Stericycle (SRCL) has seen, and continues to face, a lot of challenges in recent times. The major acquisition of Shred-it, slower organic growth and concerns about the roll-up strategy created turmoil for investors. These concerns triggered a violent sell-off in the shares after they had been priced for perfection for a long period of time.
The company surely has many challenges ahead, including the very leveraged balance sheet, accounting issues and integration challenges. In the basis, Stericycle operates some high-quality and mostly stable businesses, throwing off predictable cash flows. If the company reduces leverage and focuses on integrating the existing businesses, I think investors can await better days ahead.
The continued focus on modest acquisitions and some recent share buybacks seem to indicate management is still somewhat stubborn. I am positive that many investors would like to see increased focus on integration and deleveraging of the balance sheet, rather than another episode of deal-driven growth in the near term.
Stericycle describes itself as a consolidator of fragmented waste markets through acquisitions and organic growth. By obtaining leading positions in regulated markets, the company aims to deliver on superior margins. These profits, as well as steady cash flows resulting from long-term contracts with high renewal rates should be very valuable to investors.
The company proudly claims to have made over 400 acquisitions since 1993, for an average of nearly 20 per year. It furthermore deliberately targets smaller customers. It can charge higher prices to these customers, which boosts the margin profile, as SMEs typically grow at a quicker pace as well. This, in its turn, boosts the organic growth profile of Stericycle.
The company traditionally focused on medical waste and has made numerous deals in this area. As growth through dealmaking in this area was harder to come by, it expanded into other forms of waste processing. The issue is that Stericycle does not have the same expertise in these areas, which, at times, are less predictable and less profitable as well. Huge expansion deals into hazardous waste as well as the purchase of shredder company Shred-it in 2015 have not gone according to plan.
Stericycle's growth strategy has been in the works for 25 years now. Over the past decade, revenues have grown from $800 million in 2006 to $3 billion by 2015. Sales are actually expected to surpass the $3.5 billion mark this year.
While organic growth has certainly contributed to growth, it is hard to figure out the true organic growth performance over time. Anyway, it does not really matter as long as you can buy small businesses at relative low multiples, while reaping all the benefits of a successful integration.
EBIT margins came in as high as 25% in 2006 on both a GAAP and non-GAAP basis. Despite the promise to integrate the deals and focus on higher-margins customers, this is not reflected in the actual results. GAAP margins came in at 16% in 2015, while non-GAAP margins fell to 22%.
The good thing is that Stericycle has not even issued stock to finance this growth over the past decade. As a matter of fact, it slightly reduced the outstanding share base. Dealmaking did come at one other huge expense, however - a significant increase in leverage. The company spent roughly $5 billion on M&A over the past decade, including the $2.3 billion deal to acquire Shred-it announced a year ago.
The practice to grow even quicker requires ever-increasing acquisition targets, for ever greater acquisition sums. The resulting leverage creates real issues in case integration does not go smoothly, while synergy estimates appear optimistic and organic growth is slowing down. While shares did rise from just $30 in 2006 to a high of $150 in the summer of 2015, concerns have been dominating the developments ever since. A 40% retreat resulted in shares now trading at around $90 per share, levels last seen back in 2011.
What Went Wrong?
Stericycle has long relied on cheap debt financing and organic growth to fuel further dealmaking. As the company grew larger, integrating these ever-greater deals became a more difficult task. Not only has the integration proven to be challenging, multiples paid for acquisition targets have gone up as well. Worse, the general "roll-up" strategy has come under a lot of scrutiny following the Valeant (NYSE:VRX) disaster, which was not just indicative for the pharmaceutical sector alone.
Stericycle just released its second-quarter results and came out with a big red flag. It warned about its accounting practices, never a good sign in combination with aggressive dealmaking and the usage of leverage.
Organic growth came in at just 1.4%, while the company carries along a sizable net debt load of nearly $3.1 billion. If we generously apply the adjusted operating earnings of $372 million for the first half of the year (already adjusted for amortization charges, contract-related costs an integration charges), EBITDA comes in at $386 million following the addition of modest depreciation charges. If we multiply this by 2, we arrive with a very adjusted EBITDA number of $800 million, for a 4 times leverage ratio. In this light, it is not very prudent for the company to buy back stock in this environment, nor does it seem wise to make additional deals, even if they are small.
If we generously exclude all these costs, non-GAAP earnings came in at $2.29 for the first half of the year, with GAAP earnings being just slightly more than half of that. The good thing is that the company guides for earnings (non-GAAP) of $4.68-4.75 per share. While this marks a big markdown from the previous guidance, it does indicate that the second half of the year should be equivalent or slightly better than the first half of the year.
A halt of share buybacks, acquisitions and higher amortization charges could result in solid cash flow conversion in the near term. I think that this is important, as investors could get nervous. A string of disappointments, accounting issues and leverage can provide a dangerous cocktail.
The need for deleveraging and "quietness" is needed around Stericycle. Management seems to have put too much work and leverage on its plate, and this needs to be resolved. Fortunately, I believe natural deleveraging or modest divestitures should be sufficient to solve the situation without incurring massive dilution or engaging in other value-destructing moves.
The carrying out of 10 very small acquisitions during the recent quarter, while mentioning that the acquisition pool is still filled with $100s of millions in potential deals, is not comforting given the leverage position. Perhaps bigger gains could be made by optimizing the current structure.
So, while the problems can still be solved, I miss the urgency with management, and that can pose a problem. If management addresses the situation, however, there is real potential to be seen as well.
In the end, Stericycle is still a $3.6 billion business which operates in growth markets and should have long-term potential to post margins of 20-25%. That suggests operating profits of anywhere between $720 and $900 million on the current revenue base, not factoring in any organic growth. After applying a $100 million annual interest bill and 30% tax rate, earnings could come in at $440-560 million. With 91 million outstanding shares, this translates into potential earnings of roughly $5-6 per share.
Applying a multiple to such a business is the hardest thing. In this low interest rate world, it is rather easy for stable operating businesses (which Stericycle is) to fetch a 20 times multiple. That suggests a $100-120 price target. Serial acquirers with great track records often trade at 25-30 times multiples, suggesting a $130-170 range, versus last year's peak at $150.
The trouble is that Stericycle is not able to achieve these earnings yet, as skepticism remains very high at the moment. The 19 times non-GAAP multiple for this year is not appealing enough given the uncertainty and leverage, despite a 40% drop in the share price. While I see real potential for the shares if organic growth returns, leverage is reduced and confidence comes back, we need a current margin of safety.
As shares visited lows $80s in the wake of the release of the second-quarter results, I believe that at $75 per share, some appeal can be found. If management can work out the troubles, I see a real potential to revisit the highs of $150 before 2020. The continued low interest rate world, in which investors see stocks of predictable businesses like that of Stericycle as a bond-equivalent alternative, should provide a stimulus to valuation multiples as well.
To step in, I would like to see a little further pullback in the shares, and a greater sense of urgency by management would be very helpful as well.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.