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U.S. Ecology: Is a 4.3% Dividend Yield Sustainable?

|Includes:CLH, US Ecology, Inc. (ECOL), HCCI, WM
U.S. Ecology (Nasdaq: ECOL) is small cap waste management company providing radioactive and hazard waste disposal/treatment services in the United States and Canada.   While a waste management company with a $317 million market cap and a 4.3% annual dividend yield might seem like an enticing high-yield investment, ECOL’s focus on acquisitive growth, its low propensity for debt, and future cash flow uncertainty make dividend yields at this level unsustainable.
ECOL is hamstrung between paying dividends and making acquisitions, and management is having a difficult time deciding which choice will offer shareholders the best return. In accordance with their 2011 guidance, I believe ECOL will look for acquisition targets, but will strive to keep their debt levels low and maintain a healthy balance sheet. So where will funding for acquisitions come from? Answer: Excess revolver capacity and dividend cuts to preserve cash balances.
ECOL acquired Stablex – a Montreal-based contaminated soil/inorganic industrial waste treatment company – for $77.4 million in 2010. ECOL used $57.8 million of its revolver capacity to fund the acquisition, and now has $63 million of borrowings outstanding on its credit facility. The interest payments on this bank line are very low (2.7% interest rate), but what causes concern for me is the revolver principal repayment obligations due starting in 2012. In 2012 and 2013, total revolver obligations due are $15.8 million. In 2014 and 2015, total revolver commitments increase to $47.2 million. For some companies, these obligations might not be difficult to meet. But for a company in search of acquisitive growth with relatively uncertain cash flows (cash flow negative in 2010 due to Stablex acquisition), excess cash balances are extremely valuable, and $13.1 million in yearly dividend payments only detract from ECOL’s meager $6.3 million cash balance, which is currently at its lowest year-end level since 2006.
For dividend investors, low cash balances would not be that big of a problem if:
1.      ECOL was more comfortable with raising debt to support acquisitive growth/fund dividends, or
2.      ECOL was projected to generate the FCF necessary to sustain $13.1 million in dividend payments, while also preserving cash for expansion activity
ECOL’s reliance on Event Business and their exposure to seasonality raise concern for future cash flows. The cash-generating Honeywell cleanup projects, which accounted for 38% of total revenue in 2009 and 43% of total revenue in 2008, have ended. So what’s going to take its place and support ECOL’s profit guidance? Not government cleanup project revenue, which represented 21% of total revenues in 2010 and grew 32% from 2009 levels. Management guidance indicated that 2011 government business revenue will remain flat relative to 2010 levels, as government spending becomes more stringent.   Although ECOL’s acquisition of Stablex provided more certainty in terms of cash flow (Stablex revenues are more dependent on Base Business), without a major Event Based project to propel revenues to 2007/2008/2009 levels, I believe ECOL’s 2011 year-over-year total revenue growth will be low, 2011 EPS figures will be on the lower end of management’s guidance range of $0.75-0.85/share, and 2011 cash flow will just barely break into positive levels. These projections do not leave ECOL with much freedom (ex-debt financing) to fund acquisitions and maintain a $13.1 million annual dividend.
In February 2011, ECOL’s asset purchase agreement with Siemens Water Technologies in Vernon, CA expired and was not extended. The value of Siemen’s liabilities was approximately $8.65 million, which if you were to use the 27% goodwill premium of the Stablex acquisition, values the deal at around $11 million. In their Q4 call, ECOL’s management acknowledged that the company continues to negotiate a deal with Siemens. So if this acquisition was completed in 2011 before the first of the revolver payments are due in 2012, how would it be funded? ECOL’s squeaky clean balance sheet history makes me believe that funding for the Siemen’s deal, after just tapping $63 million in reducing revolver for Stablex in 2010, would likely be provided by freed-up cash from dividend payment reductions. Based on my projections, if ECOL cut its dividend in half, freeing up $6.5 million in cash, it could complete the Siemens acquisition without taking on $11 million in additional revolver debt – all while staying cash flow positive in 2011.
Furthermore, if dividend payments were reduced to about $6.5 million, ECOL would be left with a solid cash balance for 2012 and 2013 even after it pays down its revolver debts. The company can use this excess cash, which may resemble ECOL’s 2009 levels of approximately $30 million before Stablex, to search for additional accretive acquisitions and satisfy its bigger debt repayments ($47.2 million total) due in 2014 and 2015 without having to extend its revolver.
Management appears to already be making spending changes in hopes of preserving the company’s cash flow. 2011 capex guidance ranges between $10-11 million, which when the $4.3 million in investment for Stablex is removed, appears to be significantly lower than previous capital spending on a percent of revenue basis. While these capital spending cuts may provide ECOL with the cash flow it needs to maintain its current dividend for 2011, this is a shortsighted idea. At such low capex levels, there has to be some concern that ECOL will not be able to fund the upkeep of its facilities and equipment and/or will be unable to expand its current site offerings in 2011. If the capital spending cuts prove to be ineffective, I believe ECOL will raise their 2011 capex guidance, and will look to reduce their quarterly dividend in hopes of staying cash flow positive.
Capex Analysis
Capex (millions)
% of Revenue
*Does not include $4.3 million for Stablex investment

I believe there is a perfect storm brewing that will ultimately lead to a dividend payment reduction. ECOL is looking for acquisitions with:
-          A low cash balance
-          A low propensity for debt
-          Weak/uncertain future cash flows and $15.8 million of debt payments due in 2012/2013
If ECOL expects to add to its cash position to fund acquisitions, it will need to cut its current dividend and stay cash flow positive. To add a bit of human element to this analysis, management, when asked a question on their Q4 call regarding funding their dividend with cash from operations, seemed less than confident about the future of their dividend program. Yes, they may be able to fund their current dividend with cash from operations, but I believe ECOL’s focus is on rebuilding its cash account to finance acquisitions. I also believe that, based on their history, ECOL would much rather build a cash base with dividend cuts than additional debt.
ECOL may be worth 16x forward earnings, which is a discount to CLH’s 24.6x forward multiple, but for a company with unstable revenues, it looks overpriced on a 3.0x price to sales basis compared to CLH’s 1.5x sales. And as I’ve indicated, I’m not sure how much longer ECOL’s dividend program can and will last. So if you’re looking for a high dividend yield investment, the time may soon pass for U.S. Ecology.