Cantel Medical Corp.
Q2 2018 Earnings Call Transcript

Published: 10 Mar 2018

[Operator:]

Greetings and welcome to the Cantel Medical Corp Second Quarter Fiscal 2018 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Milicent Brooks, Director of Corporate Communications for Cantel Medical Corp. Thank you. You may begin.

[Milicent Brooks:]

Thank you, Melissa and good morning everyone. On today’s call, we have Chuck Diker, Chairman of the Board; Jorgen Hansen, President and Chief Executive Officer; Peter Clifford, EVP and Chief Financial Officer; Seth Yellin, EVP, Strategy and Corporate Development; and Brian Capone, VP, Corporate Controller. Earlier this morning, the company issued a press release announcing the financial results for the second quarter of fiscal year 2018. In addition, we have posted a supplemental the presentation to complement today’s call. This presentation can be found on Cantel’s website in the Investor Relations section under Presentations. Before we begin, I would like to remind everyone that this conference call may contain forward-looking statements. All forward-looking statements involve risks and uncertainties including, without limitation the risks detailed in the company’s filings and reports with the Securities and Exchange Commission. Such statements are only predictions and actual results may differ materially from those projected. The company will also be making references on today’s call to the non-GAAP financial measurements, non-GAAP EBITDAs, non-GAAP operating income, non-GAAP gross profit, non-GAAP diluted earnings per share and net debt. Reconciliations of these financial measures to the most directly comparable GAAP financial measurements are provided in today’s earnings release. With that, I am pleased to introduce to you, Jorgen B. Hansen, President and CEO.

[Jorgen Hansen:]

Thank you, Milicent and welcome everyone. I will start off with some brief opening comments, followed by Peter who will take you through our second quarter 2018 financial results. Finally, we will open the call for Q&A. We are extremely pleased with our results this quarter. We grew reported net sales by 15.3%, with 10% organic growth, in other words are quite in line with our strategic goal of 8% to 10% organic and 15% overall growth. The three major segments performed well and we were positively impacted by the tax reform legislation changes that were passed in December. Endoscopy sales grew by 23.6%, with organic growth of 13.8%, driven primarily by strength in all of our recurring revenue products, including chemistries, procedural products and services. We continue to see prior period capital placements driving strong ongoing chemistry and consumable sales into the installed base. Margins increased due to volume leverage and improved productivity. Water Purification and Filtration recorded revenue growth of 7.4% for the quarter led by strong results in equipment, chemistry and consumable sales. Operating profit increased modestly year-over-year. Revenue in our Healthcare Disposables segment increased by 6.2%, 5.5% organically, driven by demand of our strategic branded portfolio, which grew by 9.2%, operating product was up modestly year-over-year. From a geographic perspective, our international operations continue to perform exceptionally well with 43% growth year-over-year. This includes the impact of the acquisition of BHT Group in Germany as well as our Australian distributor. International organic growth was up 18.1%, driven by strength in Germany, China, Australia and Canada. U.S. sales up 7.8% organically versus prior year performed well across all business segments. Overall, the second quarter provided strong results in line with our previously stated guidance for fiscal year 2018. We will discuss the changes in our full year guidance based on the estimated U.S. tax benefit later in the call. With that, I will hand over to Peter to discuss the financial results.

[Peter Clifford:]

Thanks, Jorgen and good morning everyone. Let’s take a few minutes to walk through the 2Q ‘18 financial results. On a consolidated basis, the top line net sales increased 15.3% year-over-year in 2Q ‘18 versus the prior year and 14.2% on a constant currency basis. Consolidated net sales walk elements were organic came in at 10%; M&A was 4.2%; and FX was a tailwind of 1.1%. Gross margins for the quarter, GAAP gross margins contracted 40 basis points to 47.5% versus 47.9% in the prior year. Non-GAAP gross margins were flat year-over-year. Note when adjusted for segment recast and dilution from BHT, we expanded 120 basis points operationally year-over-year. Operating expenses for the quarter, GAAP operating expenses increased by $8.9 million or 14.8% in 2Q ‘18 compared to the prior year. The impact of acquired costs from acquisitions was roughly $3 million or 5%. The balance was purposeful investment in line with our strategic plan initiatives. Operating profit for the quarter, GAAP op profit increased 13.5% year-over-year to $32.5 million, while non-GAAP op profit increased 15.7% year-over-year to $38.8 million. Our effective tax rate, as we have previously signaled, Cantel expected to benefit disproportionately from the recent tax legislation. For the quarter, our GAAP effective tax rate came in at a negative 3.6% compared to the prior year rate of 34.3%. The key drivers were we incurred approximately $9 million worth of one-time benefit derived primarily from the revaluation of our deferred tax liabilities and assets, which was partially offset by one-time pull tax on undistributed foreign earnings. Note these beneficial impacts were excluded from non-GAAP presentation. Additionally, the impact of the rate change provided a benefit of approximately $5 million, which included a one-time year-to-date true-up of approximately $3 million related to 1Q ‘18 this was partially offset by state taxes on our foreign operations. For the quarter, our non-GAAP effective tax rate came in at 21.1% compared to the prior year of 33.6%. The key drivers were the impact of the rate change provided a benefit of approximately $6 million, which was inclusive of one-time true-up of approximately $3 million related to 1Q ‘18. This was again partially offset by state taxes in foreign operations. As we look forward, based upon our current geographic composition of profits, we anticipate that our non-GAAP full year effective tax rate as well as our rate for the third and fourth quarter will range between 28.5% to 29.5%, note, we intend to reinvest approximately $0.035 to $0.045 of the tax benefit in 4Q ‘18, which we expect to continue as an average quarterly run-rate into 2019. EPS for the quarter, GAAP EPS increased 79.9% year-over-year to $0.78, while our non-GAAP EPS increased 37.8% year-over-year to $0.71. Note non-GAAP EPS on a pro forma basis, excluding tax benefits, increased 13.5% year-over-year to $0.59. Adjusted EBITDAS for the quarter, 2Q ‘18 adjusted EBITDAS came in at $45.9 million, up 16.2% year-over-year, while our adjusted EBITDAS for the last 12 months was $171.7 million, up 12.9% year-over-year. 2Q ‘18 cash flow from operations came in at $24.6 million, up 21.5% year-over-year. Now, let’s provide some insight into the segment results. For our Endoscopy segment, for the quarter, sales grew 23.6% year-over-year to $116.7 million. Organic was 13.8%. Our GAAP op profit increased 30.3% to $24.5 million, while our non-GAAP op profit increased 30.7% to $27.9 million. For our Water segment, sales grew 7.4% year-over-year to $50.9 million. Organic was 6.9% driven by the strength of the beginning backlog. Note our backlog did see compression of roughly $5 million during the quarter as some of our capital customers started to see stabilization in their expansion plans. GAAP op profit decreased 3% to $8.1 million, while our non-GAAP op profit increased 2.6% to $9.1 million. For our Healthcare Disposables segment for the quarter, sales grew 6.2% year-over-year $37.5 million. Organic was 5.5%. Our GAAP op profit decreased 1.1% to $7 million, while our non-GAAP op profit increased 1.4% to $8.7 million. For our Dialysis segment for the quarter, sales expanded 2.5% year-over-year to $7.9 million. Our GAAP op profit decreased 10.7%, while our non-GAAP op profit decreased 10.6%. Now, I would like to hit a few balance sheet and liquidity details. Our balance sheet remains incredibly strong with significant capacity. We ended the quarter with $40 million in cash and cash equivalents, $173.4 million in working capital, our gross debt ended the quarter at $160 million. This includes $61.3 million of borrowings this year to fund the acquisition of BHT. We continue to pay down significant levels of debt. We paid down $8 million in 2Q ‘18. Our net debt is $120 million and our net debt to adjusted EBITDAS is 0.7. Capital expenditures were $7 million in the quarter and as we have signaled, CapEx will remain elevated for the next several quarters to support our ERP implementation project. As a reminder, we will be filing our 10-K before the close of business today. I will now hand the call back to Jorgen for closing remarks.

[Jorgen Hansen:]

Thank you, Peter. Overall, we are pleased with our performance this quarter, the positive trajectory of our business and our strong competitive position in the markets we serve. From an M&A perspective, we are encouraged with the health of our pipeline and are optimistic about the potential deals in the coming quarters. We are evaluating opportunities to acquire new businesses and technologies in all of our existing segments as well as exploring potential new verticals within infection prevention. Furthermore, we are pleased by the strength of our new product development pipeline. This quarter, we received 510(k) clearance of two products, our ADVANTAGE Pass-Thru automated endoscope reprocessor, the first of its kind to be sold in the U.S., and our Eon water system, a portable reverse osmosis water purification system. We look forward to launching these exciting products, which will enhance our market leadership position in fiscal year 2018 and beyond. Taken together and excluding the benefit from tax reform, we expect the fiscal year 2018 will be in line with our strategic plan of doubling sales and profits by fiscal year 2021, executed through new product development, market expansions, strategic acquisitions, supported by continuing evolution of potential operating margin. With the benefit from tax legislation changes, we anticipate fiscal year 2018 non-GAAP EPS of $2.44 to $2.50, inclusive of announced acquisitions. In line with the spirit of the legislation, our revised guidance incorporates a plan to reinvest part of the tax benefit back into the company, which will start in the fourth quarter of this year. This will accelerate plans we already had in place and allocate additional resources in both our business and for our team members. These plans include advancing new product development, accelerating facility expansion to support our growth and enhancing total rewards for our employees. In our earnings call presentation, we have included a chart to help model the estimated tax rates for fiscal year 2019. In closing, I would like to thank our 2,500 loyal and hardworking team members for their efforts and achievements this quarter. Our entire company takes great pride in our mission to provide solutions to mitigate infections, improve patient safety and outcomes and ultimately help save lives. Thank you for listening. I look forward to speaking with you on our third quarter earnings call in June. Melissa, we are now ready to take questions.

[Operator:]

Thank you. [Operator Instructions] Our first question comes from the line of Larry Keusch with Raymond James. Please proceed with your question.

[Larry Keusch:]

Thank you. Good morning, everyone.

[Jorgen Hansen:]

Good morning, Larry.

[Larry Keusch:]

Maybe Jorgen or Peter, I know that there was some commentary in the slide deck which you provided, which by the way is very helpful. But why was the operating margin in Healthcare Disposables and Water down on a year-over-year basis on the non-GAAP numbers?

[Peter Clifford:]

Yes. Let me take that one. So both businesses provided solid op profit leverage in 1Q ‘18 on a non-GAAP basis and we would expect both have resolved leverage profiles for the full year of ‘18 really within this quarter. On the HED side, we had a little bit of inventory valuation. That’s one-time in the current year. And in the prior year for Water, we had a little bit of a tailwind on some revaluations that didn’t reoccur this year. But ultimately, we feel very strongly that the full year for both of those businesses are going to have a nice leverage op profit to revenue profile for the year.

[Larry Keusch:]

Okay. So, we should expect those in the second half to turn positive again?

[Peter Clifford:]

To normalize, yes.

[Larry Keusch:]

Yes, okay, perfect. And then of course just two other questions, just again, obviously, the balance sheet continues to be very strong at 0.7x leverage. Just again talk a little bit about maybe the complexion of the deal pipeline and do you think you are still on track or able to continue focusing on that 2ish deals a year?

[Seth Yellin:]

Hi, Larry, Seth here. Thanks for the question. Overall, I think we feel pretty good about the M&A pipeline. I think from the balance sheet perspective, we have ample capacity and from an activity perspective, we feel that there is healthy activity that is – that we anticipate to be able to continue to execute on over the course of the year. So I think we feel pretty good and should not see any real deviations in strategy.

[Larry Keusch:]

Okay, perfect. Last one for me is you have clearly been signaling certainly at the start of this year as tax reform became more clear that you would be looking to invest a portion of those savings and obviously, you called out the three areas that again you had sort have been signaling were areas that you could put some more money to work. So, I guess a two-part question. What sort of takes you from that range of kind of a third of the savings to 0.5 of the savings, so kind of what modulates that up and down? And of the areas that you are putting the money to work in, where is the biggest amount going? In other words kind of where do you think the best bang for the buck is?

[Jorgen Hansen:]

Yes. This is Jorgen, Larry. So, we believe that we have opportunities to really accelerate and also support our business with this tax reform. We are still working through the details on how exactly to allocate the funds and that’s why we have a pretty wide range called out in terms of how much we want to invest and we will decide that over the next period here. But starting in the fourth quarter, we have specifically allocated money to accelerate some R&D projects that we have wanted to either start or have more resources on we are spending some money on or planning to spend some money on the total compensation for our team. And this was an initiative we have been looking at for a while, but we will now be able to make some adjustments that we feel are prudent across our organization. And then the last piece is really that with the growth we have had including very strong organic growth for a long time, we are really out of space in many of our locations and this has enabled us to make some decisions on getting a little bit ahead of the curve to invest in some of the facilities. So obviously, that’s more efficiency initiative than anything else, but nevertheless, an important thing that we think we need to do.

[Peter Clifford:]

And I would just add on, I mean the timing of this is unique, right, it’s midyear and candidly, we just kicked off our AOP process and that’s really our vehicle, our mechanism to be. I will say very thoughtful on scrubbing any of the investment opportunities even if this wasn’t happening right now. That’s our vehicle to make sure we are looking at everything the right way to make sure we are comfortable that it’s absolutely the right investments in the right places with the right return profile. So that’s something that we work every year and we tend to finish in late June, early July.

[Larry Keusch:]

Okay. Very helpful. Just to finish that one up and then I am done. So the run-rate in the fourth quarter for that incremental investment, did I catch that you said that, that would then continue through 2019. Is that the right way to think about it?

[Jorgen Hansen:]

Yes, that’s the right way to think about it.

[Larry Keusch:]

Okay, perfect. Thanks, guys.

[Operator:]

Thank you. Our next question comes from the line of Mike Matson with Needham & Company. Please proceed with your question.

[Mike Matson:]

Yes, hi. Thanks for taking my questions. And I guess I just wanted to start with – there was some news in the dental distribution space around this FTC investigation of some of the big distributors around independent practices. So, I was just wondering is there any risk that any of the follow-up from that could affect your Healthcare Disposables business at all?

[Jorgen Hansen:]

Yes. We have seen that, Mike and actually, there has been cases like that going on for quite a while. And I mean, historically, it hasn’t impacted our business and at this particular time, we don’t anticipate any disruption from our managed part either.

[Mike Matson:]

Okay, thanks. And then just in the Endo Disposables area, I am just wondering if you have seen any kind of changes in the competitive landscape there. It seems like Boston Scientific has been sort of talking of infection control and maybe some of the disposable products has been an area of focus or increasing focus for them. So, have you seen them getting more active in that area?

[Jorgen Hansen:]

Yes. I mean, Boston really went into or made an attempt to get a little more active in this space with the acquisition of EndoChoice, I guess, about a year ago and we haven’t really seen anything change until probably last couple of quarters. We have started to see a little more activity from the Boston organization. Just sort of to frame it, they have some products that compete with us, probably have products that are covering about 10% to 15% of our total portfolio. So, while obviously they are a strong competitor and we are acutely aware that they have something we should pay attention to it is a fairly small part of our business that they compete with.

[Mike Matson:]

Okay, thanks. And then I noticed in your commentary around M&A, you did mention potentially looking at new verticals in the infection control area. And I know that there was a rumor out there that J&J maybe selling their sterilization business. And so there is also part of that rumor that said that you guys were looking at it. So, I don’t know if you could comment on that, but anything you could say would be helpful. If not, I completely understand.

[Seth Yellin:]

Yes, Mike. We are aware of the recent reports in the news regarding that opportunity, but as a matter of policy, we just don’t comment on speculation around M&A activity.

[Mike Matson:]

Alright. Fair enough. Thank you.

[Jorgen Hansen:]

Thank you.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from the line of Mitra Ramgopal with Sidoti & Company. Please proceed with your question.

[Mitra Ramgopal:]

Yes, hi, good morning. Just a couple of questions. First on the Endoscopy business, I know you mentioned it was accelerating internationally. I was just wondering if it’s still largely in the European markets and in particular, what might be driving that if it’s more just expanding your distribution network or any other factors?

[Peter Clifford:]

Yes, I mean o-U.S., yes, we grew 43% with 18.1% on an organic. Obviously, the M&A piece of it is heavily EMEA with BHT, but we still have some impact through the middle of next quarter with our Australian acquisition of our distributor. I would tell you, it’s pretty balanced in the second quarter. We had strong growth in both APAC and EMEA both on organic and inorganic bases. So, it’s a really good story internationally this quarter.

[Mitra Ramgopal:]

Okay, thanks. And on the Healthcare Disposables side, I know you had pointed out that the branded products continue to really drive the business there. And I was just wondering what percentage of that segment now is really been driven by branded products?

[Peter Clifford:]

Branded products is still just under 70%, I think, it’s about 67% is kind of what it is now, but each quarter, it tends to move more towards the 70%.

[Mitra Ramgopal:]

Okay, thanks. And again, a real big picture question, I don’t know if you see it as a potential headwind with all the talks of many potential tariffs, etcetera, maybe raw material price is being driven up if that could be an issue for you?

[Jorgen Hansen:]

I wouldn’t believe so. I mean, we are not a large volume manufacturer in terms of some of those materials. So could there be some effect? Possibly, but it’s certainly not something we have identified as a major risk to us at this point.

[Peter Clifford:]

Yes. A key part of our metal fab supply base is actually local. So, I suspect that most of that steel is coming from either the U.S., Canada or Mexico and I think the latest rumors are that Canada and Mexico would be excluded from that tariff piece.

[Mitra Ramgopal:]

Okay. Now, that’s great. And then finally, I noted dialysis business is still – is very small, but it seems like over the last couple of quarters, it’s had a kind of a nice turnaround for you. I was just wondering if any change in strategy here?

[Peter Clifford:]

We continue to be opportunistic there. I mean, I think how we would describe it is our North American OEMs are really stabilized after 1 or 2 large OEMs sort of exiting sort of the reuse piece. So I think we have got a steady North American base now at work and we continue to find niches internationally to get some modest growth in that division. So obviously, again, it’s not a core focal point, but we do understand that we don’t have a lot of structural cost attached to that division. So anytime we can get even modest growth, the flow through to the bottom line is pretty important so…

[Mitra Ramgopal:]

Okay. That’s great. Thanks again for taking the questions.

[Jorgen Hansen:]

Thanks, Mitra.

[Operator:]

Thank you. Our next question comes from the line of Raymond Myers with The Benchmark Company. Please proceed with your question.

[Raymond Myers:]

Thank you. Let me first ask about the Endoscopy business that was very strong, what drove the high operating profit margin in Endoscopy in the quarter and how sustainable is that?

[Peter Clifford:]

Yes, I think a couple of things. So we continue to purposely drive mix within the business, right. I mean, outside of BHT and again acquiring 100% capital business, the core business is still growing faster in our higher margin product line, so procedural products and chemistry obviously are accretive to the divisional average. So, they continue to have that nuance to the mix. We are going to continue to see some margin upside in that division. As we have said before, I don’t think we are at entitlement from a gross margin perspective in that business. And then I think as we have stated over the last 1.5 years or so, we made some important investments and that’s internationally and domestically within Endoscopy to build out the infrastructure and now it’s time to optimize. So you are seeing, I think that team optimize the pretty meaningful investment that we have made in over the last 2 or 3 years.

[Raymond Myers:]

Good. And on the theme of optimizing investments, can you discuss what benefits you expect to receive from the $0.03 to $0.04 of EPS that you are investing this year?

[Jorgen Hansen:]

Well, in terms of growth, we really look at this from sort of a longer perspective that the main investment is going into accelerating our R&D pipeline. We have some very – we believe very exciting in technology platforms that we are now able to rollout more broadly across our company segments. So, I think that’s the biggest piece. The two other segments is more about actually providing platform where people can function and have good work environment, effective work environment. And as I mentioned before, we have grown really rapidly and we would be able to provide some better opportunities for our team members to do the job going forward with some of the investments we are making. So a mix of I would say growth and a mix of supporting growth, if you think about like that.

[Raymond Myers:]

Okay. And you mentioned two new products that were recently cleared can you give a little more information about those? And is that the fruit of some of this increased R&D and what other R&D investments – what other R&D benefits might we expect in coming quarters?

[Jorgen Hansen:]

Yes, that’s a good question, Ray. I mean, I mentioned the ADVANTAGE Pass-Thru AER that we just got 510(k) clearance for the U.S., this is a technology that we have developed internally. We launched the product probably 18 months ago in Europe where the market is a pass-through market. I think we discussed in our previous calls we really have a set of where we have a clean side and dirty side in the GI suite. That’s the gold standard in most Western European countries and in many markets in Asia and we are now able to take this technology into U.S. and start to offer a new higher end infection prevention solution to our U.S. customers. So, we are excited about that technology and it has been a major effort for our R&D team to get this particular product ready. The Eon is a new generation portable reverse osmosis water system that is predominantly sold into the hospital. It’s a higher volume product, the high margin or higher margin product and we are – we are very excited about being able to compete even better in that segment going forward. So, when you think about the future, we will continue to invest in both capital and consumable products. We have some good technologies, proprietary technologies that we are filling on from a capital equipment side and then we have other initiatives to drive some of our consumable products that we’ll talk about in the quarters to come as the products get ready for market launch.

[Raymond Myers:]

Great. I think on the call you mentioned your backlog declined by $5 million, could you say what the backlog was? And also, what’s the – can you elaborate on the reason for the decline?

[Peter Clifford:]

Yes. Just the softness was candidly in our medical water segment and we did see some strength in our specialty water and REVOX franchises, which partially offset some of that softness, but our backlog as we ended the quarter was about $65.4 million.

[Raymond Myers:]

Great. And last question is can you touch upon your outlook in appetite for further acquisitions?

[Seth Yellin:]

I think our appetite for acquisitions remains unchanged. Ray, I think that M&A remains a key part of our overall strategy and I think we will look to continue to acquire new technologies and new platforms that are complementary to our existing franchises or add new verticals in our portfolio. We have good capacity in our balance sheet and from a leverage perspective to be able to continue to do to execute acquisitions and we will continue to do so when we feel pretty optimistic about the health of our pipeline and the opportunities we see ahead of us.

[Raymond Myers:]

That’s great. Thank you.

[Jorgen Hansen:]

Thanks, Ray.

[Operator:]

Thank you. Ladies and gentlemen, there are no further questions. And this concludes our question-and-answer session and our call for today. Thank you for your participation. You may now disconnect your lines.