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Cantel Medical Corp. (NYSE:CMN)

F1Q10 Earnings Call

December 9, 2009 11:00 am ET

Executives

Andrew A. Krakauer – President

Charles M. Diker – Chairman of the Board

Craig A. Sheldon – Senior Vice President & Chief Financial Officer

Roy Malkin – President & Chief Executive Officer of Minntech

Steven C. Anaya – Vice President & Controller

Analysts

Dalton Chandler – Needham & Company

Jeffrey Cohen – C.K. Cooper & Co.

Mitra Ramgopal - Sidoti & Co.

Operator

Welcome to the Cantel Medical Corp. first quarter earnings conference call. (Operator Instructions) It is now my pleasure to introduce our host, Andrew Krakauer, President and CEO of Cantel Medical Corp. Thank you. You may now begin.

Andrew Krakauer

Thank you and welcome to our first quarter fiscal year 2010 conference call. Before we start 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 limitations 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.

Okay, with that said again good morning to everyone. With me today on our call are Chuck Diker, Chairman of the Board; Craig Sheldon, Senior Vice President and Chief Financial Officer and Treasurer; Roy Malkin, President and CEO of our Minntech subsidiary; and Steve Anaya, VP and Controller of the company.

Cantel Medical reported another outstanding performance in the first quarter of fiscal year 2010. In fact the company has now reported eight sequential quarters of improved earnings results and this quarter set all time financial performance records for the company. We reported first quarter earnings of $0.37 per share compared to the prior year’s first quarter earnings of $0.20 per share. This represents an 85% increase in net income.

As we pointed out in our press release, while all of our reporting segments showed improved gross margin and operating profit in the quarter this remarkable performance was significantly impacted by unusually high demand for our face masks driven by the H1N1 outbreak. I would like to thank all of our loyal and hard working employees for their great efforts and achievements again this quarter. These results reaffirm our overall strategic business direction, the rising importance and awareness of infection prevention and control in general, the effectiveness of our managers and staff and support our continued optimism about the future of Cantel with or without atypical demand for any one particular product.

Before I turn it over to Craig to discuss some specific financial details, I will briefly review the major operating segments.

Our best performance for the quarter was in Healthcare Disposables, where on a 31% increase in sales, operating profit increased by 145% over the prior year’s first quarter. This success was primarily driven by increased sales of face masks, hand sanitizers and surface disinfection wipes as a result of the pandemic nature of the novel H1N1 virus. Our Crosstex subsidiary is one of the largest US based manufacturers of FDA cleared face masks and while a virus such as the novel H1N1 is tough to predict and its status can change very quickly, the CDC has recently indicated that the influenza activity has begun to decrease in the United States and as a result we anticipate that the previously elevated demand for face masks is now returning to normal levels for now.

However, we are working on a number of activities to grow this particular product area including our very active alternate channel program that offers solutions to businesses and public entities to be properly prepared for any pandemic outbreak which of course would include having an adequate supply of face masks. We are also working with federal and state officials as they plan for proper stockpiling of face masks although at this time they have not placed any orders.

Additionally during the quarter we launched our new antimicrobial coated face mask outside of the United States. Our BIOSAFE brand coated mask offers tangible advantages to users and while we are still waiting for specific guidelines for the FDA to allow for sales in the United States, we have received great interest in this new product in a number of international markets.

In an effort to isolate the impact of this H1N1 driven uptick for us we estimate revenue in our healthcare disposables segment grew organically between 3-5% in the quarter which is above the basically flat dental market growth rate and this success is attributable to our substantially increased investments in sales and marketing.

Our endoscopic processing business which has performed well for all of fiscal year 2009 started fiscal year 2010 with another great, strong performance. Sales grew by 19% in the quarter as shipments were higher in all categories including equipment, consumables such as disinfectant cleaners, as well as service parts and accessories. Growth in equipment sales was particularly positive in light of the lingering weakness in hospital equipment purchases generally.

Another positive note was our substantial success in all product categories in markets outside of the United States. I continue to be impressed with the achievements of our direct hospital sales and service force in the United States. In this fiscal year we are continuing to invest significantly in sales, marketing and service resources to continue growing the business. We are optimistic as we have started to see good customer acceptance of our new, state of the art Advantage Plus machines with a new single use peracetic acid-based chemistry. We are also excited about the prospects for our internationally launched, mid-range single use chemistry reprocessor, the DSD [Etch] which is now approved throughout the world except in the United States where we are waiting for feedback from the FDA on our initial submission.

On a different subject, since last week we have received several requests from analysts and investors for information concerning our recent notice issued by the FDA in reference to the continued use of Steris’ System 1 Endoscope reprocessor, a competitive product to ours. At this time it is unclear what Steris customer reaction will be to the FDA’s guidance to employ alternative methods for their hospital’s device reprocessing needs. Judging from initial hospital inquiries to us we expect to gain some additional business but we can’t predict how much incremental sales we will obtain at this time. I will certainly have more information next quarter to talk about with what is going on in the marketplace related to Steris.

In the dialysis segment, as expected, sales declined primarily due to reductions of low margin dialysate concentrate shipments mostly in the U.S. Nevertheless with the continued strength of our worldwide reuse business including Renatron automated reprocessing equipment and Renalin Sterilant and with the expert management of manufacturing and distribution costs, operating profit actually increased by 31% in the first quarter despite the 10% decline in sales, a great importance.

Our water purification and filtration segment performed well this quarter as well. Sales were higher by 2% but operating income was higher by 23%. This performance is similar to the way our Marco Water Purification and filtration business is performing over last year. That is, steady profit improvement despite weakness in capital equipment sales due to the economy. We have been significantly growing our sales of higher margin parts, sterilants and filters and expanding our service revenue.

This mix shift has been one of the key strategies for the water purification business and this success has more than offset the continued softness in capital equipment sales and the net effect is that gross margins are improving. I remain positive about the future of our water purification and filtration business and we have demonstrated our capability to find growth and improved margins despite the challenges of the economic slowdown. We are also seeing a pickup in quotation activity in our capital equipment area and I am optimistic that this side of the business will improve by mid-year 2010.

Additionally in this segment we have successfully launched new products this year and have more in development. Last quarter we discussed the success of our new Teflon distribution loop system for dialysis clinics. This success of our now branded Micro Free Distribution Loop System continues to grow. We have also begun shipments of our actual peracetic acid product which is a proven sporacidal surface disinfection chemistry to be used for clean room disinfection at a major multi-national pharmaceutical company.

Further, I am very pleased with the integration of our recent Los Angeles, California based acquisition G.E.M. Water Systems. Our customers have welcomed the combination of G.E.M.’s products with Marcor’s service network. We have already brought in a new West Coast Service Leader and have just opened a branch office in San Francisco so we are expanding our business in the west coast, helped by this acquisition.

We will continue to look for synergistic acquisitions in the water purification area and new products and to expand our service coverage in the United States. That concludes the four major segments. Let me turn it over to Craig who will discuss some of the financial details and I will come back with a few summary comments.

Craig Sheldon

Thank you Andy. Good morning everyone. What I would like to do is move through the press release that was issued this morning and start with some comments on the income statement.

As you can see, sales were very strong in the first quarter and increased by 10.2% compared to last year’s first quarter. As Andy indicated before we had outstanding top line growth in the first quarter from both healthcare disposables as well as endoscope reprocessing. Gross profit, last year we continued to mention gross profit was one of the areas we wanted to focus on and you can clearly see the results in the GP area continue to be very, very strong.

Our gross profit percentage was 41.5% in the first quarter. That is well up from the 36.7% in last year’s first quarter and really an extraordinary 4.8 increase in gross margin points. 4.8 points. So very good performance. This GP percentage is the highest ever for our current business and represents the sixth consecutive quarter we have reported improvement in gross profit percentage compared to the immediately preceding quarter. This illustrates our continued efforts to improve sales mix and drive efficiencies.

So as we break down gross profit we really benefited from several key items. You will probably these as being somewhat carry-over’s from last year. Number one is very favorable product mix. We have had good sales of high margin products such as disinfectant and consumables and endoscope reprocessing, sterilants and filters in our water purification filtration segment and of course face masks and healthcare disposables. Additionally, the decline in dialysis sales is almost entirely in the area of our lowest margin domestic concentrated sales.

Number two, customer price increases in certain key product areas, some of them are carry-overs from last year. This coupled with a decrease in certain raw material distribution costs primarily due to the lower cost of oil and fuel compared to last year’s first quarter. Three, improved efficiency in our manufacturing, transportation and service functions. This includes the prior year relocation of our Dutch manufacturing operations.

So those really are the three primary areas. Obviously when you have a big increase in sales and you combine that with drastic improvement in gross profit percentage, what you are getting is an enormous overall pickup in gross profit dollars which increased by $5.8 million in the first quarter. That is up by 25% compared to last year’s first quarter. Certainly, our ability to sustain this level of gross profit percentage is highly dependent on many factors including overall sales volume, sales mix including the level of healthcare disposables products and the price of oil.

Moving down the income statement, take a quick look at operating expenses. They were extremely well controlled and we will continue to better leverage these expenses against incremental sales. Gross operating expenses increased by $1.7 million for the first quarter which is an increase of 9.5% compared to the prior-year quarter. This increase is concentrated primarily in two areas. Number one, variable expenses and stock compensation directly related to the strong performance of the company. Two, as Andy mentioned before planned investments in the selling and R&D areas including an increase in personnel necessary to pursue a number of strategic initiatives.

As we stated on the fourth quarter conference call a number of these initiatives within operating expenses are not expected to contribute to our sales growth this year but are clearly investments for future growth and we should see some of those benefits in fiscal 2011.

Looking at operating income overall reporting a 68% increase in operating income compared to last year’s first quarter and operating margins of over 14% for the quarter. Really a tremendous performance. This compares with operating margin of about 11% for the full fiscal year 2009. You only have to go back a few years when margins were below 10%. When the form 10-Q is filed tomorrow evening you will see that all of our segments turned in very solid growth for the first quarter.

Interest expense decreased by 44% in the first quarter compared to last year’s first quarter and this is a continuation of our pattern of quarter-to-quarter reductions. These decreases are reflective of continual repayment over the course of the past year and reduced interest rate. All of our debt is on LIBOR contract at very favorable rates extending well into fiscal year 2010 so we will be well protected as the year progresses. We will definitely continue to see meaningful reductions in both outstanding borrowings and interest expense throughout fiscal 2010.

A quick look at income tax, overall the effective rate was 38.2% in the first quarter which we believe to be a very normal rate. As I have mentioned in the past, due to the international scope of our operations, the uncertainty of future statutory tax rate changes and generally the overall complexity of the tax area it is extremely difficult to precisely predict what our future overall effective tax rate will be. However, having said that since the bulk of our income is generated in the United States where our effective rate in the first quarter was 38.1% and when we look back at the full fiscal year 2009 our US effective rate was 38.6%, we definitely feel very confident an overall effective rate of around 38% going forward should be achieved.

Moving onto the balance sheet, it continues to remain very strong. $23.1 million in cash and cash equivalents. Working capital was $32 million at October 31 which is down from $49.8 million at the end of July. The current ratio of 1.5 to 1 at October 1 which is down from 2.3 to 1 at the end of July. Now, it is very important to mention that the reduction both in the working capital as well as the current ratio is entirely due to the reclassification of our debt.

As we indicated at year-end the revolving portion of our debt of $20.5 million at the end of the quarter has now been reclassified to current due to the fact the expiration date of August 1, 2010 is now less than one year away. So of course according to the accounting rules we had to move that from long-term to current. We are in very active discussions with our banking syndicate about an amendment to this facility and we fully expect to complete an amendment in the spring.

Our funded debt was $38 million at the end of October. This is down from $43.3 million at July 31. Again, reflecting back two years ago, at October 31, 2007 and this was a point in time where we just completed three acquisitions, our outstanding debt was $70.5 million so our borrowings at the end of October was down by almost one-half over this two year period. In fact, we repaid $3 million just last week so today it is actually $35 million so it is exactly one-half of where our debt position was two years ago.

We continue to pay down significant levels of debt. We paid down $5.3 million in the first quarter and we expect at least this level of pay down or perhaps more during the second quarter. Our net debt was $14.9 million at October 31. This is down from $19.9 million at July 31. So this improvement in the first quarter is despite the fact that the first quarter is traditionally a very heavy cash usage quarter for the company.

Our gross debt to equity is just under 0.2 at October 31 and our gross debt to rolling 12-month EBITDAS is now well under 1.0, in fact it is 0.82 so very strong performance there.

A quick look at cash flow which is the third page of the press release, EBITDAS was $14 million in the first quarter which was 46% ahead of last year’s first quarter EBITDAS. Cash flow provided by operations was $6.5 million in the first quarter and free cash flow after deducting capital expenditures was $5.1 million. So every measure you look at demonstrates very strong cash generation capabilities.

As I mentioned a moment ago we will be filing our 10-Q on its normal schedule tomorrow evening. At this point I will turn the call back over to Andy for some closing remarks. Andy?

Andrew Krakauer

Thanks Craig. In summary this quarter has been a particularly great success for the company much of it driven by this atypical demand due to the H1N1 outbreak. Given the increasing levels of vaccine supply and the recent abatement in influenza cases, I anticipate a return to historic levels of purchasing for our face masks for now. We do not give specific guidance but I expect Cantel to return to a more normal level of business for now in general.

However, I do note this pandemic has raised global public awareness around the importance of infection prevention and control and we continue to see future opportunities ahead as healthcare professionals, governments and the general public embrace the seriousness and the need for greater attention to preventing the acquisition and transmission of infection.

Specifically on H1N1, obviously I cannot predict what is going to happen more than anybody else can. At the moment it seems to be abating but none of us can predict what is going to happen in the traditional flu season January through March. We know that there are a lot of people that are not taking the H1N1 flu shot because they are afraid to take it. Maybe nothing will happen or maybe it will mutate, or it could expand in the winter months. These are all future things that we will just have to wait and see what happens. For now our commercial channels have been satisfied with their supplies.

My take-away from this quarter is that Cantel has tremendous earnings capability in its portfolio. We did make $0.37 with the products that we have and sell. We are always looking for ways to maximize these opportunities whether they are short-term, medium or long-term. We will capitalize on these opportunities opportunistically just as we did with face masks in this quarter and the fourth quarter of last year.

More importantly we are proactively working to develop many more of these prospects and we will [go over that] whether it be more disposables or equipment or chemistry. We are continuing our initiative to increase the profitable growth of the company into the future. The main strategy for fiscal year 2010 is to substantially increase R&D and technology spending as well as our sales and marketing investments and continue our effective acquisition program. What we are talking about here are several million dollars of incremental investments which we believe are appropriate expenditures to make for our future growth.

Besides adding greater marketing and sales strength and coverage to various businesses, these investments are designed to greatly accelerate our R&D efforts in liquid chemical germicides, development of new equipment in water purification and endoscoping processing, accelerating our advancement of new and novel filter applications, increasing our efforts in the alternate channel development and aggressively looking for strategic acquisitions.

With these greater investments we hope to further accelerate the growth rate of the company in fiscal year 2011 and beyond. While we are making these investments for the future our base business is solid. Every segment is performing well with our focus on growing disposables, parts and service, which now make up 75% of our revenue and because we sell somewhat recession buffered products we have a solid base with cash producing businesses from which to grow.

On another note we were pleased to announce this quarter that Cantel was chosen by the S&P index selection committee to be included in the S&P Small Cap 600 Index. This is a significant positive statement about Cantel Medical. The criteria to be selected include many factors including specific earnings and trading volume guidelines but the net conclusion is that to be selected a company must have a market capitalization between $200 million and $1 billion and be investment grade quality. We believe this exhibits a certain value about Cantel that will make it more attractive to investors. Cantel is now also in the S&P 1500 Index as well.

Before I take any questions let me close by telling you we are still very excited about the prospects of Cantel Medical. We look forward to implementing our strategic growth plan that we are working on now and we are committed to profitably growing the company while serving our customers and benefiting our shareholders. With that, I will open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Dalton Chandler – Needham & Company.

Dalton Chandler – Needham & Company

Let me start by asking a little bit about your comments on the disposables business and your expectation it will return to a more normal growth pattern. First of all should we assume that is going to happen in the current quarter or do you think you have a little bit more unusual growth from H1N1? Secondly, you talked about 3-5% organic growth in the quarter. Is that what you expect it to return to?

Andrew Krakauer

Let me answer your second one first. We think at the moment until unemployment picks up and the dental market starts to resume its historical 3-5% growth that as we get organic growth of 3-5% in what effectively is a flat to down market that is a good rate for us on an organic basis. I think that is probably a good way of looking at our base business in healthcare disposables. As far as masks go, I would view the second quarter as likely and again I can’t be specific today. I don’t really know exactly and be a little more specific than we normally get but my best thought would be to assume we are at somewhat normal levels in the second quarter because while there is clearly some commercial business that is still being generated by some distributors, others are at full in their channel and may actually be slightly less than normal. So I prefer to think about it as a normal quarter for healthcare disposables.

Dalton Chandler – Needham & Company

You also had a really strong quarter in endoscope reprocessing. Can you give us any color on that and what you would expect going forward there?

Andrew Krakauer

I think in general we have continued to add resources in both sales and marketing in that business so we are getting better coverage. We have launched several new products and the sales force I think is just getting better. I don’t want to make any prediction other than I would be disappointed if we didn’t continue with at least some version of double digit growth.

Dalton Chandler – Needham & Company

On the pickup in the gross margin you did mention mix was a big part of that. As the disposables returns to its more normalized growth pattern, what do you think is going to happen to the gross margin?

Craig Sheldon

I think as a general statement, we have moved our business now for awhile to where we have about 75% consumable type products, consumables and service versus 25% capital equipment. As long as the capital equipment continues to not be quite at the levels we want such as our water business, we should be able to stay relatively close to the gross profit percentage but clearly I think it is a hard statement to make that these mask sales return to more normal levels it will be hard to be at that 41 plus percent gross profit percentage. We will probably be lower than that but we still expect to be very high. We definitely have a different business model than we had several years ago.

Dalton Chandler – Needham & Company

Any sense of when you might have the BIOSAFE mask on the market in the US?

Andrew Krakauer

I would say we cannot give an estimate there. We are still certainly months. Probably several months away from a submission to the FDA. Whether or not we get guidelines or not and that could take several months. The FDA is very unpredictable. It has been almost 3 years since they initially, we submitted recommendations to their guidelines for antimicrobial coatings for masks over two years ago. I don’t know the answer to that question. My guess is it is really a 2011 story, not a 2010 story as far as the US.

Dalton Chandler – Needham & Company

A final housekeeping question, can you give us the CapEx for the quarter?

Craig Sheldon

CapEx for the quarter was approximately $1.4 million which is very normal by historical standards and pretty much right on the money with what we spent last year in the first quarter.

Operator

The next question comes from the line of Jeffrey Cohen – C.K. Cooper & Co.

Jeffrey Cohen – C.K. Cooper & Co.

I have one housekeeping question and one other question. First of on the housekeeping side, could you discuss the common shares and diluted shares for the quarter?

Craig Sheldon

In terms of the gross number of those shares?

Jeffrey Cohen – C.K. Cooper & Co.

Yes.

Craig Sheldon

The diluted shares for the quarter were 16,768,000 and the basic shares were 16,650,000.

Jeffrey Cohen – C.K. Cooper & Co.

The second question is for this quarter and probably for what you project for 2010 overseas sales as a percentage of gross sales. Do you expect that number to increase? I know it has been around 20% if I am not mistaken.

Andrew Krakauer

I would expect it to be fairly constant. I am still expecting some significant success in the U.S. which will keep the percentage where it is even as we get successful in some areas internationally. For example that pharmaceuticals business I was talking about at the moment is starting out in Europe. But I hope to see the US growing as well. I would say it is going to be pretty much the same although I do believe international growth is an opportunity.

Operator

The next question comes from the line of Mitra Ramgopal - Sidoti & Co.

Mitra Ramgopal - Sidoti & Co.

As you go through the next couple of years I think right now about 75 % of the business is recurring because it is consumables. Do you see that moving up materially from here?

Andrew Krakauer

Let me just put it this way. I would not be unhappy if we were able to grow those businesses and develop the chemistry that would start moving that number beyond 75%. On the other hand, I would not be unhappy if our equipment sales start returning to significant growth as the economic conditions around the world improve. So if everything was growing and the equipment businesses were returning and we stayed at 75% I would still [still be happy] but I think in general I see that number probably still increasing a bit.

Mitra Ramgopal - Sidoti & Co.

You did touch on acquisitions. Looking at the balance sheet clearly you have the ability to go and finance something pretty sizeable. I don’t know if you could give us a sense of any areas or what I kind of the overall strategy is for an acquisition?

Andrew Krakauer

We are very actively looking for acquisitions led by Seth here. Let me just give you flavor. We are looking at several different areas. We would like to continue to add both products and service coverage in the water business plus with what we have just done with G.E.M. That is one. We are looking in general for acquisitions that could help us in our liquid chemical germicide businesses with products that can be sold throughout all the sales forces we have and all the different markets we have completed. And we also have a particular focus and are interested in companies that are in some ways related to helping us expand into the hospital business in general. So those are our big categories.

Operator

There appear to be no further questions. I would like to turn the call back over to the speakers for any closing comments.

Andrew Krakauer

Again thanks everybody for listening. I look forward to speaking to everybody on our second quarter fiscal year 2010 conference call in March. Thanks again. Goodbye.

Operator

This does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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