Article text goes here...
Clean Harbors (NYSE:CLH) has recently been out of favor with the market. It appears to me that this is due to the lack of market's confidence in the viability of CLH's sizeable acquisition of Safety Kleen (SK) at end of 2012. The Price to Sales Multiple shown below is virtually at its lowest level in the past five years. Such valuation presents of course a wonderful opportunity for the value-oriented and long-term investor if the underlying financial performance of CLH remains strong. This article portends to show that this indeed is the case.
CLH is in the business of collecting hazardous waste produced by refineries, factories and such and also cleans up after oil spills and similar environmental catastrophes. In 2012 CLH acquired SK and got with it a large customer base that compliments its existing customer base by means of services cross-selling. The fact that CLH does not need to rely on one significant customer makes its business attractive (to be precise, SK derives about 7% of its revenue from one large customer, but so far there has been no indication suggesting a loss of that customer).
CLH conducts over 50% of its business in Western Canada where the oil and gas production has slowed in the recent years contributing perhaps to the depressed CLH valuations. However, the Winter issue of the Alberta Oil Sands Industry Quarterly Update describes that the exploration and drilling activity in the region may be changing towards the better mainly due to the introduction of the more efficient horizontal drilling technology and the recent commitment of the Canadian government to increase trade with China. In the long-term the increase in activity will play into CLH's hands. As far as U.S. business is concerned, a perfunctory and common sense remark is that reliance on carbon sourced energy and all associated activities are to continue in the foreseeable future.
Since the acquisition of SK, CLH reports its business in five segments and prior to that in three segments. The below chart shows on the quarterly basis the segmental Revenue split, EBITDA Margin and Asset Turnover (EBITDA by segment is provided by CLH and Asset Turnover is calculated as Revenue from each segment divided by Fixed and Intangible Assets combined). The EBITDA Margin and Asset Turnover remain strong for three segments: Technical Services, SK Environmental Service and Oil and Gas Field. Two segments have shown deterioration in the exhibited indicators: Oil and Re-refining, which the management during the Investor Day attributed to the decline in Group II Base Oil Price, in other words an occurrence beyond management's control and Industrial and Field, which the management during the 3Q conference call attributed to a loss of a contract in the Alberta Oil Sands region representing about 0.8% of annual revenue and a delay in opening of its newly constructed lodge. Management feels confident about being able to replace the lost contract and the lodge is now up and running, prompting me to conclude that the setbacks are (almost) history.
The below chart shows the P/E valuations and the financial indicators (annual basis) for the last five years. It allows the reader to compare the current financial situation and the valuation placed upon it by the market vis-à-vis the historical record. Return on Equity is decreasing in the last three quarters mostly due to the integration of SK, which in and of itself is a negative sign. However, management expects to increase the EBITDA margin from the current 12.3% to high teens, which will subsequently increase the ROE (as per the 3Q conference call). The ballooning debt to equity ratio resulted from debt issuance for the purchase of SK. The first principal payment on this debt is not unlit 2020 and the Free Cash Flow should until then cover all contractual obligations with a substantial margin.
The current P/E of 25 appears to fairly value CLH; it is not below nor over the lowest and highest valuations achieved in the past five tears but somewhere in the average range. The multiple does however fluctuate considerably and it is good therefore to gauge another multiple, the Price to Self-Financing, which compares the Market Cap to Net Income and all non cash and one-off items added back (it is sourced from the Cash Flow From Operations before changes to Working Capital). The Self-Financing Cash Flow tends to be more stable and thus allows a better comparison of the data. The graph below shows that CLH once again is valued at its lowest level in the shown period even though the Self-Financing Margin (Self-Financing to Revenue) remains at 13%.
If my hypothesis from the beginning of the article regarding market's incredulity regarding the viability of SK addition to CLH business is true, then it behooves to review the SK financial performance as well. What I was able to retrieve are the SK financial statements provided in the acquisitions prospectus for the past three years and I show them below. By no means is the SK financial performance strong as far as Income Statement margins go, but the Company was able to grow Revenue, it has a higher Asset Turnover than CLH, rather strong cash flow margins and (not shown here) is able to cover all investment-related cash flows from by Cash Flows From Operations.
I cannot find a single support for the lowest valuation of CLH currently placed on it by the market. I am not saying the business deserves high valuations, but the undervaluation does not make sense and I think there is an opportunity here for acquiring an undervalued business with continuing sound financial performance and long-term prospects.
Disclosure: I am long CLH.