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Cantel Medical (NYSE:CMD)
Q3 2018 Earnings Conference Call
May. 31, 2018 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings, and welcome to the Cantel Medical Corp. third-quarter 2018 earnings call. [Operator instructions] It is now my pleasure to introduce your host, Milicent Brooks, head of corporate communications at Cantel Medical. Thank you, Ms.

Brooks. You may begin.

Millicent Brooks -- Head of Corporate Communications

Thank you, Doug, 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. Early this morning, the company issued a press release announcing the financial results for the third quarter of fiscal year 2018. In addition, we have post we have posted the supplemental 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 measures, 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'm pleased to introduce to you Jorgen B. Hansen, president and CEO.

Jorgen Hansen -- President and Chief Executive Officer

Thank you, Milicent, and welcome, everyone. I'll start off with some brief opening comments, followed by Peter, who will take us through our third quarter 2018 financial results. Finally, we will open the call for Q&A. We are very pleased with our results this quarter.

We grew reported sales by 13.1%, with 7.6% organic growth. Our three major segments performed well despite headwinds related to timing of shipments and tough comparable growth in selected markets versus prior year. In addition, we closed a highly strategic acquisition, which adds new capabilities to help drive growth in the midterm. Endoscopy sales grew by 18% with organic growth of 8.1%, driven primarily by procedural products, services and chemistries.

Despite new entrants into procedural products space, this category provided another quarter of solid opportunity growth rates. Total recurring revenue was up 16.1% in the quarter, which was slightly offset by [Inaudible] due to difficult prior year comparable sales. In March, we closed our acquisition of Aexis Medical, which addresses an important customer need for tracking, documentation and analyzing reprocessing workflows to drive best-in-class infection-prevention processes. This platform increases the value of our unique full circle of protection that we currently offer to customers in the GI suite as well as providing a meaningful expansion opportunity into the Central Sterile Department and Operating Room.

Water Purification and Filtration recorded revenue growth of 9.2% for the quarter, led by strong results in chemistry, consumables and service. Orders [Inaudible] specifically medical water, were down this quarter, partially due to one of our key customers moving to water dual-source approach. Strategically, we are expanding into new adjacent, higher-margin technologies in markets and distribution. As an example, we shipped two of our REVOX low-temp sterilization systems in the current quarter to one of the world's leading medical device manufacturers, and we're excited about the future opportunities in this new emerging business segment.

Revenue in our healthcare disposables segment increased by 6.5% with organic growth of 7.3%, which is approximately 2x the market, driven by demand for our branded -- strategic branded portfolio, which grew 9%. This category was led by water -- our waterline disinfection and mask franchises. From a geographic perspective, our international operations continued the high growth story, with sales increasing 25.6% year over year led by Germany, Australia, and China. This includes the impact of the acquisition of Aexis Medical in Belgium, the BHT Group in Germany and our Australian distributor.

International organic growth was up 3.6%, impacted by difficult comparables in the prior year of record capital sales in the U.K. U.S. sales were up 9.2% and 8.9% organically versus prior year and performed well across all business segments. With that, I will hand over to Peter to discuss the financial results.

Peter Clifford -- Chief Financial Officer

Thanks, John. Good morning, everyone. Let's take a few moments to walk through the 3Q '18 financial results. On a consolidated basis, our top line net sales increased 13.1% year over year in 3Q '18 versus the prior year and 11.6% on a constant currency basis.

The consolidated net sales walk elements were: organic came in at 7.6%, M&A came in at 4% and FX was a tailwind of 1.5%. Gross margins for the quarter. GAAP gross margins expanded by 60 basis points to 48.2% versus the prior year of 47.6%. Non-GAAP gross margins expanded by 40 basis points year over year.

Although when adjusted for the segment recast and dilution from BHT, we expanded our core 150 basis points operationally year over year. Operating expenses for the quarter. GAAP operating expenses increased by $13.6 million or 21.3% in 3Q '18 compared to the prior year. The impact of acquired costs from acquisitions was roughly $3.8 million or 6%.

Note, we had $3.5 million of one-time expenses related to a legal settlement and business optimization. The balance was purposeful investment in line with our strategic plan initiatives. Operating profit for the quarter. GAAP op profit decreased 1.4% year over year to $27.1 million, while our non-GAAP op profit increased 10.1% year over year to $36.3 million.

Our quarter effective tax rate on a GAAP basis, the overall ETR for the quarter was 26.7% as compared to the prior year rate of 33.6%. The impact of the federal statutory rate change provided a benefit of approximately $2.1 million during the quarter. This was partially offset by state taxes. On a non-GAAP basis, our non-GAAP effective tax rate came in at 28.3% as compared to the prior year of 33%.

Again, the key driver for the impact of federal statutory rate change provided a benefit of approximately $2.8 million during the quarter, again, partially offset by state taxes. As we look forward to the balance of the year, based upon our current geographic composition of profits and information available, we anticipate that our non-GAAP full-year rate as well as our rate for the fourth quarter will be around 28.5% to 29%. Note, we intend to reinvest approximately $0.03 to $0.04 of the tax benefit in 4Q '18. We will provide guidance on how to model the reinvestment for fiscal year 2019 on our fourth quarter earnings call in September.

EPS for the quarter. GAAP EPS increased 7% year over year to $0.45, while our non-GAAP EPS increased 16.6% year over year to $0.60. Adjusted EBITDAS for the quarter. Our 3Q adjusted EBITDAS came in at $43.6 million, up 12.3% year over year, while our adjusted EBITDAS for the last 12 months was $176.4 million, up 14.8% year over year.

Our 3Q cash from operations came in at $35.3 million, up 24.5% year over year. Now let's provide some insight into the segment results. For Endoscopy segment for the quarter, sales grew 18% year over year to $118.4 million. Our organic was 8.1%.

Our GAAP op profit increased 10.8% to $20.5 million, while our non-GAAP op profit increased 22.6% to $26.3 million, providing strong leverage. For our Water segment, for the quarter, sales grew 9.2% year over year to $52.3 million. Organic was 8.9%, driven by strength of the backlog. Note our backlog did see compression of roughly $3 million during the quarter, driven primarily by our medical water business, offset by modest increases in our non-core specialty water business.

GAAP op profit increased 7.8% to $8.5 million, while our non-GAAP op profit increased 11.7% to $9.3 million returning to a leverage profile. For our HCD segment for the quarter, sales grew 6.5% year over year to $38.5 million. Organic was 5.3%. Our GAAP op profit increased 18.7% to $7.6 million, while our non-GAAP op profit increased 16.1% to $9 million, again, providing strong leverage.

For our dialysis segment for the quarter, sales expanded 4.9% year over year to $8 million, and our GAAP and non-GAAP op profit decreased by 23%. Now I'd like to hit a few balance sheet and liquidity details. Our balance sheet remains very strong with significant capacity. We ended the quarter with $51.9 million in cash and cash equivalents, $177.1 million in working capital.

Our gross debt ended the quarter at $169 million. This includes $82.3 million of borrowings this year to fund the acquisition of BHT and Aexis Medical. And we paid down debt at $12 million in 3Q '18. Our net debt is $117.1 million, and our net debt to adjusted EBITDAS is 0.66.

Capital expenditures were $10.3 million. As we have signaled previously, capex will remain elevated for the next four to six quarters to support our ERP implementation project. As a reminder, we will be filing our 10-Q tomorrow. I will now hand the call back to Jorgen for closing remarks.

Jorgen Hansen -- President and Chief Executive Officer

Thank you, Peter. Overall, we are very pleased with our performance this quarter, the positive trajectory of our business and our strong competitive positions in the markets we serve. Looking at our M&A pipeline, we are encouraged with the opportunities we see across all of our divisions as well as near adjacencies in life sciences, chemistries and other key strategic areas. We are optimistic that we'll have more to share on acquisitions over the next several quarters.

Furthermore, we are pleased by the strength of our new product development pipeline. We recently launched DEFENDO FUJI valve. That is the only single-use valve for high-volume FUJI source. This new innovation addresses an unmet clinical need for infection reduction and importantly will improve the experience of both patients and clinicians during procedures.

This product introductions, coupled with the recently launched Advantage Pass-thru Automated Endoscopy -- Endoscope Reprocessor and our EON Portable Reverse Osmosis, our old water purification system, will continue to enhance our market leadership position in fiscal year 2018 and beyond. Taken together, we expect to continue to perform in line with our 5-year strategic plan objectives to drop of sales and profits by 2021. As demonstrated this quarter, this would be achieved by our new product development, market expansion, strategic acquisition supported by continuing evolution of the Cantel operating model. With the benefit of the tax legislation changes, we anticipate fiscal year 2018 non-GAAP EPS of $2.47 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. In our earnings call presentation, we have included a chart to help model the estimated tax rates for fiscal year 2019. This tax benefit would accelerate plans we already had in place to invest additional resources in both the business and our team members. These plans include advancing new product development, enhancing total roster for use and accelerating facility expansion to support our growth.

As an example, we recently committed to a new building in Minnesota to a white space, capacity and drive process efficiency as we continue to grow and add talent. In closing, I would like to thank our 2,500 loyal and hard-working team members for their efforts and achievements this quarter. Our entire company takes great pride and 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 fourth quarter earnings call in September. Doug, we're now ready to take questions.

Questions and Answers:

Operator

[Operator instructions] Our first question comes from the line of Mike Matson with Needham & Company. Please proceed with your question.

Mike Matson -- Needham & Company -- Analyst

Yes. Thanks for taking my question. I guess, just wanted to start with the endoscopy business. I think the slides mentioned, there was a difficult comp in the U.K.

Can you just talk about what caused that? And can you quantify the impact of that at all?

Peter Clifford -- Chief Financial Officer

Yes. If you think back to our prior year in the U.K., we probably only shipped about 25% of our AERs in the first half of the year with the bulk coming in the third and fourth quarter of last year. So we had a very capital intense third and fourth quarter in the U.K. and it was heavily slanted toward the third quarter.

To give some perspective, our EMEA business would have grown 7% organically if we excluded the U.K. business. So it was much stronger than the reported 3.6%.

Mike Matson -- Needham & Company -- Analyst

OK. And then you'd also mentioned that capital growth was normalizing in the U.S. Can you explain what that means?

Jorgen Hansen -- President and Chief Executive Officer

Yes. So this is Jorgen.

Mike Matson -- Needham & Company -- Analyst

Hi.

Jorgen Hansen -- President and Chief Executive Officer

If you think back to -- well, a few years back to '11 and '12, and '16 and '17, we had really a windfall in capital related to recalls in the market, and was selling capital and really elevated levels in the U.S. And that is now, I would say, back to more of a normalized growth level. Just as an example, we sold up to 1,000, 1,100 machines in the U.S. in '16, '17, and that's now down sort of in the 600 to 700 level, which is still a very nice growth rate when you look at the business long term.

And we're still winning market shares every day out there, and we're defending and growing our sort of 2/3 market share. So it's just more like getting into a more regular nonevent impacted business in endo.

Mike Matson -- Needham & Company -- Analyst

OK. That makes sense. All right. And then just one more on the water business.

So it's continuing to see kind of this high single-digit organic growth. I know you've talked about that kind of being a mid-single-digit business over the longer run. But what's driving a higher growth? And is it sustainable? And then you mentioned this medical device kind of opportunity in that business. Can you maybe talk about that? And that's all I have.

Peter Clifford -- Chief Financial Officer

You want to take REVOX? And I'll take --

Jorgen Hansen -- President and Chief Executive Officer

Yes. Yes, so I mean, just if you think about the water business, it is a sort of a mid-single-digit business longer term. And it's quite cyclical if you look at the longer-term trend onboard or we've had years where the business was flat. And we had years like this where we had close to 10% growth sort of averaging around high 6% growth.

What we are talking about is that we are starting to see growth drivers and other things than our traditional medical water business. We sold a couple of our REVOX low-temp sterilization systems this quarter into one of our leading manufacturers for medical devices. And we're starting to build a meaningful pipeline in this product, which is really providing another technology, great margins and also a great consumable stream, as we develop this business. So still early stage, but interesting things going on there.

And likewise, we have other businesses under our water segment. Chemistries, we see good development there and also filtration. So a lot of interesting things going on to create a sustainable long-term growth path for our water business.

Peter Clifford -- Chief Financial Officer

Thank you.

Operator

[Operator instructions] Our next question comes from the line of Larry Keusch with Raymond James. Please proceed with your question.

Larry Keusch -- Raymond James- Analyst

Hi. Good morning, everyone. So I just wanted to start with Endoscopy. So relative to our model, Endoscopy was really the big variance.

Everything else came in at or above what we had been anticipating. So I guess the question is, it sounds like to the extent that there were any tough comps. It was primarily in capital. You clearly knew about that tough comp.

So I guess the question is, relative to your expectations, how did endoscopy capital come in and to the extent that it was a little bit lighter, where potentially was that? Where was that coming from?

Jorgen Hansen -- President and Chief Executive Officer

No, I would say that -- yes, it's a great question, Larry. I mean, the endo sales of all came in very much as we expected. And we have had a good line of sight into the capital comps. I would say, if we talk about the U.K., it was probably a little lighter than we had hoped for.

The NHS are really holding back on spending in the U.K. right now. So that impacted our ability to really push a little hard on capital in the U.K. market.

I'd say, the U.S. is very much in line with expected. Again, we have a very strong pipeline. But as it is with cancer business, it really depends on our customers' ability to pickup sales.

So we do know that some orders were pushed from the third quarter probably into the fourth quarter and even into next year as a natural cycle. So I'd say, in conclusion, very much a performance in line with what we expected for the quarter.

Larry Keusch -- Raymond James- Analyst

OK. And then one more on that and just a couple of other very quick ones. But -- so it sounds like there was a timing of order issue or at least observation within this quarter. So maybe some of that falls in the fourth quarter as you talked about it or into next year.

You still have a lot of international expansion opportunity. You still have opportunities for procedural products growth in the U.S. and OUS, etc. So there still seems like there's a lot of opportunity to continue to grow this global business at healthy rates.

So is it still fair to look at the business longer term as kind of this 10% low double-digit grower? Or should we be thinking this quarter sort of suggest that perhaps the growth is decelerating some?

Jorgen Hansen -- President and Chief Executive Officer

It's a great -- you made all the right points, Larry. I mean, this is -- there's a lot of opportunity in this business, particularly on our procedural side. We are probably penetrated 28% to 30% in the U.S. and the procedural product penetration OUS, as you know, is much smaller.

In addition, we think that the market -- underlying market is very sound. I'm sure you -- I know you put out a piece on the new guidelines from the American Cancer Society yesterday, moving the screening recommendation from 50 to 45, which meaningfully expands the market and also something that we see as an upside long term. It's not going to change the market tomorrow, but it will help continue the opportunity for us to grow this business in a meaningful manner. So I certainly -- we still feel that with the international opportunities with the good changes that we see in the U.S., with the competitiveness of our product portfolio, we will be able to grow this business in sort of the low double-digit range longer term, but we will have quarters like this, where capital may be a little low or other things are impacting.

So it's not going to be every single quarter. That's for sure.

Larry Keusch -- Raymond James- Analyst

OK. Perfect. Understood. Last two from me.

Just on the guidance. What's changed in the organic revenue and M&A guidance outlook for the year? And again based on our model, it would seem to imply that you're looking at mid-single-digit organic growth in the fourth quarter. And again, just want to see if we're thinking about that correctly? And if so, why would that be the case?

Peter Clifford -- Chief Financial Officer

Yes. Larry, our range sort of as you know, implies sort of a two 23 to two 27 in the fourth quarter. And what's different than 9 to 12 months ago when we came out the original guidance is we've articulated on the last couple of quarters, our water business, good or bad, we can see out a couple of quarters with the backlog. And we've been signaling the last couple of quarters that there's been some compression in the backlog there as the business is lumpy and it does have a cycle to it.

So as we think about the fourth quarter of last year, our water businesses really started to accelerate. We were just over $51 million of revenue last year in the fourth quarter. So that's a comp that's going to be meaningfully tougher with the compression of the backlog. And then as Jorgen said, I think the one difference is probably U.S.

capital is a bit softer than we suspected. And I think internally, we've gone back and looked at literally the last 10 years of AER sales. And as Jorgen was articulating, there is a nuanced pattern that seems to be there in the '11, '12 bubble and in the '16, '17 that really the two years coming out of both of those upticks. You can really see there's been more than a pull-ahead effect, where the two years following those bubbles, the business has been pretty flat on capital.

I think honestly that's probably what we didn't see when we started the year that we're seeing as we get to the back half of this year on the endoscopy business is that U.S. capital is going to be a little bit tougher environment than what we anticipated. We still think the prospects long term are how we've thought about the business of 5% U.S. capital growth is it sustainable.

But we do think coming out of these issues on the recalls that it does seem to bring a nuance for two years worth business is sort of in that 650 to 750 annual units and is more flattish than necessarily typical 5% growth.

Larry Keusch -- Raymond James- Analyst

OK. Perfect. Thanks very much, guys.

Operator

The next question comes from the line of Mitra Rampogal with Sidoti. Please proceed with your question.

Mitra Rampogal -- Sidoti -- Analyst

Yes. Good morning. Just a couple of questions. Just regarding R&D, obviously, increased sequentially and definitely year over year.

I was wondering if it's already reflecting some of the tax reinvestment?

Peter Clifford -- Chief Financial Officer

I would just say, we've had a mission all year to try and purposely invest more in R&D than we historically have had. I would argue in the first half of the year, there wasn't really much of an impact. In the third quarter, I think there were projects that we more forcefully leaned on, knowing that we would likely have some air cover with the tax benefit. And I think you'll see more of that more forcefully this quarter here.

Mitra Rampogal -- Sidoti -- Analyst

OK. Thanks. And in terms of how you are viewing your growth opportunities going forward and getting to your 5-year target? I think if you look at organic growth this year, it looks like it will be the lowest versus what we've seen over the last few years. And I was wondering if you feel there's something that you could do to really improve that? Or you probably go to be more aggressive on the acquisition front to make up for it?

Jorgen Hansen -- President and Chief Executive Officer

Well, I think as mentioned earlier on this call that we're still very optimistic on the business. We have great end markets and we have growth -- we have great long-term growth opportunities. And obviously, as you know, coming out of many quarters, more or less since we launched our strategic plan in '13 with very solid organic growth. So I don't really -- we don't believe that we will depart too much from that.

We still are very bullish on our product pipeline. We have made lots of investments in our commercial teams and have great confidence that they will continue to deliver. And we do see great opportunities in the M&I -- M&A. I don't know if you want to add anything, Seth, on the M&A side.

Seth Yellin -- Executive Vice President, Strategy and Corporate Development

No. I think from the acquisition perspective, we're pretty happy with where we're at in the pipeline overall and the opportunities we see in front of us, both in our existing businesses and in near adjacencies that we think could be good long-term growth drivers for the company with new technologies and new markets that could be really interesting drivers for us in the medium to longer term as well.

Peter Clifford -- Chief Financial Officer

I would just echo that. I think the pillars are still the same. When you think of the endoscopy business, there is still a meaningful part of the procedural products market that is there to be penetrated. We're not alone anymore in that space, but we've got a commanding share position and the best products.

We still have a conversion issue on the reuse chemistry machines in the U.S. We're going to rotate out to a singleshot chemistry. We still got geographic expansion, really low share position outside the U.S. and capital on our endoscopy business.

And we still have a plenty of runway to acquire and grow differentiated products in the HCD space, which we've been doing over the last couple of years, so that continued pivot from private label to branded and continued growth of organically of acquired products into that basket. I think, it's still exactly the same as before. I think, again, we've got a endo capital issue that we're running our way through, but that's temporary. And we see the growth rates again returning to, as we thought about the business, 5% sort of U.S.

capital. And outside the U.S., our ambition is to try and grow that capital number 2x that.

Seth Yellin -- Executive Vice President, Strategy and Corporate Development

And just to add to Peter's comments, I mean, if you think about new products, you can almost include Aexis Medical, the information analytics company, because it's still a fairly small business that we haven't even launched in the U.S. yet. And information analytics and data capture and big data is a theme everywhere and is a theme from our customers that we are talking to them about every single day, and that's an example of a business that should grow with many times over the next several quarters and years going forward. So -- and obviously right now, it's dilutive from an investment perspective, but can almost be thought about as a product launch.

Mitra Rampogal -- Sidoti -- Analyst

OK. That's great. I guess, I'll just follow-up quickly on the Aexis Medical acquisition and if you could maybe -- Seth, if you can just give us a sense of the market maybe overall or international versus domestic, etc. anything would be helpful?

Seth Yellin -- Executive Vice President, Strategy and Corporate Development

Yes. I think that the market and the demand for a information solution and workflow -- reprocessing workflow is high. I mean, I don't know if I want to characterize the market size right now. I think it's a very developing market.

But as we speak, it's a rapidly growing. Certainly, this is a product that has a leading solution for track and trace, documentation and then the ability to provide additional analytics around reprocessing workflows. Historically, this business has been focused primarily in the Center Sterile Department and OR solutions, the scheduling and tracking and tracing in hospital partners in Europe. But they have also quite good products that are applicable to the endoscopy space, and we see the opportunity really to marry this with our overall endoscopy portfolio and then provide us also greater access to the Central Sterile Department, which as we've spoke about many times, central sterile remains a core category or core market that we see good opportunity for continued growth for our overall business, and this would be a good entry point for us.

So we're quite optimistic about the potential of this acquisition. For sure, it is an early stage business that has been fairly limited, but we think it has best-in-class technology and represents an attractive opportunity for us to drive growth in both our existing endoscopy portfolio as well as to provide an access point and growth opportunity in the broader hospital central sterile space. So real optimistic and enthusiastic about the potential this embarks for us.

Mitra Rampogal -- Sidoti -- Analyst

OK. Thanks again for taking my questions.

Seth Yellin -- Executive Vice President, Strategy and Corporate Development

Thanks, Mitra.

Operator

There are no other questions in the queue. I'd like to hand the call back to management for closing comments.

Jorgen Hansen -- President and Chief Executive Officer

Well, thank you for joining the call. I look forward to speaking to you at our fourth call -- quarter call in September. Thank you.

Operator

[Operator signoff]

Duration: 30 minutes

Call Participants:

Millicent Brooks -- Head of Corporate Communications

Jorgen Hansen -- President and Chief Executive Officer

Peter Clifford -- Chief Financial Officer

Seth Yellin -- Executive Vice President, Strategy and Corporate Development

Mike Matson -- Needham & Company -- Analyst

Larry Keusch -- Raymond James- Analyst

Mitra Rampogal -- Sidoti -- Analyst

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