Description

Executive Summary:  Cantel Medical is a leading pure-play provider of products and services to the growing $50bn global infection prevention market, with its current product offering operating in markets sized at ~$7bn relative to its annual revenues of ~$900mn. The company enjoys leading market positions in its core end markets, namely endoscopic reprocessing equipment, consumables, and procedural products used in the GI suite, water purification systems for dialysis centers, and in portions of its dental consumables business, as management’s strategy of marrying investment to support strong organic growth with complementary M&A has effectively enabled the company to build out its capabilities over time. Importantly, the business does not have much cyclicality. Approximately 75% of sales are recurring in nature, and demand for its products are supported by structural growth drivers that suggest the business can grow organic revenue growth in the mid-to-high single digits for years to come. When coupled with a disciplined M&A strategy and modest operating leverage on higher volumes, we think CMD can grow earnings at a mid-to-high teens rate over the medium term.

Why now? After years of strong, double digit organic growth and operating leverage, CMD slipped on the proverbial banana peel in 2018/2019 through a combination of forced and unforced errors. Specifically, at the same time the company was investing significant capital and expenses to begin the consolidation of its 9 legacy ERP systems into 1, make needed facility investments to consolidate disparate operations, invest in promising new product development, and invest in its employee base through living wage adjustments, the company was also hit by the double whammy of distributor destocking in  its dental business and a decision by one of its major dialysis center customers to dual source water purification systems at the same time dialysis clinic new build activity dried up temporarily. As a result of the confluence of factors, CMD saw operating margins decline over 200bps from FY2017 to FY2019 (ended 7/31), its forward earnings estimates cut ~15% and its forward twelve-month earnings multiple cut in half off the highs. As a result, the CEO, who had been awarded the role in 2016, was replaced in March 2019.

Is CEO change a good thing? In this instance, we think so. Initially, we viewed the CEO changed skeptically, thinking that it was a sign of deeper problems under the surface, but after speaking with the company at length, and seeing the changes made by the new CEO, we have a new perspective. According to the company, the former CEO was quite adept at expanding Cantel’s addressable market via new product acquisitions and geographic expansion, but the Board felt he lacked the sufficient capabilities to execute and properly leverage the major investments put in place over the past 4-5 years. Moreover, seeing as the Board was then looking at larger deals in their M&A pipeline, including the $775mn deal ultimately consummated in August, it felt that a change would be best implemented before even more operational challenges presented themselves with a new company to integrate post-deal. Hence, what felt at the time to be an abrupt CEO change from the outside looking in.

In making the change, the Board prudently chose to promote from within, announcing Board member Mr. George Fotiades as the new CEO. Mr. Fotiades has over 35 years of experience, including the former role of President and COO of healthcare distributor Cardinal Health, and is known as a pragmatic individual who makes thoughtful decisions quickly. He has been a board member since 2008, and was actually the Chairman’s  (Charles Diker - long-term investor and shareholder, ~10% owner of shares, and architect of Cantel’s decision to pivot towards infection prevention) first choice as CEO 10 years previously, so there was no need for the company to take a step back while an external CEO got up to speed on the challenges/opportunities ahead of the company.  

For his part, Mr. Fotiades has wasted no time leaving his mark on the company. In the six months since taking the role, he has (1) appointed new leadership throughout all aspects of the organization (all of which by appointing internal and former CMD employees), (2) completed new product assessments to focus on the highest value innovation efforts, and (3) announced several cost structure initiatives to help offset the significant cost inflation accrued in the business over the past few years. Most recently, he oversaw the acquisition of Hu-Friedy for $775mn, the company’s largest acquisition to-date. So he’s been busy.

That sounds like a lot of things going on. Why not wait to see how it goes? Optically, it sure feels like a lot of changes have been made in a short time, but for the most part the company avoided messing with culture by promoting internally which we think should pay dividends in terms of increasing the likelihood that initiatives meet expectations or at least avoid utter disaster. Additionally, the cost actions are necessary after investing ahead of sales for several years and should be achievable in our view. Lastly, we firmly believe that current earnings are depressed by the confluence of factors described in “Why Now” and expect operating results to sharply improve as those factors normalize/improve regardless of whether the initiatives undertaken by management ultimately bear fruit, and as results get better, we would be shocked if CMD didn’t return to trading at or near its historical levels. This approach could result in increased near-term volatility, but if we are correct about the quality of the business, these would most certainly be buying opportunities longer-term.

Company Overview: Cantel Medical is a leading global pure-play provider of infection prevention products and services broadly designed to prevent the occurrence or spread of infections in environments such as hospitals, ambulatory surgery centers, dental offices, and dialysis clinics. Its operations are divided into 4 segments: (1) Medical (57% of revenues and 64% of profits); (2) Life Sciences (22% of revenues and 15% of profits); (3) Dental (18% of revenues and 17% of profits); and Dialysis (3% of revenues and profits). Capital equipment accounts for ~25% of revenues while recurring revenues (i.e. consumables and services) account for the remainder. In FY2019 (ended 7/31), Cantel generated 72% of revenues in the US (and an additional 4% in Canada), 16% in the EMEA regions, and 7% in Asia Pacific.

Headquartered in Little Falls, NJ, Cantel, has been around in some fashion since right after World War II. Originally, the company was established to distribute cameras and optical products (which eventually included endoscopes) for Japan’s Olympus Optical Company, and over the next few decades it branched out into the distribution of a broad range of other products, including fine art supplies and residential furniture. It wasn’t until the late 1980s that the business in its current form began to take shape, when the CEO at the time began a 10+ year period of divesting non-core assets and acquiring more broadly into infection prevention. It ultimately changed its name from Cantel Industries to Cantel Medical in 2000, and since then, the company has aggressively expanded under the infection prevention umbrella. Today, the company generates over $900mn in revenue and over $140mn in operating profits.

Since changing its name in 2000, revenue growth has been extremely strong, increasing at an 18% CAGR driven by both organic and inorganic means. Margins have also increased steadily along the way, with gross margins increasing from 38% in 2000 to 47% today, while operating margins have increased from 12.6% to 15.4%, though we think elevated investment in the past 2+ years has limited the operating leverage in the underlying business of late. As a result of the strong revenue growth and margin expansion, earnings per share has increased from $0.13 to $2.37, representing a 17% CAGR.

Historically Cantel has managed its balance sheet conservatively, with net debt-to-EBITDA typically below 1x and net debt as a % of equity averaging just 10%, though we do expect leverage to expand to ~3.75x EBITDA following the completion of its Hu-Friedy acquisition this fiscal year. In prior periods following larger-sized deals, Cantel has quickly de-levered and we see the leverage declining to less than 2x within 3 years, and potentially faster depending on whether the company opts to sell its dialysis water business.

Segment Overview

Medical (57% of sales): The medical segment includes capital equipment, consumable products, and services that prevent infections related to the use of endoscopic devices. An endoscope is a flexible instrument fitted with a video camera to allow doctors to inspect a patient’s colon, intestines, or lungs for polyps and cysts that might turn into cancer, and they are used globally in over 80mn procedures annually, with a an estimated forward growth rate of 7%. Endoscopes are expensive devices designed for reuse, so they must be disinfected in between procedures to reduce the risk of hospital acquired infections, the most common complication of hospital care and one of the top 10 leading causes of death in the US. In the developed world, endoscopes are disinfected using automated equipment but in the developing markets, endoscopes tend to be disinfected manually .

Cantel sells automated endoscopic reprocessing systems, disinfectants and sterilants (either re-usable or single-shot chemistries), storage cabinets and transport systems, manual cleaning products, endoscope process tracking products including software, and maintenance/services on its products. Additionally, the company sells endoscopy procedure products that are designed to eliminate the challenges associated with hard-to-clean reusable components used in GI endoscopy procedures, including CO2 and water irrigation pumps, irrigation tubing, and valves. Roughly 20% of segment sales are capital equipment, 20% are chemistries, 10% is from services, and 50% is procedural products.

• Capital equipment: The majority of this ~$100mn product category is automated endoscopic reprocessing systems (i.e. industrial dishwashers for flexible endoscopes), but it also includes drying and storage cabinets. Approximately 50% of sales are outside the U.S. Within the U.S., Cantel has ~65% share (9,000 of the 13,000 systems installed across the country) as the company has benefited from two competitor recalls in the past decade (Steris and Custom UltraSonics).

• Chemistries: This ~$100mn product category is growing low double-digits as Cantel is converting the industry from open, reusable platforms to closed systems that require single-use chemistries. Management estimates this switch changes the annuity revenue stream from $3-4K annually with low margins to $10-12K at high margins. Looking forward, this business should continue to benefit from the conversion from reusable to single-use as ~3,500 of Cantel’s 9,000 systems are still reuse machines.

• Services: This ~$50mn revenue stream is growing low double digits with low growth in the U.S. offset by much faster growth outside the U.S. tied to strong capital growth and need for implementation services. 

• Procedural Products: Of this $250mn product category, ~$100mn is related to the sale of air suction valves, a notoriously hard to clean component. Cantel entered this market with its 2011 acquisition of Byrne Medical, who was the first company to create an injection molded plastic air suction valve that was low enough cost to allow for the switch from reusable products to single use. Cantel estimates that single use products have penetrated ~30-35% of the US market and that the company has 85-90% market share. Outside the U.S., the market is fragmented and penetration is only ~5%. Looking forward, this business should continue to grow briskly on the continued conversion to single use products in the US and abroad. One caution is that Boston Scientific increasingly is looking to move into this area and represents a threat in ~10-15% of Cantel’s portfolio. Its first effort cost Cantel share early on, but the product was inferior and Cantel was able to win back its share. If Boston Scientific does make this a core focus, it is likely Cantel would be a share donor, though BSX could also help drive market penetration and expand the total addressable market.

After acquiring many of its global distribution partners, Cantel sells direct in the US, Canada, UK, Germany, France, Australia, China, and Hong Kong. The company will use distributors when necessary but tends to think that distributors are less capable of selling clinical solutions. In general, Cantel is selling to nurses and infection prevention staffing rather than the doctors or procurement departments.

Life Sciences (22% of sales): The Life Sciences segment includes its water purification systems business that primarily sells into dialysis centers, filtration and separation products, liquid disinfectants, clean room services, and its REVOX in-line sterilization systems. Approximately 75% of sales are its water purification systems for dialysis centers with the remaining 25% split between the other disparate offerings.

• Dialysis Water: This ~$150mn revenue business includes equipment, parts, consumables, chemistries, and services/installation of hemiodialysis water systems. In the dialysis process, water is used to aid in the removal of harmful waste and extra salt and fluids from the bloodstream, but it must be purified before use. The business is capital equipment driven (~60% of revenues), so growth is more lumpy than other segments, but longer-term, (1) the U.S. end-stage renal disease patient population continues to grow 3-4% annually, (2) new hemiodialysis clinic construction has historically grown at an ~5% CAGR historically, and (3) half of the 9,000 dialysis clinics in the US continue to use old technology (cold disinfection vs. newer clinics using heat-based disinfection), so management expects industry demand to grow at a mid-single digit rate over the course of a cycle.

After rolling up the U.S. industry over a number of years, Cantel enjoys an extremely strong market position, with share as high as 90% recently. However, its dialysis center customers are extremely consolidated with the top 7 customers equaling ~75-80% of revenues, and the businesses’ results have been negatively impacted by its largest customer (Fresenius) opting to in-source a portion of its supply needs. Two years ago, Fresenius acquired European competitor Evonic after Cantel allegedly tried to acquire them first (Fresenius swooped in and threatened to re-direct business away from them if Fresenius couldn’t acquire them). This negatively impacted FY2019 results and will continue to weigh on 1HFY2020 results before stabilizing starting in 2H based on a 3-yr contract with specified volumes. From a timing perspective, the decision to dual source couldn’t have been worse as new build dialysis clinic construction also dried up at the same time. In light of recent developments, management is currently reviewing its potential options for this business and most investors expect it to be sold for ~$150-200mn, but given signs that the market is stabilizing, the company may opt to wait to try and get a better price.

• Filtering: Cantel licenses out its membrane technology for use in applications like military canteens. The filtering business is small at ~10-12mn in revenues and growing 3-4% with pretty good margins.

• Controlled Environmental Solutions (CES): This clean room services business was acquired in 2018 from Stericycle. The business itself is small, generating ~$8-10mn in revenues and growing ~5% organic, but management believes it an attractive roll-up opportunity even if it isn’t the company’s highest priority currently.

•  REVOX: This business does not generate much meaningful revenue currently, and is currently losing $3-4mn annually, but management believes there is a lot of potential for this product. REVOX is the company’s in-line sterilization system, which if scaled, would represent a competitive threat for Steris’ Applied Sterilization Technologies segment, though it will be several years before we can ascertain whether or not this is a truly scalable solution.

Dental (18% of sales): The Dental segment sells a broad selection of single-use products used by dental practitioners, including sterility assurance products such as biological indicators and sterilization pouches, consumables and personal barrier products like face masks, shields, and hand protection products, sedation equipment with related single-use disposable nasal masks, and waterline treatment products. Its products are sold through distributors, and management noted that Dental Support Organizations (DSOs) represent 15-20% of the segment and growing. Its top 3 customers accounted for 48% of segment sales. Of its portfolio, approximately 70% of its products are branded vs. 30% are legacy products. Management believes it will continue to grow price 3% annually on branded products, whereas it loses 100-200bps of pricing on its legacy products. Broadly, management expects its current business mix to grow organically in the +4-6% range.

• Sterility Assurance: After dental tools are used, they must be reprocessed and sterilized in an autoclave and then put into sterility pouches with chemical indicators to assure the tools are sterilized. Cantel’s sterility assurance portfolio, which accounts for ~$65mn in revenues, includes both the indicators and pouches. Management estimates the business is growing 3-4% annually (volumes flat to +1%) and that it holds ~50% market share in what is a still fairly fragmented industry after them.

• Consumables and Barrier Products: This business accounts for ~$60mn of sales and is where most legacy products reside. Management estimates that pricing is a 100-200bps annual headwind in this business.

• Waterline Purification: Cantel offers a screw-in iodine filter (replaced every 6 months) that is installed in the water lines on dentist chairs to ensure proper wastewater management compliance. This is a $10-11mn revenue business with great margins and a long runway with industry penetration <10%.

• Gas masks and consumables: Through its acquisition of Accutron in 2016, Cantel entered into the gas mask equipment market, but post-deal, changed the nasal hood product from a reusable format to single-use. It is now a 90% consumable business growing strongly, and we estimate its revenues to be in the $10-12mn range.

Hu-Friedy deal more than doubles Dental business, structurally raises growth and margin profile: In August 2019, Cantel announced it was acquiring privatetly held Hu-Friedy for $725mn in upfront cash and stock (up to $60mn worth) and up to $50mn in commercial based milestones over the next 18 months. Hu-Friedy is the leading global manufacturer of a comprehensive portfolio of dental instruments (2/3 of sales) and its proprietary instrument management system (1/3) with a 111-year operating history. It enjoys near 100% brand awareness, its mix is almost 100% recurring revenue, and it has grown organically consistently in the +6% to +8% range.  On an LTM basis, Hu-Friedy generated $214mn in sales (vs. $160mn for CMD’s Dental business) and $48mn in EBITDA (22% margins vs. ~19% for CMD’s Dental business). Overall, management expects the deal to be 10% accretive to EPS in year 1 (and +mid-teens accretive in FY2021) and to increase the Dental business organic growth rate potential by ~150bps.

Dialysis (3% of revenues): Cantel manufactures and sells reprocessing systems and sterilants for dialyzers (a device serving as an artificial kidney) as well as dialysis concentrates and supplied used for renal dialysis. These products are limited to use by centers that choose to reuse dialyzers for the same patient. This practice has been in a significant downward trend since 2001, which has negatively impacted sales and profits in this business.

Key Points:

(1)   Several growth drivers support continued strong organic growth in Medical, which should drive significant operating leverage. With ~80mn endoscopic procedures globally growing 7% organically driving growth in colonoscopy screenings, endoscopic reprocessing represents a large and growing global addressable market that management estimates is over $4.5bn. Despite several years of strong double-digit growth, we expect continued growth of ~10% driven by procedure growth, increased equipment placements outside the U.S. as reprocessing transitions from manual to automated, continued conversion of chemistries from reuse to single-shot in the U.S., and continued penetration of procedural products in the U.S. and abroad.

Currently, the Medical segment generates the highest EBITA margins at 22%, but we expect significant upside potential based on mix (chemistries and procedural products higher margin), leverage on higher volumes (particularly in international where the footprint is built out and is under-absorbed currently), and efficiency opportunities now that the company has completed its ERP implementation in its U.S. Medical operations. Management believes its longer-run potential margin should be closer to 30% and we are inclined to agree.

(2)   The absence of a negative is a positive. After a whirlwind year filled with both planned and unplanned challenges, a return to normalcy would be a welcome relief and major driver of earnings growth. We estimate FY2019 earnings were negatively impacted by $0.32 for ‘planned’ investments ($0.29 relative to the prior year) and an additional $0.23 relative to ‘unplanned’ events, namely a distributor destocking in Dental that impacted 1H results and Fresenius’ move to insource a portion of its water purification systems.

Of the planned events, we aren’t necessarily expecting a decline in FY2020, but we also aren’t expecting a further step-up from current levels, which all else equal would allow for the underlying operating leverage to shine through. Moreover, we expect the Dental destock to not recur and for management to offset some of the challenges in the Water business with cost realignments, which combined should add ~$0.05-$0.10 of earnings (2-4% growth) in FY2020. And over the next two years, management expects an incremental $0.30 - $0.40 of benefit from facility consolidation in Dental and roll-off of ERP-related costs plus the realization of efficiencies as the systems becomes fully operational. Taken together, we think earnings can grow 7-10% annually over the next two years just from the rolling off of timing-related challenges and execution on restructuring actions, which is accretive to the normal operating leverage in the business (though we would expect a meaningful portion to be reinvested in growth initiatives).

(3)    Hu-Friedy acquisition structurally increases Dental segment growth profile, though not without adding risks along the way. The pending acquisition of Hu-Friedy, the largest deal in Cantel’s history, structurally improves the Dental segment’s organic growth profile from +4-6% to +5.5-7.5% and is accretive to segment and corporate margins. Further, the deal is expected to be meaningfully accretive to earnings near-term, ~10% accretive in FY2020 and mid-teens accretive thereafter. With that said though, the deal is not without its drawbacks and risks. First, Cantel is paying a full price for Hu-Friedy, with valuation pegged at 16x LTM EBITDA (13x adjusted for the undiscounted value of tax benefits related to the transaction. And even giving the company credit for expected synergies, the deal structurally reduces Cantel’s returns on invested capital from an average of ~15% the last three years to ~10%. Moreover, the deal significantly increases leverage from ~1x to ~3.75x. This should not be a huge headwind given the business’s ability to rapidly de-lever but does increase the downside should problems emerge.

In addition, the deal more than doubles Cantel’s exposure to the Dental segment, a market that has historically been a very attractive one but that has lately faced its share of challenges, mostly from the rise in DSOs. This rise has negatively impacted all types of industry participants and is not expected to abate any time soon, so it is a reasonable to ask whether now is the best time to double-down on this end market. For its part, the company does not think its portfolio is immune to these challenges, but it does think its comprehensive portfolio of differentiated infection prevention products will allow it to gain share at DSOs looking for one provider to solve these specialized needs. Moreover, Hu-Friedy’s infection management system offering is gaining significant traction with DSOs, so this product offering, which is 1/3 of Hu-Friedy’s revenue, should continue to see strong uptake.

Net, net, we appreciate the risks associated with the deal, and will continue to monitor the integration process and the segment’s outlook going forward, but we currently think that the pros outweigh the cons and our estimates embed below management expectations for organic growth as a hedge to compensate for what we think are reasonable concerns.

(4)   A sale of the Medical Water business would be dilutive but would also reduce leverage and increase the business’s organic growth profile. With the Dialysis water segment struggling in the wake of Fresenius’ decision to in-source a portion of production, Cantel announced it was looking at its strategic options for this business. Management originally expected to have an answer on the 4Q conference call in September, but ended up postponing the conclusion of its study for a few more weeks. This was not well received by the markets, with shares down meaningfully since it posted results. We think investors ultimately expect this business to be sold, and that the delay was interpreted as the company was having difficulty achieving the price it desires for this asset (which calls into question what it intends to do with this business).

Prior to Fresenius insourcing, the business was a very attractive mid-single digit grower with high-teens margins and not much in the way of additional capital requirements. Unfortunately, the business does have a reasonable amount of fixed cost leverage, so its largest customer opting to insource significantly impacted sales, margin, returns, and ultimately, the multiple Cantel expect to obtain for this asset.

We think the business will be sold for a valuation in the 7-9x EBITDA range, which amounts to $150-200mn. The proceeds will help the company de-lever post Hu-Friedy, which will increase earnings as interest expense declines, but this benefit will be more than offset by the dilution from the sale. On our estimates, the Water business generates ~$20mn in EBITA and likely helps absorb an additional $5mn in additional expenses that otherwise would be allocated to other segments. Accordingly, we see the deal as being $0.30 dilutive to earnings, essentially wiping out the benefit from Hu-Friedy accretion. However, it would also increase consolidated organic revenue growth by ~80bps, which would likely increase the valuation that investors would be willing to pay for Cantel’s earnings stream.

Valuation: At ~$72.5, Cantel shares are trading at ~25x/22x FY2020/FY2021 earnings, which compares to a historical forward P/E of 27x (albeit with periods of significant over- and under-valuation). Relative to the broader market, Cantel is trading at 143% of the S&P 500, its lowest relative value since 2013.

 Notably, estimates stand to be significantly revised should Cantel sell its Dialysis water business. We estimate the sale would be ~$0.30 dilutive to earnings, but would also provide cash flow to pay down a portion of the debt incurred to acquire Hu-Friedy. Notably, it would also add ~80bps to the Cantel’s normalized organic growth rate, which combined with a better balance sheet, should be accretive to valuation to the extent the company executes well.

Relative to peers, Cantel is trading at a meaningful discount to both infection prevention (Steris and Ecolab) and SMID cap MedTech peers, and at a premium to dental industry participants.

Operating Model: We think its its Medical business should continue to grow around +9-10% (guidance is +LDDs), Dental in the +5% range (below pro forma guidance of +5.5-+7.5%), and Life Sciences in the Flat to +LSD range. Net-net, we see organic sales growth in the +5-6% range (assuming Dialysis water is retained). As results snap back after a tough year, we see margins improve ~100bps in FY2020 and an additional 120bps cumulatively over the next two years. Combined, we see operating profits increasing at an ~20% CAGR, driven by a recovery in Dental margins, the acquisition of Hu-Friedy, and continued strength in Medical, which with debt paydown should drive EPS growth in the mid-to-high teens through FY2022.

Risk Factors:

• Execution. Execution is the foremost risk in every segment. The Medical segment needs to continue to digest its recent ERP implementation and drive efficiencies. The Life Sciences segment needs to come to a decision on the Dialysis water business and execute. And the Dental segment needs to execute on the integration of the company’s largest acquisition to date. Challenges in any or all of these areas would negatively impact shares.

• Increased competition in procedural products weighs on Medical organic growth rates. BSX competes with ~10% of its procedural products portfolio. Cantel does not believe it is a core product offering for BSX, but noted a greater emphasis on the part of their competitor would likely take share (albeit in a much larger sized market).

• Cost effective, high-quality disposable endoscopes would eliminate the need for reprocessing. Over the next few years, both BSX and Ambu are set on bringing to market sterile, single-use endoscopes, which they view as the ultimate solution to prevent hospital acquired infections. The price points BSX has suggested ($2-2.5K) points to this product being more of a niche solution. Ambu is aiming to get their costs lower, but Cantel does not believe they will be able to get the price point to where it needs to be for mass adoption. Notably, Cantel actually looked at the company Ambu acquired (Invendo) and opted to pass. Moreover, both single-use and reusable scopes will require procedural products (50% of segment sales) going forward, and arguably, disposable scopes would accelerate the penetration of disposable accessories and help offset declines in reprocessing equipment and consumables. .  

• Rise in DSOs could continue to pressure Dental industry and impact prices. CMD believes it’s acquisition of Hu-Friedy provides it with a comprehensive infection prevention solution that resonates well with DSOs, and expects to increase its share of wallet with these customers. It does concede that pricing for its non-branded product portfolio (~30% of legacy Dental and 10% of Hu-Friedy) will likely continue to be under pressure.

•  Alternative technologies/methods for colorectal cancer detection, i.e. liquid biopsies.

Catalyst

Good execution