Cantel Medical Corp. (NYSE:CMN)

TMF1000 (99.81) Submitted: 10/17/2006 7:21:40 AM

Recs: 1

Using $0.50, which is the amount the company felt was a fair baseline to base future growth, we get a PE ratio of 25.40.

Cantel Medical truly had some bad luck. It may be the only company to lose a 55 year partner that represented such a large part of their revenues and earnings. This is pretty rare. It is not the same company, but that doesn't mean at today's price it won't be a good investment. The unknowns are high and I certainly wouldn't blame people who wanted to lighten their position.

When something this major happens there is room for irrational selling. This time, it appears that the selling was fairly orderly. The earnings drop was much lower than expected based on Olympus revenues. But other things happened to lower earnings too. They are trading at about the same PE ratio as they did from the beginning, only now earnings are lower as is the price.

In 2005, the company had five operation segments.

Dialysis, Endoscopy and Surgical, Endoscope and Reprocessing, Water Purification and Filtration and they group everything else in the “all other” category. When Olympus officially departed and Cantel Medical sold Carsen to them, it totally took the Endoscopy and Surgical business segment. This represented $41,469,000 in sales lost to them after this year. It also represented $10,004,000 in operating income.

Revenue breakdown for 2005:
Dialysis $65,457,000
Endoscope Reprocessing $30,278,000
Water Purification and Filtration $29,111,000
All other $31,087,000

Total sales in 2005 was $197,402,000

Olympus paid Cantel Medical for Carsen and fees for leaving them. I discussed that in earlier page reports. They used this money to build a cash reserve and keep debt at a fairly low level while buying Crosstex which targeted a new business segment – Dental.

Total Sales in 2006 from continued operations:
Dialysis $58,908,000
Dental $54,293,000
Water purification and Filtration $36,356,000
Endoscope Reprocessing $30,403,000
All Other $12,219,000

Total sales in 2006 was $192,179,000

The departure of Olympus affected other business segments too. It took over half of the “all other” other category. The number below show the difference in continued operations from this year and last without Olympus and Carsen.

Changes from this year to last from continued operations:
Dialysis: $58,908,000 from $65,457,000 (unaffected by the departure of Olympus)
Dental: New category: Reported sales of $54,293,000 up 10% from the numbers reported by Crosstex last year.
Water Purification and Filtration $36,356,000 up from $29,123,000 (mostly unaffected by the departure of Olympus)
Endoscope reprocessing $30,403,000 up from $28,677,000 (lost about $2 million from discontinued operations.
The 'All other' business segment reported sales of $12,219,000 down from $13,900,000. This segment lost about $8 million from discontinued operations.

Earnings per share from continued operations were $0.41 compared to $0.49 last year. There were some one-time events.

First the continuing operations (the only ones that investors will now be interested) were impacted by the initial costs of $500,000, net of tax, or $0.03 per diluted share to develop their direct endoscope reprocessing sales and service network in the US. (this is due to Cantel correct decision to do the job themselves rather than allow Olympus who left to continue to handle this business). If you remember, Olympus offered to continue to help Cantel with their direct endoscope reprocessing sales in the United States.

So, now continued operations provided about $0.09. Still not great; Last year this segment produced $0.16.

Stock compensation cost the company a penny. Remember too last year there was no option compensation expensed. So, let's subtract one penny from last year's results and add one penny to this year's results.

Now we get a comparison of $0.10 to $0.15. Still not great.
We can also subtract $0.024 cents from last year's results that was a one time sell of products that would not be repeated this year. So, arguably we can say the comparison is $0.10 to $0.126.

Higher tax rate costs them another $0.03, now we are up to $0.13 and taxes should equal out next year as will option expenses. Unfortunately, the other $0.03 was due to lower sales and lower average selling prices on dialysis products due to continuing consolidation in the industry. The company warned about this and it's was one of the risks I listed in past page reports. It is not good but not fatal.

They reported a total of $0.96 per diluted share counting both discontinued and continued earnings last year. Earnings per diluted share dropped 57% while the stock price 59.4%. Sales only dropped 2.7%.

Yahoo estimates:
Fiscal 2007 - $0.59
Fiscal 2008 - $0.75

The New Cantel Medical:

On August 2, 2006, the company began to sale and service Medivators brand endoscope reprocessing equipment, high-level disinfectants, cleaners and consumable throughout the United States using their own sales team. Last year Olympus distributed their products for them in the US. Cantel believed it was in their best interest not to renew the contract with Olympus. There may be more charges in the future from this ramping of their sales force in the US.

The acquisition of Crosstex on August 1, 2005 provided them with $54 million in sales which is about 28.3% of their revenues last year. This is a totally new market for them. Crosstex manufacturer and reseller of single-use, infection control products used principally in the dental market. The acquisition gives them over 60 categories of dental merchandise. These products are disposable so represent a repeat business for them. The products include face masks, towels, bibs, tray covers, saliva evacuators and ejectors, germicidal wipes, plastic cups, sterilization pouches and surface barriers, eyewear, disinfectants and cleaners and many other disposable items. It is believed they were a market leader in these products.

The Dental segment relies on four customers who collectively accounted for 48% of Dental segment net sales. Three of such customers, Henry Schein, Benco Dental and Patterson Dental each accounted for 10% or more of this segment's net sales during that period. The dental product field is a hot market because it's a play on the baby boomers aging and failing teeth. As baby boomers age, their teeth need more and more work. Single-use means repeat sales. I think the Crosstex acquisition will prove a long-term winner for the company.

Dialysis – another shoe could drop!

The murky area which we will learn more about at a later date is the recent consolidation in the dialysis industry. In May 2005, Fresenius Medical Care AG (“Fresenius”), the largest dialysis chain in the United States and a provider of single-use dialyzer products, announced that it entered into an agreement to acquire Renal Care Group, Inc. (“RCG”). RCG is a significant customer for Cantel Medical dialysis reuse products. It is probable that Cantel will lose RCG's business. Also, the acquisition of Gambro by Davita gives them more buying power that may cut the profit margins for Cantel Medical's products. Both Gambro and Davita are customers of Cantel Medical. According to the conference call they have not yet lost any business from RCG.

There are two problems with the Dialysis business segment. When Fresenius is the largest dialysis chain in the US and they are a provider of single-use dialyzer products and they bought Renal Care group with is a large customer of Cantel and they use reuse products. Cantel believes that eventually Fresenius will require RCG to changeover to single use products. So, far though, they have not lost this business and RCG continue to buy reuse products from Cantel. But this may not last. Fresenius represents 19% of the dialysis sales which includes RCG clinics. Conversion of RCG to single use would significantly affect this business segment. Most of RCG business is in the concentrate business which is less profitable than other portions of their dialysis business.

The reuse process is cheaper. And generally gives clinics a cost saving of $3.00 to $4.00 per procedure. I don't think there is any question the conversion will eventually take place. I feel it's certainly a risk to the business segment. Presently, RCG is continuing to buy both Renalog, Renalin and Renatron from Cantel Medical. Keep in mind that Fresenius manufactures single use products, so it is in their best interest to convert the RCG clinics.

Davita bought Gambro which made them a significantly larger customer. They have used the large size to get better pricing from Cantel Medical. Because of this, Cantel Medical has suffered lower average selling prices of their products which lower sales for this business unit. This was previously discussed and expected.

This business unit has some problems. Cantel Medical believes that the demand for dialysis is growing so that they will see growth in this area, even with the competitive pressures from Fresenius and their push for single-use dialysis products.

Water Purification and Filtration $36,356,000 up from $29,123,000 (mostly unaffected by the departure of Olympus). This one segment has done well. This segment is an important one for Cantel Medical. It started out a fairly small business segment when it was first acquired but has grown into a sizable part of their business. Dialysis require about 30 gallons of contaminate-free water per treatment. So this business segment compliments their dialysis business and should represent a growing source of repeat business.

A wild card is that a major customer of therapeutic filters had a major recall that had nothing to do with Cantel Medical filters. The FDA placed all their sales on hold so they were unable to sell Cantel filters. The recall is over and new orders should follow. This is a very profitable part of Cantel's business, so this could boost future quarters' earnings.

Conclusion:

The

TMF1000 (99.81) Submitted: 10/19/2006 9:22:05 PM

Recs: 0

Conclusion:

The valuation remains similar to when it was first recommended. I feel they are addressing some growth markets, but it will now take time to produce results. There will be events that will pressure the stock price. Almost without a doubt RCG clinics will convert to single-use dialysis products. Further consolidation in the industry is likely to reduce the average selling price of their products. The dialysis business unit is likely to suffer for a while.

This is not much of a conclusion. I feel there are just too many unknowns to try to value Cantel Medical. In a few more quarters, some of those unknowns may clear up a bit. I would be patient buying them. If my position was a large one, and I could not stomach a drop below $10 which is definitely within the realm of possibilities, I would lighten my position. But I feel the company will grow from this small base and be a good future investment. It may take a few years for things to start running smoother, but I expect they will start showing improvments.

The CEO is leaving; options grants are pretty high considering the poor performance for shareholders. They have $38 million in debt and about $29 million in cash. They produce good streams of cash flow even with the loss of Olympus. The present valuation is somewhat high given the unknowns Cantel is facing, but long-term I believe they will rise to the challenge.

Over the years, Cantel Medical has changed their mix from 15% consumables and 85 capital equipment to 85% consumables (repeat sales) and 15% capital equipment. This should allow them to create predictable cash flow into the future even if growth does not materialize. For an acquisition based business model it is essential that they produce predictable and significant cash flow.

In the short-term anything can happen.

If I had a large position, I would probably lighten it. I don't like selling whole positions, I think when we develop that habit we tend to stop learning and miss opportunities. If you see a better place to put your money sell the majority of your position and go for it. But I like to keep some money in my losers and rather than look for greener pastures I rather study the company and see if investors overreact. We can see that they reported $0.41 from continued operations this year, but they did have some legitimate one-time events that should be adjusted. But even using that number and giving them a PE of 19, we get a price of $7.79. I think that would be cheap and I think everyone out there knows it, so I don't expect it to go that low. But I personally would keep that number in mind.

My next step is to use the $0.50 ( this number has legitimate adjustments) and give them a PE of 19 – This gives us a price of $9.50. That is where I feel the bleeding will stop. I think they are a growth company. I think their business segments will grow. They are definitely starting all over now. They lost Olympus officially so future earnings reports are going to reflect ongoing operations. Net income from continuing operations is anemic when compared to how well they were doing when they had Olympus, but that has happened and it's done. We can now poke through the rubble to see if there is any opportunity.

In the short-term they could drop much lower. But in the long-term, I think they do have some good markets that will offer interesting growth opportunities. They are not going to come out of this with no earnings or no growth. The next few years could be tough for their dialysis business, but I agree with management view on dialysis. The aging US population will increase demand and Cantel Medical will grow with that demand even with the competitive pressures. It will also help them grow their water purification business.

I think the dental segment will provide moderate growth and solid streams of predictable cash flow that will allow them to continue buying companies that fit compliment their businesses. I cannot tell you how to invest in Cantel. I do believe they may go lower in the short-term but I equally believe they are going to grow from this low point caused by the departure of Carsen/Olympus.

tom e