Stericycle Overdue For A Downturn; Fundamentals Continue To Deteriorate

Oct.30.11 | About: Stericycle, Inc. (SRCL)

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. Earlier this month I wrote that Stericycle was overdue for a downturn and, after the latest conference call, I continue to hold that view.

The company’s multiple of 30x+ is reflective of a fast growing company. The problem is that SRCL’s “roll-up” strategy has resulted in a tremendous amount of debt and a broken balance sheet. In order to maintain its growth rates (and, in turn, its multiple), it needs to make acquisitions. The company is getting larger and the law of large numbers is making acquisition growth difficult. The company is also running out of capacity to make these acquisitions as the balance sheet erodes and the likely large targets are few.

Ultimately, this company’s growth rate is going to slow dramatically (resulting in a much lower multiple) or the company will overreach and make some mistake in this flurry of acquisitions. Some important internal metrics have been deteriorating and continued to do so this quarter.

Balance Sheet: First let us look at the balance sheet. Total debt equal $1.4b and total tangible assets is $706m. The tangible book value is negative $1.24b. That equates to negative $14.61 a share. This is up quite dramatically from negative $11.76 per share last quarter. In 2007, as a point of reference, the negative book value was $5.09. The ultimate level of balance sheet deterioration is troubling, but the accelerating rate of deterioration is unsustainable. This is occurring because of the high number of acquisitions that the company is doing. Negative book value cannot grow to minus infinity; sooner or later the company will collapse on itself.

The other major item of deterioration is the DSOs. Receivables are climbing faster than sales for 3 straight quarters.

Q 3

Q2

Q1

Q4

Sales

420m

410m

398m

393m

Receivables

282m

252m

231m

215m

Days Sales Outstanding

61.27

56.08

52.96

49.92

Click to enlarge

Sales grew only $10m sequentially last quarter and receivables grew $30m. The company is doing a lot of acquisitions, so naturally that number should be growing as SRCL acquires new companies and each company’s receivables. There is, however, one minor fly in this theory - allowance for doubtful accounts is growing as a percentage of this ballooning accounts receivable.

Allowance for doubtful accounts rose to $18.5m or 6.1% of the receivables. In Q4, for comparison, the numbers were as low as $10.8m, or 5.0%. According to the company’s 10-K, it can only move a receivable into allowance for doubtful accounts “when we have determined that the receivable will not be collected.” A sell-side analyst asked on the call if the allowance for doubtful accounts had gone up simply as a result of the international acquisitions, to which the CEO responded “that is correct”. This doesn’t add up. Either the company’s 10-K is incorrect or the CEO is misinformed about his own balance sheet, because the 10-K clearly states that a receivable needs to be determined to be uncollectable for it to move into that column.

One thing we don’t know is the average age of those receivables; no one on the call thought to ask. The company itself may not even know due to the fact that it is acquiring at such a brisk pace (17 acquisitions last quarter alone). No one outside the company can know whether this increase in DSO is a problem or if it is benign; however, it is a red flag that has historically preceded distress in some roll-ups.

The Growth Rate: The company has grown through acquisition quite nicely over the years; however, the core growth rate is slowing. Last quarter, according to the transcript, the company grew the business organically 5.8% year over year and this quarter, if you similarly back out acquisitions and foreign exchange, you get only 3.8% growth.

As we move forward, the comps get tougher and tougher. The company has not been growing the top line very fast sequentially. It did 410m in June and is only projected to do $425m in December. If it only comes in at that number, its top line growth rate will be only 8% versus the $393m it did in Q4 last year. Currency will likely be a headwind this quarter, so it might be tough to get a big beat. The company claims that it is going to do roughly $1.85B (the midpoint) next year, which would assume a quarterly run rate of roughly $462m. Certainly it is not going to do $462m in Q1 2012; it is going to have to ramp to get there. Lately sales have been growing just $10m or so sequentially.

If its grows next quarter in line with that average, which would be better than expected even with the currency headwind, and continues that sequential growth rate through the first half, it would only be at $888m YTD by the end of the June quarter. It would need to do roughly $500m per quarter in the back half to make the numbers for the year.

Somewhere there has to be a stair step in the growth rate to make the 2012 numbers, and this is only to achieve the guidance which calls for 12% growth. 12% growth is a far cry from the high teens that investors have grown accustomed to, and is hardly worthy of the 30x multiple that the company currently receives.

Conclusion: My negative attitude on SRCL has nothing to do with any insights about some sort of malfeasance. I believe this is an excellent company which serves a solid need to the community. I am simply using the mosaic theory to paint a picture of a company whose growth is slowing and whose multiple is too high. In my experience, roll-ups carry significant risks because a company cannot continue to roll-up forever. Sooner or later, something has to give. Either the company runs out of good targets or it runs out of capacity (balance sheet flexibility) to continue. I believe that the balance sheet is stretched, and the rate of acquisitions has to slow.

This in turn will slow the growth rate, which in turn will crush the company’s multiple. Someday this company will trade in line with other trash collectors. But before that happens, it needs to throttle the business back and begin using cash flows to pay down debt, so that some day it can use the excellent steady cash flows to pay a healthy dividend. The growth phase is ending and the faster the company realizes that, the better.

Disclosure: I am short SRCL.