Stericycle (NASDAQ:SRCL) is a medical waste management company. These are the guys who go around to all the doctors’ offices and pick up the waste in those bio-hazard storage containers. It is a fine company that serves a useful purpose. There are a number of things that I find bothersome about Stericycle at its current price. For one thing the stock is 30x earnings and its growth rate is slowing. The second problem is the company has a balance sheet that is horrendous. Lastly some internal metrics seem to be deteriorating and signaling there could be more problems under the hood. With SRCL’s high P/E, poor balance sheet and slowing growth any hiccup in their earnings will cause a severe revaluation of the company’s shares.
Stericycle is a roll-up. You need to be a big time money manager to understand that term, for those of you who are not I will explain it as best I can. A roll-up is a company who has been created by rolling-up a bunch of little companies into one big one. (And you wondered why those fat cat money mangers earned so much). Of course I jest; the term itself is comically simple. A seasoned investor however will know that many roll-ups have a similar life arch, often ending badly. This process was extremely common in the late 1990’s. Some say that Wayne Huzienga’s roll-up of Waste Management was the first which kicked off the craze.
After the process of rolling-up got too popular investors saw many failures, including US Office Products (OFIS) whose stock fell from $30 in June of 1996 to $0.15 by 2001. USA Floral Prodcuts (OTC:ROSI) which fell from $25 in March of 1998 to $1.96 by Jan 2000. Laidlaw tried to consolidate the school bus and ambulance industries in the late 90’s, and by May of 2000 the stock was under a $1 and the debt could not find bidders. Loewen, a consolidator of funeral homes, suffered a similar fate.
In March of 1999 the Chicago fed wrote a piece (pdf) on Roll-ups because of the risks they posed to bank capital. It cites the advantages and risks associated with roll-ups.
I will summarize in my words what often happens in a roll-up:
They often look like this:
They start with good intentions and smart economics. Someone identifies a highly fragmented mom and pop industry where efficiencies can be wrung out by scaling operations. This is what gets the ball rolling. The consolidator gets some financing and buys up all the little operators usually going region by region. Obtaining scale quickly through acquisitions, they can offer lower prices to their customers thus driving out any smaller competitors.
In the beginning things go great, they carve out the best markets and they buy the best local operators. They get great customers, while lower prices and word of mouth help them take share. The growth looks great. The company begins to devour everything in sight. It keeps making good acquisition after good acquisition. Wall Street buys in and the premium awarded the company grows.
Eventually, however, the problems start (sounds a bit like a VH-1 episode of “Behind the Music”). One day the company begins to grandfather in the good businesses it first accumulated and its core growth rate trends back down towards the industry norm. The easy fixes have been made, the best companies have been acquired, and the densest markets have been exploited. The company however needs to maintain their growth rate if they want to maintain the stock price so they begin making second tier acquisitions in second tier markets.
Eventually even the best management team gets one wrong, and an acquisition turns out to be less than they expected. In the early days they never would have done it, but they looked past some red flags because they needed to keep the growth machine moving. Wall Street bankers love the steady stream of fees of course and the sell-side analysts seem never rock that boat.
When the company does finally trip over that wire, by acquiring a mistake (the worst case) or admitting that they have run out of acquisition targets (the second worst case), what’s left is a slow growth company, with a terrible balance sheet, and a multiple that is way too high.
And that is the typical arch of a Wall Street roll-up. Let’s compare that to SRCL.
Stericycle is a company with a growth rate (ex acquisitions and ex foreign exchange) of less than 6%. Last quarter they grew 5.8% year over year according to the webcast conference call transcript. This company however sports a near 30x P/E. For now they are still posting top line growth rates in the teens, but even this purchased growth doesn’t justify this multiple.
Their balance sheet is in tatters. Their 10-Q shows they have a meager $680m in tangible assets which is propping up $1.7b in liabilities. $1.2b of those liabilities are debts, against a mere $57m in cash. SRCL has always run a low cash balance, but these debt are starting to really pile up. They are getting to the point where even if there were a mountain of great acquisitions still to do, they’d have trouble financing them. A recently as 2007 the company had a negative tangible book value of only $438m according to their filings. While this negative value of $438m may seem troubling, today it is more than two times that at over $1b. That’s over $11 a share in negative tangible book value. Certainly this company cannot double its negative value again in the next 4 years. Something has to give.
This company has only one leg to stand on should any type of trouble arise, and that is there cash flows. Investors are supremely confident in this company’s ability to continue to devour and grow because they think the cash flows are so steady that there is almost no risk. They even have been hiding in this stock during this correction because it is viewed as defensive like a typical trash collector(this is a trap).
The problem with that analysis is the multiple. In order to maintain this multiple the company needs to grow. In order to grow they need to make acquisitions. In order to make acquisitions they need to take on ever spiraling debts. Investors need to step back and ask where does it end?
It may be that the company’s model is defensive and can handle a slowing economy. If however there are any company specific problems, they would lose their access to capital and the multiple would plummet. Take Waste Management, a very well run waste pickup company. WM has a multiple of 16x trailing EPS and 13x forward. That would put SRCL stock somewhere in the low $40s, assuming earnings don’t deteriorate. Of course WM pays a 4.20% dividend and unfortunately for SRCL’s shareholders this company cannot afford such a luxury.
So we’ve established that SRCL has issues with its terrible balance sheet and ultra-high multiple, but what could cause the business to hit a rough patch (the final requirement for the stock to turn lower).
If you revisit the outline of the typical roll-up from above you will remember that eventually the acquirer runs out of highly desirable targets and overreaches. This is like a feather dancing on a cliff with a wind gust approaching.
It is very hard in advance to spot the internal clues, but the asset side of the balance sheet can help. In some cases a rise in inventories that doesn’t correlate to a rise in sales can clue an investor in. SRCL however doesn’t carry any inventory. They do have receivables. If a company were acquiring poor targets you could see a decrease in the ability to collect on receivables, or if a company were acquiring too quickly one could see an inability to manage receivables.
In SRCL’s case you are seeing an uptick in receivables. It is not drastic yet but it is a bit faster than sales growth and that’s a minor red flag. In the last two quarters, receivables have grown 7.4% and 9.1% sequentially while sales have grown 1.2% and 3.0%, according to their filings. Last Q receivables grew 29% year over year versus 18% for the company’s sales. This could be explained away by there big acquisition of Health Waste Services (HWS), but if we see one more Q where receivables rapidly outgrow sales the stock will plummet. Obliviously, doctor’s offices are good credits, but what about labs, emergency medical service offices, and hospitals? As of the last 10-k no single customer was more than 2% of the company’s receivables. We don’t know the composition of HWS’s receivables.
The other trick that can happen is a management team can ignore red flags in making acquisitions because they need the growth. I have no insights into what happened exactly but in the press release; SRCL said that they reduced the terms of the acquisition (of HWS) from $245m to $237m. This may be totally benign, but it is possible that there was some blemish that was discovered upon further inspection. Again I have no insights into this.
Finally I have a very hard time trying to understand how this company is going to meet its EPS targets over the next 6 quarters. The company stated on their last call that they think they will do 1.60-1.65b in sales this year. So far they’ve done $808m so they are on track, but the adjusted Net Income margin has only been 14.94% and 14.80% in the last two quarters. (the numbers are adjusted to take out the expenses or fees associated with acquisitions, a cost that used to be amortized like along with goodwill but is now required to be expensed in the Q in which they are incurred). The analysts have them earning 70 cents this Q on $405m in sales and $0.74 cents next Q on 423m in sales. They have to do 15.2% margin in Q3 and 15.4% in Q4 based on the consensus sales estimates. If they only do 15% for the rest of the year they have to report revenues closer to 860m in the back half instead of the 828 that is expected.
Next year things get tougher. The analysts expect the top line to grow 9%. While that may not seem like much given their historical track record, they are running out of capacity for acquisitions. Further this large HWS acquisition is one which will have to be digested. At the same time margins need to keep drifting higher. The current estimate of $3.20 a share on revenues of 1.78b assumes a 15.8% Net Income margin assuming 88m shares. They would need to grow more like 14% if you assume they keep their historical 15% margin. It is this $3.20 number that seems most like a stretch to me.
When you put it all together you have a series of negative factors that all suggest that at the very least the stock has seen its highs for a while. The history of roll-ups however can lead an investor to speculate that a negative surprise could be in the offering. Investors feel very comfortable and defensive in shares of SRCL, but I can assure you that while the business model for SRCL may be defensive, the stock is not. A very rich multiple, a Swiss cheese balance sheet and an unsustainable model for acquisition based growth is a recipe for eventual disaster.
At the very least the EPS targets set forth by the analyst community will be hard to achieve resulting in a lower multiple on a lower EPS number. Moreover, in time the unsustainably of the acquisition growth will lead to a major compression of the multiple.
Disclosure: I am short SRCL.
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