Stericycle Inc (SRCL) 2003 Q3 法說會逐字稿

Good day, ladies and gentlemen. And welcome to the Stericycle third quarter earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will follow at that time. If anyone should require assistance during today's conference, please press the star then the zero on your touch-tone telephone. As a reminder, this conference call is being recorded. I would now like to introduce your host for the conference, Liz Brandel, vice president of finance. Ms. Brandel, you may begin.

Thank you. I will be Reading the Safe Harbor Statement. Statements by Stericycle in this conference call which are not strictly historical are forward looking. Forward-looking statements involve known and unknown risks and should be viewed with caution. Factors described in the company's Form 10-K, 10-Qs, as well its other filings with the SEC, could affect the company's actual results and could cause the company's actual results to differ materially from expected results. The company makes no commitment to disclose any revisions to forward-looking statements or any facts, events or circumstances after this date that may bear upon forward-looking statements.

During the conference call, we may refer to our total debt to capitalization percentage. This is calculated by using the total debt as numerator and the total debt plus preferred stock plus share holder equity in the denominator. We consider this ratio to be a good indicator of a strength of a company's balance sheet. It's not a measure in accordance of GAAP accounting principles and is not a measure of net income, cash flow, or liquidity.

We may also talk about EBITDA. EBITDA is calculated for any period of the sum of net income plus interest expense, income tax expense, depreciation and amortization expense. We consider EBITDA to be a widely accepted financial indicator of a company's ability to service debt, fund capital expenditures, pay interest and taxes and expand its business. EBITDA may be calculated differently by different companies and is not a measure in accordance with GAAP accounting principles. EBITDA funds may not be available for management's discretionary use due to legal or functional limitations, debt service, et cetera.

With that I would like to pass the call to Mark Miller.

Thanks, Liz. Good afternoon, everyone, and welcome to our third quarter 2003 conference call. With me today are Frank Ten Brink, chief financial officer and Richard Kogler, chief operating officer. And you've heard from Liz, vice president of finance.

Once again, we're pleased with the record results achieved by the team in the third quarter. On a comparative basis, net income in the quarter grew by more than 41% and reached an EBITDA level of $35.2 million. Stericycle finished the third quarter with earnings per share of 37 cents, up 37% over the 27 cents we earned in the second -- in the third quarter of 2002. And once again for 29 consecutive quarters since our IPO in 1996 we either met or exceeded expectations for our company's performance. That brief overview, I will hand the call over to Frank who will walk you through the financials.

Thanks, Mike. We had an outstanding quarter as revenues grew $11.2 million in the quarter to $113.2 million, up 11% from $102 million in the third quarter up 2002. Excluding international machinery revenues of $0.2 million in the quarter, revenues were up over 13%. Acquisitions less than 12 months old contributed approximately $120 million to the revenue growth in the quarter. Excluding acquisitions, small customer revenues grew over 9.5% due to our continued focus on Steri-Safe, and large customer revenues decreased 2.9% due to our increased efforts to improve large customer margins.

Revenue mix was approximately 61% in small and 39% in large customers. Gross profit as a percent of revenue increased from 41.2% in the third quarter of '02 to 43.7% in the third quarter of '03. The improvement resulted from better margins in our large quantity business sector, integration of synergies from acquisitions, continued success on the rollout of Steri-Safe, both penetration and mix, lower variable cost partially offset by higher insurance and employee benefit costs.

SG&A excluding amortization was 15.3% of revenues versus 14.6% in the prior year. The absolute dollar spent was up primarily due to higher revenues from internal growth and acquisitions, higher benefit costs and investment spending related to programs such as BioSystems and Steri-Safe.

Operating income rose 18.8% to $31.6 million in the quarter from $26.6 million in the third quarter of '02. As a percent of revenue, operating income increased from 26.1% to 27.9%.

Net interest expense was lower in the third quarter of '03 versus the third quarter of 2002 by approximately $3.9 million, due to lower interest rates and lower debt outstanding. At the end of the third quarter, the balances of our Term A loan was $83.2 million and $36.4 million for the Term B loan. The total outstandings for our senior subordinated bonds at the end of the quarter was $50.9 million.

Net income from the third quarter rose 41.5% to $17.2 million, from $12.1 million last year. And EPS was 37 cents for the quarter up 37% from a year ago quarter. EBITDA increased 16.4% to $35.2 million versus the $30.2 million in the prior year. EBITDA as a percent of revenue was 31.1% in the quarter, up from 29.7% in the prior year period. Our debt to EBITDA ratio on a consolidated basis was 1.32.

Now the balance sheet. During the quarter, we continued to make significant progress in improving our balance sheet. Our debt to book cap at the end of the quarter was 30.1%, down from 39.1% at the end of the year. In the third quarter, our total debt decreased by $24.6 million due to repayments. During the quarter, our Cap Ex was 4.8% of revenues. DSO in the quarter was 51 days versus 59 days a year ago in the quarter and two days lower than the previous quarter.

And now some selected balance sheet numbers. Cash and cash equivalents, $7.8 million. Accounts receivable, $6. -- $63 million. Current assets, $91.3 million. Total assets, $696.8 million. Short term debt, $9.8 million. Long term debt, $170 million for a total debt of $179.8 million. The net worth was $416.6 million. And depreciation and amortization were $3.9 million and $0.4 million representatively.

For the nine months ended, now the nine months numbers. For September 30th, '03, revenues increased to $338.7 million, an increase of 13.5% from the same period a year ago. Gross profit as a percent of revenue expanded to 43% for the nine months ended '03 versus 40.6% for the same period ended September 30th, '02. Earnings per share increased 35.5% to $1.03 from 76 cents per share fully diluted in the same period year ago.

This concludes our strong financial picture, and I will pass it over to Rich.

Thanks, Frank. During the quarter, the operating team was focused on improving productivity in all areas of our existing business. Their hard work helped us achieve record gross margins in Q3. The whole team is also heavily involved in preparing for the BioSystems rollout. They are fully committed to doing whatever it takes to help support this important strategic initiative.

The sales teams efforts helped us achieve another record quarter. In 03, we saw continued growth in the small customer segment of our business; and as we prepare to exit the year, we remain extremely pleased with the increased penetration of Steri-Safe into our existing customers. For the balance of the year and on into 2004, the team will remain focused on the three key drivers of our small quantity growth strategy: new sales, customer conversion, and upselling higher program levels.

The major account reps focused on improving the margins of our LQG business. In the quarter, they secured 45 new LQG contracts. They also worked hard on the LQG margin improvement project. Each quarter as the reps worked through their list of low margin accounts, they invariably find some customers that are unwilling to consider any changes to their current service arrangements. The reps know if they can't improve the margins to an acceptable level, they have no choice but to stop servicing the customers. Working the program this quarter, we made the decision to stop servicing a group of LQG customers whose combined annualized revenues were approximately $1.5 million. In each case, these accounts had unacceptably low or even negative gross margins. Although this had the effect of reducing our LQ revenues by 2.9%, we extremely pleased that our LQ margins grew 33% year over year.

Now I would like to provide an update on the BioSystems rollout. We have now achieved our goal of obtaining all of the permits required to install operating infrastructure in our rollout service areas. These permits let us reach over 50% of the potential customer base once equipment installation is completed. At several plants we were already into the second phase: equipment installation and validation. Hiring and training of sales and operating personnel has started in preparation for next year's launch. Customers who have heard of BioSystems are very interested in the program, and based on these early indications we remain extremely excited about the growth potential of BioSystems in 2004 and beyond.

Summarizing the third quarter, we now have approximately 65,000 small accounts on the Steri-Safe compliance program, equal to 26% of our eligible SQ base. At the end of the quarter, we had signed up over 3800 new small customer service agreements. Thanks to the continuing hard work and efforts of the sales team, we currently have approximately 300,000 accounts with over 294,000 small and the remainder large. And now I'll just turn it back over to Mark.

Thank you, Rich. Clearly Stericycle had another exceptional quarter, and I would now like to provide insight on our current outlook for the remainder 2003 and provide our preliminary guidance for fiscal 2004. Please keep in mind that these are forward-looking statements as we go through the guidance.

Important point, the guidance for the remainder of 2003 and 2004 does not include nonroutine items such as the assumption of additional repurchase of our bonds. Should we elect in the fourth quarter of 2004 to repurchase the remainder of the bonds now at the balance of approximately just under $51 million, the pre-tax charge would be approximately $4.5 million of which $1.3 million would be non-cash and $3.2 million would be the cash premium paid. The EPS impact of this repurchase decision in Q4 of 2004 would be approximately 6 cents per share. This would provide a benefit after 2004 of approximately 5 cents per share per year due to lower interest expense.

Now for 2003. Current analyst EPS estimates for 2003 range from $1.39 to $1.41. We believe that analysts after detail review of the models will potentially raise their estimates to a range of $1.40 to $1.42, which we are comfortable with, and this assumes an average share count of over 46 million for the fiscal year 2003.

We'd like to provide fine tuning to that outlook for 2003. We believe that analysts may adjust their revenue estimates to between $452 and $453 million. This assumes continues Steri-Safe penetration, between zero to 1 million of additional international equipment revenues in Q4, and continued calling of low margin business.

We believe analysts will increase their estimates for net income to approximately $64.8 million to $65.2 million including the one time after tax charge of approximately $2 million that we took in the first half of this year on redemption premiums on bonds. 2003 annual analyst estimates -- EBITDA estimates may be increased to approximately $139 to $141 million, with depreciation and amortization expense of approximately $17 million.

Now I would like to provide a preliminary outlook for 2004. We believe that analyst estimates will be in the range of $1.67 to $1.72, which we are comfortable with. This assumes an average share count of approximately 47 million shares for the year.

We believe that estimates for revenue for 2004 will be in the range of approximately $478 to $488 million, with modest variances depending upon the assumptions on international equipment sales, account calling, BioSystems launch, and acquisition revenues. These estimates were to include internal growth rates on small accounts or SQG business of between 9 and 10%, of between minus 1 to plus one on our large account base, and incremental BioSystems revenues between $1.5 and $4 million, and $4 to $7 million in international equipment sales. We believe analysts will have estimates for net income between $78 and $81 million, depending on the assumptions for improved margins, acquisitions, interest expense, and strategic spending. 2004 annual analyst EBITDA estimates will be approximately $157 to $161 million with D&A expense, or depreciation and amortization, of approximately $18 million.

In closing, we are very pleased with the results to date, and we are extremely excited about the tremendous opportunities ahead in 2004 and beyond. Next year's launch of the BioSystems Sharps Management Program will allow us to offer our customers a proven outsourcing service and will provide Stericycle with a very unique platform for continued growth at higher margins. We're also investing heavily in this $200 million opportunity because of the tremendous benefits it provides to our customers and our shareholders. We'd like to thank our customers, our employees and our shareholders for their support in building the leading company in the industry, and with that, that ends our prepared comments, and I would like it to hand over to the operator for our question-and-answer session.

Certainly. Ladies and gentlemen, if you do wish to ask a question, please press the one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once again, if you would like to ask a question, please press one. Our first question is from Pete Delinsky from Copper Arts Capital. Please go ahead.

It's Steve DomeskiGanowski. Quick question on the STERICORP annual report that came out. They made mention that the ETD technology was not meeting specified standards and they were working with you guys because it was either warranted or guaranteed and I forget the name they used. And they mentioned that the Argentina joint venture, they were trying to get out because of the decline in the Argentinean peso and they were looking to sell their stake. Can you comment on international and how it relates to the $4 to $7 million in guidance for next year?

Sure. First of all, on the comment on EPD, I think they had experience trouble in learning the operational performance, the other operations we have around the world have been able to come online and operate efficiently and we are helping them through their learning process and integrations. As far as the comment that they may have had in Argentina, I think there is pressure on their organization due to their tremendous lack of cash.

Has that been a drag on the financials this year?

No, it hasn't been. I think the real key for them is for them to want to get out. As we understand, their cash is really needed to really do their acquisitions locally and reduce their debt which is fairly high. So from a point of view of some upfront cash that we knew which was needed for working capital, they did not have the capital to do that and as a result did not want to put more cash up. But the business is performing the way it was intended.

And on a different subject, I calculated internal growth was 1.1. Is that right?

I think if you look on the internal growth on the small quantity side, you have about $5.2 million in growth versus the prior year. The large quantity was about a $1.1 million reduction and the overall mix between those two is about 4.4%. The difference between that and maybe your numbers are that both 3CI and Mexico were slight low down. 3CI is calling large accounts and Mexico there was an exchange factor there.

Great, thank you.

Our next question will be from Kevin Monroe from Thomas Weisel Partners. Go ahead.

Good afternoon. Could you give us some of the underlying assumptions of the BioSystems revenue contribution in '04 in terms of number of customers and maybe annual revenue you expect from those customers.

On BioSystems, the reason we have been relatively conservative by some people's expectations is that we have not launched yet. Where we are at now, the single biggest variable that was unknown to us was timing of permits, and as Rich mentioned we are pleased we have the permits in hand and now it's execution based. What we look at is that initial opportunity in terms of focus, the initial target accounts would be towards our large account space. Obviously, there are customers in our small accounts base which would be in excess of 15,000 potential customers but at smaller revenues per account than we would expect to experience with large accounts such as hospitals. So as we look at the timing of it, if we achieve a 5 or 10% penetration by year end of the geographies we launched in early '04, would give us that range of numbers and that would be based on a 35 to 45,000 revenue per account base. So I think for us the unknown and what we have to prove out is as we launch into a market, what is the overall selling cycle and will we see the same type of cycle we have seen in other large quantity clinical sale businesses of anywhere from 5 to 10 months.

What is your -- I know January 1 you plan to be able to address 50% of your existing customer base. Is it 100% by the end of '04? Or something between the two?

I think for us the next phase of 50% and beyond, eventually our goal is to offer it to all geographies and we were continuing to work on the permitting process. And it's hard to tell at this point as to when it will all pop. Our objective is to get to 100% over time. There is plenty of opportunity and plenty of work to be done even with 50%. There is thousands of customers to be had and over $100 million in potential market to be gained.

And one more question. On the SG&A line, that number is creeping up a bit as percentage of revenue. Imagine that's for the BioSystems investing ahead of that. Where do you think that creeps up to and where does it level off and when do you think you can bring it on track and maybe even come down again?

I think you will see as we go over the next several quarters a modest rise where you have seen us in the high 15s to low 16s and then as we build critical mass and start having the annuity stream builds of the new accounts coming online and it will start tapering down. This is a huge opportunity for us that we think over time can be very significant, EBITDA margin fall through in that platform and is worth the investment.

Okay. Thank you.

Our next question will be from John BozlerBasler from Oppenheimer. Please go ahead.

Yes, gentlemen. Going to the small customer accounts, maybe I wrote down the numbers wrong. I believe you said total accounts of 294,000, 65,000 Steri-Safe signed up but you said 26% of eligible. Can you tell me what the difference in the number there is?

The percent of eligible on Steri-Safe we do not market Steri-Safe to any of our affiliates for example, Mexico, Canada or with 3-CI also as we have customers there may be under national contracts or recent acquisitions. The universe that right now we view as our target market is little over 250,000 accounts.

Okay. On the Steri-Safe, I believe you said you signed up 3800 new agreements. Is that how many you signed in the quarter?

Yeah.

And how does that compare to how many were signed? Were these new accounts as far as acquired businesses? Or were these from the existing pool that you are now beginning to cultivate.

The 3800 would be in addition to the ones that were conversions from existing accounts. Period-to-period, we went up about 5,000 customers on Steri-Safe.

Okay. So the 3800 was what you had basically acquired.

Those were new accounts that came in, correct. Most of those went to Steri-Safe, not all, and were conversions in addition to that to get up to the 5.

Okay. Can you comment -- it just seems a little slow on the ramp of we are sitting here with the huge base of quarter of a million accounts and we are getting kind of maybe 1,000 here a quarter and a thousand there. When will we see a bigger push to cultivate that huge base of customers to Steri-Safe?

In terms of the conversion process, what we are doing to date is focusing our direct sales efforts on new accounts. For example, the 3800 new. Most of the other activities that we have been doing are through direct mail and mailer activities and we are having success with that. We just have not put additional sales resources against it at this point. Clearly we have not run into a ceiling effect. So there is plenty of opportunity there to go. It's really more of a resourcing issue at this point in time.

And just lastly, I believe you said on a prior question that the small growth -- small customers grew $5.2 million in the quarter. How much of that was relative to the new account Steri-Safe's acquired and how much growth is there?

In terms of the delta change, more of that would have come from the existing base growth, capture of new accounts, because the incremental impact if you take, for example, if we signed up a customer during the quarter that was maybe $900 per year service agreement and we got half a quarter's effect may affected that 5.1 by $100 or $120. More of that is just fundamental growth of our base business as well.

Great. Thanks.

Our next question will be from Lorraine Maikis from Merrill Lynch. Go ahead.

Could we go back to the BioSystems for a minute. You had said that half of your customer base has permitting in place. Is that half of geographies? Or half of total customers?

It would be half of customers which are pretty evenly spread geographically.

Okay, so If you had 5,000 large quantity customers and we get a 5% penetration next year, that's 250 converted accounts.

If you use 5,000 as the metric and you had 50% that you can reach, if you remember we also had about 10% that we could reach with the existing BioSystems, so you have a potential universe, little over 300 accounts on it so you have about 2200 potential accounts to go after. So a 10% which is over 220 accounts of 5%, about 100, 115 accounts.

And then even using a $35,000 number, that gets us to $4 million which I think was the higher end of your range.

I think the key which we don't know at this point is the ramp up curve. So the reason we gave fairly broad band on the numbers is if the sales cycle -- say, for example, if we start in a geography in Q1 and we find that the sales cycle is 5 or 6 months to get people closed and on the program, the net impact will be much greater than if we find it's a 7 to 10 month cycle. It's more the timing of when the annuity stream begins to build into 2004. And that's something that metrics that we can go off of is what BioSystems historically did and what we had history on in going into new markets and going after medical waste services in the large quantity generator space. It's something that we will learn as we go through the year and we will keep people updated as we progress.

And then just moving over to your capital structure, debt to cap at 30%, what do you do with your cash from here?

I think again, the key there is we will look for opportunities to invest acquisitions and the like. We keep reducing our debt which obviously brings our interest down. And those are the two primary. For next year want to get ready for the taking out of the bonds at that point. That's $50 million, $51 million roughly. That's going to be one of the key parts. We also have an approved stock buy back program so in case we have the opportunity to do all of the above, that is one of the other alternatives that we can take advantage of. There is a fair amount of tools that we can take advantage of to improve value for the customers or in this case the shareholders.

Thank you.

Our next question will be from the line of Tom Ford from Lehman Brothers. Please go ahead.

Thanks. What should we use for the BioSystems assumptions in term of a margin, like a gross margin?

I think you would have to range it. For those of you that are familiar with it, the BioSystems program has historically ran in the high 20s to low 30s gross margins. We believe as we look out in the future our long term goal will be to move that business into the 40% plus range. So it's comparable and in line with our overall blended gross margins. Obviously there is a build factor that comes in as we start into a market. There's some semi-fixed costs. We won't from day one be at those kinds of levels. We think those kinds of levels are rational and achievable and that's one of the things that excites us. We think it's a business that can have meaningful fall through.

And then did you say earlier that the assumption for BioSystems in terms of G&A would be something like -- was that what you said? 15? 16?

No. That would be total SG&A as a percent of revenues.

And that includes the amortization. That was referred to total SG&A, Kevin asked what the total SG&A for next year potentially would be and it would be in the low 16 percent of revenue and then reducing over the year to high 15s, mid 15s.

And Frank, there is going to be anything notable in terms of BioSystems, in terms of capital needs?

I think the capital expenditures for next year are really roughly around the 21, $22 million, still in the range 4 to 5% of revenue. Again, those kind of things will be timed. If we see things speed up on the change of cycle here, the sales cycle, we will speed that up. We have the flexibility. Cash is not an issue. But it will stay within the range of 4 to 5% of revenue for the total business.

And then I was curious about for international equipment in terms of -- I know that you guys had said if I remember correctly it was more the Asian issue and more a timing issue with respect to the second half of 2003. And so I wanted to get updated thoughts from you with respect to that.

As we said in last call we had taken the guidance to between 0 and $2 million based upon timing of permits and shipments in the latter half of this year. We revised that downward to 0 to $1 million. And again it's in the process of finalizing the permit, infrastructure and build out. We are proceeding with the program and the project is a tremendous opportunity for us. If some of it ships this year, it would be a [INAUDIBLE] part on the tail end of the quarter or if not it will end up in '04.

In other words, don't expect much. I think you did what, 200 in the third quarter?

Correct.

So while zero to 1 in the third quarter, it's more like minimal.

Yeah.

Great, thanks.

Our next question will be from Raymond Baker from Bower Assets. Please go ahead. Raymond Baker, your line is open for our question. We will move on. Our next question will be from Greg Halter from LJR Great Lakes. Please go ahead.

Good afternoon. Good results. Can you tell me how much 3-CI contributed to revenues?

3-CI in the quarter was about $3.6 million.

And on a sequential basis, how many small and large accounts did you gain? I don't know if you gave that number already.

I think if you look at the total customer count, on the large it was fairly even. The gains and losses and on the small, we added about 3800. And then on the loss side there, that was in middle 2000s.

Lost 2000?

That's a normal erosion for us.

Little over 96% retention rate.

And the internal growth numbers you gave at 5.21, 0.1 and 4.4. Were those dollars or percents?

Percents. 9.5% was the percent for small. Negative 2.9 for large and blended of 4.4%. It comes dollar-wise close. The blended dollars is 4.1.

And on the internal growth on the small and large, that 5.2 and 1.1, that was percent also?

Those were dollars.

5.1 was dollars and 1.1 was dollars.

And 4.4 was?

That was percent.

The blending of the two.

And what percentage of your debt is at variable rates.

Right now all except for the high yield. So everything but about 51 million is variable.

Great. Thank you very much.

Once again. Ladies and gentlemen, if you do have a question, please press the 1 key. Our next question will be from Sheetal Mehta from Bear Stearns. Please go ahead.

Just a couple quick questions. On the large accounts that you're letting go in the first quarter we saw $2 million in analyzed revenues, second quarter $4 million, and this quarter was $1.4, $1.5? Are we seeing you identified most of the large accounts that you will let go and maybe it will start to tail off from here? What are your assumptions on that?

I think we still are pleased with the progress side because we are retaining the bulk of the revenues that are coming up for renewal, particularly the ones we make money on. We still have a lot of work to go. If you look at where we were last quarter, we had roughly maybe 30% of our LQG revenue base that was not at levels that we would like to retain long term. We have made probably, picked up another 5% of that that we have been able to work through and either readjust to more rational margins, but we still have about 25% to work through. So at the pace we are working on, if you took a snapshot in time and said, assuming zero acquisition, we still have the remainder of this year and through '04 to work through this universe of accounts. But it's hard to call on a quarter-by-quarter basis which ones you will keep or not keep. But I think overall if you look at it we are well over 90% retention of the important work, the ones that make money.

And can you give us a sense of where gross margins are in the large quantity generated are now?

The third quarter our blended average is about 24%. That's comparable to a year ago. We were 17 to 18%. And if you just look at absolute dollars, we were positive gross margin by 33%, real dollars up that fall through the bottom line even though absolute revenue dollars were down 2.9%.

And a couple of quick follow-ups, did you say what your acquisitions were in the quarter or the annualized?

The growth was $10 million. Year over year, and there were no acquisitions. But that was acquisitions that were done in the prior 12 months.

And then finally can you give us an update? I think the private lawsuits that you have going on? I think there were two from potential customers. Give us an update on that?

Those lawsuits were consolidated in one court and now being heard by a single judge in Utah. There has been no activity other than the consolidation since the last call. Again, they are not meaningful suits. Our attorneys have advised us we will defend them vigorously and we think they are without merit.

Thank you.

Our next question will be from Amanda Tepper from JP Morgan.

Good afternoon. My first question and I don't know if you will have a good answer or not. Do you know why your stock was down this afternoon after the release?

I can speculate. My sense is that because we had originally in the past had people asking us for the press release earlier than the call, over the last several quarters we had been trying to get the press release out earlier so people had plenty of time.

Which we all appreciate.

My sense is that by doing that, people were either getting spooked or trying to play games or take advantage in the last few minutes by having news. But because people like yourself and others hadn't had a chance to go through, study and comment, were reacting not based on factual information. So just to clarify for everybody, as we go forward we will be delaying that release until after market close. It may put pressure on folks in terms of getting their hands on the press release. We think it's really not appropriate nor reflective of the results to have choppiness in the latter part of the day prior to the call.

Okay. That's understandable. Thanks for the head's up for next time. I had a couple questions around gross margins because they are running ahead of what we had looked for in this quarter and your guidance for next year, especially given that you are guiding for SG&A margins to be up are implying big expansion in gross margin and I'm wondering if you could talk generally where that's coming from? And then specifically give me some sense of how much of that is Steri-Safe.

In terms of the key drivers of gross margin expansion, as we think of small accounts, Steri-Safe helps us on gross margins. Upgrade of levels of Steri-Safe help us on gross margins. And fundamental blocking and tackling. We are constantly achieving productivity improvements through optimizing routing, optimizing utilization of infrastructure, leveraging our buying power, et cetera. And there is still tremendous opportunities in the small. In the large accounts, the things that drive gross margin improvement in a meaningful way is calling of accounts and re-upping the bulk of the accounts that we keep and improved margins and obviously productivity on that business. And also BioSystems we think will continue to expand its margins as we grow that business and penetrate.

If you look at kind of the bridging from Q2 to Q3, where we had meaningful step-up in the gross margin, that was driven half by the large quantity generator calling program and about half of it was just from the other items we mentioned such as productivity and Steri-Safe. So those are the main drivers as we look into the remainder of this year and next year. And we were excited about the opportunities. We think this is a business that long term our objectives are to get the BioSystems into the 40s. We think our small quantity generator program as you look at a Steri-Safe account on a preferred level moves well into the 60s. As you look at our base business for large accounts we are looking to move that into the high 20s, mid-30s. In every sector that we are operating in, we are shooting for longer term to improve by anywhere of 5 to 10 percentage points above where we are running at today.

On the large quantity, you said 50% of it comes from the calling. Is it just losing low market accounts or are you moving the average price up on the accounts you are retaining?

You are moving the book of business you are retaining and improving the service value relationship. And it's not necessarily through price. It can be some accounts we take revenues down and adapt service levels but make a lot more money instead of making five percent on a higher number making 30% on a lesser number and more absolute dollars fall through. We have the flexibility to do it both through service adaptations and helping them in terms of minimizing our cost on stops and utilization infrastructure as well as price.

And on Steri-Safe, just that product aside from your Steri-Safe small account is in the gross margins in the 60s. Where is just the Steri-Safe portion gross margin.

The incremental revenues which would be above their base service, those are well into the 70s. So if you take when we were talking about 60s, if we had an account that today was at 50 or 55% gross margin for base transactional and they add on and go to our Steri-Safe preferred level, our overall blended gross margins for those two services will go up 10 full percentage points.

Go up. Do you have any Steri-Safe accounts who are not otherwise using Stericycle for the medical wastes?

Not that I'm aware of.

Okay. So its always a cross sell. Okay, great. Thank you very much.

The next question will be from the line of Matt Litfin from William Blair. Please go ahead.

Question, could you give us an update on the acquisition pipeline in the base medical waste business.

The acquisition pipeline --

The acquisition again, two dozen companies. Still from a pool. There is about 40 plus million in revenues and it's fairly stable from that point and we have not included that in our guidance and we will see where it goes.

Couple other questions and I will throw out there. One is, can you comment on any shifts that you are seeing in the pricing environment in both of your or either of your customer groups. Secondly, maybe you could just give us some color on what you are seeing on energy costs in the quarter and in your assumptions going forward.

In terms of shift in pricing environment, I think it's fairly consistent. It's not a business that moves dramatically one way or another. And so we haven't seen any mega changes. We are finding that because not only ourselves but every company in the health care community continues to have very strong year-to-year increases in health care costs that it's more understandable what that customer base when we have cost increases that we are able to get levels. I wish we could achieve the price increase level most health care companies are achieving. But over time maybe that's possible. And do you want to address the energy cost?

Yes. On the energy side again, fuel in the quarter fairly stable. Same with energy. No major moves there. Looking forward in '04, between fuel and energy, anywhere, 5 to 10% up is probably the rough guideline that we have seen.

You mean are you talking 5 to 10% of expenses rather than revenue?

That is 5 to 10% of expenses.

Increase as opposed to a percent of revenue.

Right. Not a percent of revenue.

Okay, thank you very much. Congratulations.

Once again, ladies and gentlemen, if you do have a question, please press the 1 key. We do have a follow-up question from John BozlerBasler from Oppenheimer.

Yes, just on back on the legal front. If I understand you correctly, all of the private litigation is consolidated. There is no other private litigation outside the two suits that were consolidated in Utah?

That's correct.

And there is also nothing on no inquiries from the state or federal side?

No, none.

Great, thank you.

We have no further questions in the queue at this time. Please continue.

Well, everyone, I thank you for taking the time out to listen to our call. I think we have a phenomenal opportunity for us on BioSystems. I know we are probably frustrating everybody because we are not shooting up to $100 million incremental in the first quarter. I will tell you, this is a really interesting program. The customers that became aware of the program and who have called us about it are interested and it's ability to have a safer work environment and free up nursing time and allow them to focus on their base. And it really has the potential to be the Steri-Safe program for the large generators, an ability to more than double the revenue opportunity per account and at superior margins. We are excited about it and looking forward to updating each quarter as we move forward throughout the rest of this year and '04. Thank you so much, everyone.

That does conclude your conference call for today. We thank you for your participation. You may now disconnect and have a good day.