taking into account the exceptional performance reported to-date, and to us this still appears conservative. Rough math suggests management is implying a 3.5% comparable growth rate in the fourth quarter to get to its 6% updated expectation for the full year. This compares with approximately 7% through the first three quarters, and management commentary that suggests end market demand continues to grow at a mid-single-digit pace or better. The combination of selling day variances and conservatism around Brexit at the end of the quarter likely account for this down beat outlook, but we think this undersells the firm's long-term opportunity. We model revenue growth closer to 5.5%, on average, over the course of the next five years compared with a comparable rate nearer 5% since the firm closed the acquisition of Synergy Health.

In addition, the firm's total backlog ended the quarter at record levels, which gives us confidence in our outlook for the firm's life sciences and healthcare products businesses over at least the next year. These businesses have grown 5% and 7%, respectively, on a  year-to-date  comparable basis, and we anticipate mid-single-digit performance to continue into fiscal 2020.

Finally, while management lowered its free cash flow outlook for the year, we'd note that the bulk of the revision was driven by truly one-time expenses. Higher costs associated with redomiciling the business, a cash restructuring charge, and modestly higher inventory needs coinciding with record backlog drove operating cash flow expectations lower by roughly $20 million. This was partially offset by a timing-related capital expenditure reduction of $10 million for this fiscal year. We expect these effects to reverse by 2020 and forecast free cash flow to rise to nearly $400 million, up from the $330 million now guided for fiscal 2019.