Clean Harbors (NYSE:CLH) is a large moat business with high returns on invested capital and juicy margins. The company is a niche business that is expanding into adjacent and complementary areas of the industry while implementing a new cost-cutting plan starting in the first quarter of next year. Shares are down 22% over the last six months due to the fall in the price of oil. Recent acquisitions that management has undertaken have increased risks by opening them up to exposure to the price of oil. With new activism in the shares along with a strategic review ongoing, we think the company could unlock significant value by paring down the non-core assets and re-rating the shares.
Clean Harbors is a provider of environmental, energy, and industrial services in North America. They operate six business segments. Through their Safety-Kleen division, they are the largest collector of used waste oil that is refined and recycled into their Ecopower brand of engine oil. In their Oil and Gas services business, they provide fluid management to drilling operations in North America. They also have a Lodging services segment that provides remote location housing for the materials and oil E&P industries. The Technical Services segment provides a broad range of hazardous material management services including packaging and collection. Industrial and Field services provides high-pressure and chemical cleaning, decoking, and material processing. And lastly, SK Environmental services provides a broad range of services such as parts cleaning, containerized waste services, and oil collection. Below is a breakdown of the revenues of each division year-to-date:
(Source: Third Quarter Earnings Release)
Acquisitions and Disparate Business Make-Up, Cloud Core Business
Prior to 2012, the company had a more narrow core operation within the hazardous material management and disposal services space. In December of 2012, they made a transformational and very large acquisition buying Safety-Kleen for $1.25 billion in cash. The purchase added significant capacity to their waste recycling operations while pushing the business into adjacent areas like the solvent-recycling industry.
Almost a year later, the company announced the acquisition of Evergreen Oil, a bankrupt, California-based environmental services company that was one of the state's largest collectors of waste oil. It also runs the only re-refinery in the state of California. Clean Harbors used $60 million in cash to fund the purchase. The acquisition aligned well with their Safety-Kleen re-refinery businesses and created opportunities for the company to apply synergies across all three organizations.
Upon adding Evergreen, Clean Harbors now collects and recycles approximately one-quarter of all waste oil in North America. With that type of scale, they should be able to achieve pricing power, cost cutting through nationwide synergies, while augmenting their already stiff barriers to entry.
We think investors are misunderstanding the core business by selling off the shares due to lower oil prices, and the performance of the non-core businesses. Their technical services, along with the Oil Re-Refining, Field Services, and SK Environmental businesses, are the core competency and primary operation. On an adjusted EBITDA basis, those three businesses account for 94% of the company total. Over the prior 9 month period, they have realized an 8.3% growth rate.
However, as we will detail below, we think the SK Environmental business, 22% of adjusted EBITDA in 3Q2014, could also be labeled as non-core and scrapped greatly improving the profile of the company. Through several acquisitions, the two largest of which we discussed above, the company has attempted to grow into a total solution company that both collects waste, transports it, and feeds it into their disposal operations (landfill or incinerators).
Management talks about this sort of operation as a "closed loop" operation in each geography, as transportation costs limit the distance the operation can profitably ship the waste. The closed loop needs just two pieces, the Technical Services segment which operates the disposal business and the Field Services business which provides the environmental cleanup at customers' sites and other locations.
Strategic Review Could Unlock Shareholder Value
Management announced a strategic review in the first quarter when the firm significantly missed expectations. The company hired a firm to review their operations to assess underperforming and non-core assets in an effort to improve their returns on invested capital. They stated on the same call that the company has a long-term goal to leverage their business model in order to achieve 20% EBITDA margins and double-digit returns on invested capital.
The company clearly has some assets that are non-essential to their core operation and could be disposed of through a divestiture or sale to an appropriate suitor. The top on the list would be reducing exposure to the oil and gas segment. We don't see why the firm would expose itself to the volatility of oil prices by entering the exploration and production side of the solid waste business. The sharp decline in oil prices has drastically slowed Canadian oil sands activity which has hurt the segment's performance. We think the company's operations in the oil sands and even in parts of the US energy shale play, are poorly positioned within a market that is too competitive. We think this is likely reducing the barriers the company previously had and would otherwise enjoy lowering their multiple.
Another piece of the company that makes little sense to us is lodging services. This had been a high growth area in modular housing over the last several years in order to house the massive growth in oil field and natural gas workers in increasingly remote areas (a la' North Dakota, Alberta, West Texas). The company has little operational leverage in a space that is completely owned by various REITs and home builders. To us, it makes strategic sense to simply sell this business off to an appropriate suitor.
Earlier this year, it was announced that Relational Investors LLC, an activist fund co-founded by Ralph Whitworth and David Batchelder, had amassed a 9.1% stake in Clean Harbors. The fund was not seeking a board seat, yet, but noted that they want the company to refocus on that core business of hazardous waste collection, transport, and disposal, which earns a "consistently high return on invested capital."
We think the company would be wise to shed the two most obvious segments, Oil and Gas Field Services and Lodging Services, which together account for 16% of revenues. This would pare the firm down to just the collection, disposal and recycling businesses, where returns are much higher, the businesses are much more defensible, and the margins and opportunity better.
Getting back to SK Environmental, we think the business does not carry the same level of defensiveness and pricing power that the other "core" businesses (Technical Services and Oil Re-Refining) have. The core business prior to the acquisition spree was collection and disposal. The Safety-Kleen acquisition altered that co-dependence by exposing the firm to price spreads between the cost it pays for waste oil and the refined product it sells. The prime core business (non SK segment) gets paid to take waste from clients and their size and scale allows for pricing power. Conversely, the SK segment must pay to acquire waste oil and then opens itself up to price moves until it can finish the re-refining process as it must sell at market prices. We think this added risk and lower return business (more competition) is hampering the shares of the company.
Given the fall in oil prices which will affect their oil sands exposure as well as the SK Environmental segment, we think EPS expectations are going to have to come down further. In the last 90 days, fiscal 2015 EPS estimates have been reduced by 23% with another 3% drop in the last four weeks. The stock is not overly cheap trading at 24x forward earnings and a PEG around 4.5x.
However, margins are poised to expand significantly on the back of a $75 million cost reduction initiative, which was the driving force for their 200 bps improvement in adjusted EBITDA margins from a year ago. The strong margin performance in the quarter, including a 90 bps improvement in SG&A expense, also was driven by the initiatives surrounding their $75 million annual expense reduction.
We think the downside from here is fairly muted given the recent share price declines. Additionally, we believe that the cost savings initiatives and share buyback program announced in the second quarter should help mitigate downside risks from the oil price collapse. However, we feel the upside potential is also fairly limited, unless oil prices mount a strong rebound. The true upside potential comes from strategic moves that the company may undertake to unlock shareholder value and pare the firm back down to a core collection and disposal service. If Relational Investors gets some activist assistance, we think that process could be sped along. Under such a scenario, the returns could be in excess of 50%-75% if undertaken correctly.
(Source: Author's Calculation)
The operational performance of Clean Harbors has been meandering aimlessly since they acquired and moved into several non-core and disparate businesses. We think the recent activism in the shares could provide the needed spark to guide management back towards their prior core competency and away from a diverse set of businesses that expose the firm to an array of added risks. The CEO, Alan McKim, owns a 7.6% stake in the company. His interests are firmly aligned with growing the company and rewarding shareholders in the process. His recent endeavors haven't produced the results that he likely envisioned despite a valiant effort. We think the strategic review and activism are likely to aid in refocusing Mr. McKim back to his core strategy, which will likely reward shareholders with an increasing share price.
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