Steris down $45 million for Q1 due to hefty customer retention program

Steris Corp. (NYSE:STE) lost $45 million in its fiscal first quarter, thanks to setting aside $110 million to cover a rebate program in a bid to hold on to customers of its flagship sterilization technology.

The Mentor, Ohio-based infection prevention and decontamination technology maker said more customers than expected may use rebates to switch to System 1E — a liquid chemical sterilizing system used by hospitals, surgical centers and other healthcare facilities to sterilize heat-sensitive medical instruments, such as endoscopes — from the original Steris sterilizer, called System 1.

Food & Drug Administration mandated the switch and in December declared the Steris System 1 a “violating device” and that hospitals must stop using it within 18 months. The FDA argued with Steris for years that the company should have sought new market clearance as the it refined the system after its 1988 launch.

Steris settled its dispute with the FDA in April, announcing a rebate program to compensate System 1 customers for turning in their equipment and supplies. In the meantime, the FDA signed off on the company’s next-generation chemical sterilizing system, System 1E.

Now, securities analysts are concerned that the higher cost of making System 1E — and the fact that Steris, as CEO Walt Rosebrough said, is “giving our customers a good deal as we enter this business” — could narrow the company’s wide profit margin.

Analysts have also been asking questions about Steris competitors that may use the System 1 transition as an avenue to gain market share.

Of note, the Advanced Sterilization Products division of Ethicon Inc., a Johnson & Johnson company, has been offering Steris System 1 customers advice on how to transition to alternative technologies — including its STERRAD sterilization system.

The biggest difference between the two sterilization systems is that System 1E is restricted to sterilizing heat-sensitive devices, which are largely endoscopes made with materials or adhesives that degrade when heated, while System 1 can be used to sterilize both devices that are heat sensitive and those that aren’t. System 1E likely will be able to process about 80 percent of the devices that System 1 can.

Rosebrough said Tuesday his company expects 80 percent of its U.S. customers to turn in 20,000 System 1s for System 1Es. However, because the next-generation system does its job faster and on a narrower array of instruments, he expects customers to buy fewer System 1Es to replace the System 1’s they trade in.

“While it is still too early to predict what the total System 1E demand will be, we are optimistic about customer response to this new product,” Rosebrough said in his company’s earnings release. We continue to believe we will be able to manufacture 4,000 to 6,000 units this fiscal year, with shipments beginning in the next few months.”

Rosebrough told analysts during a Tuesday conference call that his company has fewer than 1,000 orders for System 1E, which likely will begin to be shipped around Sept. 30.

“That 80 percent of S1 customers will convert to 1E strikes me as a bit aggressive,” CL King & Associates analyst Robert Goldman said during the call. “That would be almost 100 percent conversion of your customer base that uses System 1 to sterilize of endoscopes.”

Omitting the anticipated cost of the System 1 rebate, Steris net income rose 10 percent to $28 million, or 46 cents a diluted share, from $25.5 million, or 43 cents a diluted share, in the year-ago quarter.

Including the cost of the rebate, Steris lost $45.2 million, or 76 cents a diluted share, in the quarter ended June 30.

Revenue rose 3 percent to $291.3 million from $283.5 million a year ago. That despite losing 20 percent of S1 sterilant sales since last year, Steris CFO Michael Tokich told analysts during the conference call.

S1 sterilant sales have made up about 10 percent of Steris revenues. Judging by the company’s continuing revenue growth, it is replacing at least some of the lost sterilant sales with those of other products. Tokich said Steris is seeing “good traction” from its operating room tables, lights and audio-visual integration technologies.

Also Tuesday, Steris increased its quarterly dividend by 4 cents to 15 cents per share for shareholders as of Aug. 24. The company repeated its outlook for fiscal 2011 for revenue growth of about 5 percent, and earnings-per-diluted share in the range of $2.00 and $2.30.

Since Dec. 3 when the FDA issued its System 1 safety alert, Steris shares have fallen nearly 4 percent. The company’s shares were up 1 percentage point to $32.39 in afternoon trading.