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Morningstar | Near-Term Headwinds Cloud Long-Term Growth Opportunity for Cantel Medical

Cantel Medical reported fiscal fourth-quarter results that fell in line with our expectations, and we will probably hold steady on our $92 fair value estimate. However, management's outlook for fiscal 2019 fell short of our forecast on an organic basis. Our model called for 9% organic growth and core earnings growth of nearly 16%. Parsing through management's guidance, organic revenue growth for Cantel is set at 6%-7% over the coming year, with core earnings anticipated to expand 12%-14% including the ongoing impact of tax reform. As we roll our model, we expect this modest shortfall versus our expectations will be offset by cash flows received since our last update.

While there are a handful of negative factors influencing fiscal 2019, we think the firm's long-term growth story is intact. Management reiterated its 2021 outlook for roughly $1.3 billion in revenue and $150 million in adjusted net income, implying three-year compound annual growth rates of 14% and 13%, respectively. While our model is a little less optimistic on sales growth and more favorable on earnings, we think the firm is likely to trend in line with these objectives over time. This bodes well for expectations surrounding Cantel's organic growth opportunities, new product pipeline, and potential acquisition prospects, in our view. Management's history of exceptional capital allocation gives us added confidence that the long-run growth opportunity at Cantel is unchanged.

We believe management's decision to change the names of its reporting segments to medical, life sciences, and dental (from endoscopy, water purification, and healthcare disposables) highlights the continued expansion of the enterprise. These broader market definitions signal that long-term growth will be driven by more-expansive product offerings and acquisition opportunities probably in markets slightly adjacent to the firm's more recent core investment areas.

The upcoming commercial expansion of the firm's REVOX sterilization business illustrates this point well. Positioned as a safer, faster, and cheaper alternative to existing sterilization modalities in medical device and pharmaceutical manufacturing, the firm is putting incremental investment behind expanding this product offering to large-scale medical and life sciences customers. In our view, the firm's offering is likely an attractive alternative to existing sterilization done in house, but we're more skeptical regarding its positioning against the larger outsourced market. This is a market defined by high switching costs, in our view, with regulatory, contractual, and competitive barriers that we think will make it difficult for Cantel to make significant inroads into the space over the near to medium term. Over the five- to ten-year time frame, however, we think this initiative is a prime example of management's ability to expand and position the company for long-term value creation.

In 2019, elevated investment needs and weakness in the firm's water purification franchise have created headwinds, but we don't anticipate these effects to persist in the long run. An ongoing transition onto a global enterprise planning system along with leasehold improvements at a newly acquired facility account for the bulk of the one-year step up in capital requirements. In water, a dialysis customer's decision to insource a portion its water system installation activity has led to backlog contraction and weakness in the one-year growth outlook. We believe multiyear growth will remain in the mid-single-digit range, in line with our forecast for dialysis facility expansion and treatment growth on a national basis.

In endoscopy, we think the firm will remain positioned as the market leader in scope reprocessing, but lower capital sales in the U.S. market will probably weigh on growth over the coming year. Competitive recalls provided a tailwind to the firm's unit placements over the past several years, and it seems we are seeing this effect beginning to dissipate. We've taken our compound annual growth forecast for the segment down slightly over the coming years as a function of this dynamic combined with Johnson & Johnson's decision to sell its Advanced Sterilization Products business to Fortive in June. This business had long been an industry laggard, with roughly flat revenue growth over the last several years. We think Cantel is likely to face stiffer competition over the long run with this business in the capable hands of Fortive management. That said, long useful lives for installed equipment and embedded switching costs are likely to limit this dynamic to only a marginal headwind over time.