|Shares Out. (in M):||43||P/E||0||25.8|
|Market Cap (in $M):||3,081||P/FCF||0||0|
|Net Debt (in $M):||900||EBIT||0||0|
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.
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.