The Short Case For Stericycle

| About: Stericycle, Inc. (SRCL)

Summary

SRCL is a roll-up business and its current valuation is based on unsustainable earnings growth expectations.

Like many roll-ups, this is an accounting-driven stock and one where street analysts quote prices based on multiples of the vaunted “Cash EPS” metric.

SRCL is playing aggressive accounting games and overpaying for companies, its only growth driver, and the real economics of its business strategy are destroying shareholder value.

Catalysts include dilution from conversion of preferred stock, legal settlement charge, impairment of intangible assets from prior acquisitions and/or goodwill, and negative surprises for revenue.

Target Price and Rationale

Stericycle (NASDAQ:SRCL) is a roll-up business and its current valuation is based on unsustainable earnings growth expectations. Like many roll-ups, this is an accounting-driven stock and one where street analysts quote prices based on multiples of the vaunted “Cash EPS” metric. I believe that SRCL is playing some aggressive accounting games and overpaying for companies, which is its only growth driver, and that the real economics of its business strategy are actually destroying shareholder value for the following reasons:

  • Increased competition and stronger buyer power pose an underestimated threat to SRCL’s already unambitious top-line growth guidance. I believe flat to LSD growth is too optimistic. Negative organic growth is likely.
  • The company can no longer use its balance sheet to hide the underlying negative economics of its business. The company’s fundamentals have been deteriorating at increasing rates as:
  • The $2.3B Shred-It acquisition leveraged the balance sheet, increasing fixed costs and inhibiting future acquisitive growth
  • Customers have been breaking contracts due to SRCL’s reckless, and allegedly illegal, pricing practices
  • Accounts receivable, bad debt and amortization expenses have all spiked as a result
  • Bogus accounting is getting alarmingly worse as:
  • The number of line times and total value of adjustments continue to rise
  • Amortization expense and equivalent Cash Flow add-back have exploded,
  • Non-GAAP and GAAP net income’s divergence grows, driven by SG&A and Gross Margin adjustments
  • Avoiding dilution from Preferred shareholders in September 2018 requires ~$750M of repurchases

Relevant Comps

Republic Services, Inc. (NYSE:RSG)

Waste Management, Inc. (NYSE:WM)

Clean Harbors, Inc. (NYSE:CLH)

US Ecology, Inc. (NASDAQ:ECOL)

Sharps Compliance Corp. (NASDAQ:SMED)

Advanced Disposal Services, Inc. (NYSE:ADSW)

Casella Waste Systems, Inc. (NASDAQ:CWST)

Heritage-Crystal Clean, Inc. (NASDAQ:HCCI)

Cintas Corp. (NASDAQ:CTAS)

Iron Mountain, Inc. (NYSE:IRM)

Catalyst

Catalysts include dilution from conversion of preferred stock, legal settlement charge, impairment of intangible assets from prior acquisitions and/or goodwill, and negative surprises for revenue.

Stericycle – SHORT

A Garbage Business, Consistently Shredding Shareholder Value

Recommendation

Short on SRCL with a price target of $41, +50% downside from today’s price of $87.

Investment Thesis Summary

SRCL is a roll-up business and its current valuation is based on unsustainable earnings growth expectations. Like many roll-ups, this is an accounting-driven stock and one where street analysts quote prices based on multiples of the vaunted “Cash EPS” metric. I believe that SRCL is playing some aggressive accounting games and overpaying for companies, which is its only growth driver, and that the real economics of its business strategy are actually destroying shareholder value for the following reasons:

  • Increased competition and stronger buyer power pose an underestimated threat to SRCL’s already unambitious top-line growth guidance. I believe flat to LSD growth is too optimistic. Negative organic growth is likely.
  • The company can no longer use its balance sheet to hide the underlying negative economics of its business. The company’s fundamentals have been deteriorating at increasing rates as
    • The $2.3B Shred-It acquisition leveraged the balance sheet, increasing fixed costs and inhibiting future acquisitive growth
    • Customers have been breaking contracts due to SRCL’s reckless, and allegedly illegal, pricing practices
    • Accounts receivable, bad debt and amortization expenses have all spiked as a result
  • Bogus accounting is getting alarmingly worse as
    • The number of line times and total value of adjustments continue to rise
    • Amortization expense and equivalent Cash Flow add-back have exploded,
    • Non-GAAP and GAAP net income’s divergence grows, driven by SG&A and Gross Margin adjustments
  • Avoiding dilution from Preferred shareholders in September 2018 requires ~$750M of repurchases

Business Description

Stericycle is provider of regulated and compliance solutions for healthcare, retail, and commercial businesses. The company grew successfully through its focus on the collection and processing of regulated and specialized waste. It has since expanded into the collection of personal and confidential information for secure destruction, plus a variety of training, consulting, recall/return, communication, and compliance services. Slowing organic growth has led to some operational problems, and the stock has already fallen substantially from its high of $150 in 2015. SRCL does enjoy a scale advantage over many of its competitors, but increased competition and poor capital allocation have been more powerful forces.

Investment Thesis

The core business of Regulated Medical Waste is deteriorating much faster than investors realize. SRCL’s growth was traditionally driven by acquisitions and price increases on its ever-expanding customer base. SRCL has completed 466 acquisitions over its history, including 31 in 2016. Acquisition activity peaked in 2015 when SRCL made its largest acquisitions to date, purchasing Shred-It, a privately owned Canadian document security and destruction company for $2.3B USD. Shred-It itself was a roll-up and had previously consolidated the legacy shredding segments of Iron Mountain and Cintas. In its wake, management has said they will pursue much smaller tuck-in acquisitions which means that that avenue for growth is capped. That leaves management with the second lever, pricing, but SRCL is facing severing declining pricing power due to both economics and legalities.

Pricing has become extremely competitive and will hurt the top line over at least the next two years. SRCL built itself through its regulated medical waste collection and disposal business, primarily serving what are known as Small Quantity customers. These are mostly doctor and dentist offices with between 1-15 practitioners. Through consolidation of its industry, SRCL created economies of scale by increasing route densities and better pricing as a result of its scale. But now a confluence of factors is causing severe pricing pressure. First, more competitors are in the market and are competing on price. Second, healthcare provider budgets are increasingly strained meaning that they are looking for the absolute cheapest alternative, or outright selling themselves to larger health systems to cut costs. SRCL is being undercut by low-cost, local competition and forced back to the negotiating table for lower prices by the Large Quantity Hospitals and Health systems. Third, most of the international customers are Large Quantity and therefore negotiate lower prices, and have been less inclined to purchase additional services. This began two years ago, as the Regulated Waste segment has averaged negative revenue growth over the past 8 quarters, but the impact was obfuscated by the Shred-It acquisition. As core revenue was stagnating SRCL management was able to add approximately $726M of revenue from Shred-It, and re-configure the reporting segments for good measure. SRCL has acquired many adjacent businesses, but they do not have the growth nor margin profile of the traditional core SQ regulated waste business. As a result, SRCL is now more highly levered than it was historically and is a slower growing, competitively disadvantaged business.

Competitors continue to bid for SRCL's business as contracts roll off naturally, or customers exit them early because they are unhappy with SRCL's service. Online reviews of SRCL are scathing and commonly mention the better service and pricing available elsewhere at a discount. My research has shown that competitors are coming it at anywhere from 10-35% lower, and that SRCL is also starting to make pricing concessions just to hold on to the customer rather than let them leave. SRCL’s abusive pricing is well documented online and in legal filings. The company has faced several accusations over illegally raising prices in breach of the agreed upon contract. The remaining outstanding case had a class certified in February 2017 and could settle for up to $600M according to street estimates. This is not a one- quarter or one-year issue, because higher priced contracts will continue to roll off for the at least the next few years, and maybe longer if you believe SRCL’s estimate that the purchased customer relationships actually last for 15 years. At a very minimum, SRCL’s practice of gouging customers for 100% increases every nine months is over, and more likely customers will opt for cheaper service elsewhere. I estimate that the total pricing impact will be ~6% this year.

The core business mentioned above was never actually as good as it looked, either, and that is now becoming evident as the company can no longer grow via acquisition. Higher leverage and fixed costs are restraints on management’s ability to grow the business and allocate capital effectively. Net Leverage has grown from 2x to 4x and the fixed charge coverage has been more than halved. The issuance of $750M mandatory convertible preferred stock in 2015 has effectively canceled any return of capital to common equity for the time being as excess cash is being deployed to fund enough buybacks to negate option exercise dilution, pay preferred dividends of ~$40M/year, and repurchase preferred shares before conversion in September 2018.

As is always the case with rollups, SRCL has had to account for the assets it purchased over its history. SRCL carries disproportionately high value of Goodwill and Intangible Assets. This is symptomatic of acquisitive growth strategies.

SRCL has purchased smaller competitors and accounted for most of the purchase price in the valuation of the Acquired Customer Relationships. The carrying value of customer relationships has exploded in recent years, notably because of the Shred-It acquisition. The accompanying amortization of these accounts has also ballooned. The amortization is therefore a real expense, intrinsic to the operating model of the company, and should not be excluded from earnings nor free cash flow calculations. This is crucial, because as amortization has grown fast earnings, “Cash EPS” estimates of future earnings are being falsely inflated. Instead of marketing and winning business through traditional sales channels, SRCL elected to buy their customers. Paying upfront for expected future cash flows, especially a premium, is a risky endeavor. Now, SRCL is hamstrung by its large acquisition of Shred-It which only has very modest growth potential, elusive synergies, and took up all the debt capacity on the balance sheet. The inability to purchase more growth to offset the back weighted amortization expenses means that earnings will be materially lower moving forward. Without the financial flexibility to add new customers the problems with current customer attrition and negative organic growth will be magnified. If customer attrition continues as I believe, then SRCL will be forced to re-evaluate the carrying values of the Acquired Customer Relationships, currently estimated to last for 15 years, and the value of its goodwill. Additionally, bad debt expense increased $28M, doubling from 3.5% of Receivables to +7%, showing signs of further pressure on the business.

These Acquired Customer Relationships are valued using forecasted future cash flows. They have an estimated useful life of ~15 years. This is misleading because Stericycle customer contracts are up for renewal every 5-9 years based on my research of SQ customers. And, even 5-year contracts for garbage collection are excessively long and binding. SRCL customers are increasingly alarmed by the renewal and pricing practices of SRCL, and they are adamant about getting out of contracts sooner rather than later. The uptick is dissatisfaction could render SRCL’s valuation assumptions very inaccurate.

Net Earnings are not what they appear to be and continue to decline in quality as the accounting adjustments are getting more and more aggressive. Major metrics which should normally move in concert are diverging, management has struggled to report results in a timely fashion, and the auditors of E&Y feel that internal controls are lacking. GAAP and non-GAAP Net Income, GAAP and non-GAAP gross margin, and GAAP Net Income and Cash Flow from Operations are all diverging by increasingly greater amounts. The excessive adjusting items, as well as relocation of multiple items between COGS and SG&A, is a worrisome red flag. The company has restated past earnings and uses an inconsistent methodology to calculate margins each year. In 2H16, SRCL started adjusting Gross Margin for contract exit costs, an effect of paring back its international business. The company also apportioned some contract exit costs to operating expenses but it is unclear what causes the distinction. As SRCL continues to adjust its business, similar costs are likely to persist, not to be omitted as one-time. In 1Q15, SRCL made 6 adjustments to its SG&A expenses. That increased to 9 in 4Q16. The value of adjusting items in FY16 was $333M. Using the original calculation of each line item from past years, actual SG&A as a percentage of revenue is 33.5%, a staggering divergence from the reported non-GAAP 23.3%. In 4Q16, Total Adjustments as a % of Net Income was 869%, and GAAP/non-GAAP Net Income was just 14%.

The increase in ADA for 2016 “based on historical collection experience” can be loosely translated to mean that the company had previously under-reserved for uncollectable accounts, and now is being forced to realize losses as customers break contracts. Bad Debt Expense was up 3x in 2016, or an increase of $28.1M.

Pending dilution from preferreds will cost ~750M to repurchase before the conversion in September 2018.

There are significant potential cash requirements coming up aside from the traditional debt maturities that most investors look at. First, the pending class action lawsuit could settle for up to $600M. That would be approximately equivalent to 10% of the market capitalization. SRCL has successfully settled law suits in the past, but this is the largest they have faced to date. Litigation is likely a few years away, and settlement prior to a ruling is also more likely than not, but this poses an outside risk to common equity holders because any significant cash outflow could require issuance of additional debt or a dilutive equity offering. The second cash requirement will come due during 3Q18, when the outstanding balance of preferred shares will be converted to common equity at a ratio of between 5.8716 and 7.3394 shares per preferred share. Before then, SRCL is actively repurchasing shares at discounted prices to reduce the impact, but not at nearly a fast-enough pace to retire the balance by the conversion date. In my bear case scenario, assuming maximum dilution from the Preferreds, but not litigation settlement, the impact is an additional 8% of downside, reaching a price target of $34.

My price target is based on what I believe to be the most likely outcome over the near term for the explicit cash requirements discussed above, as well as the long-term implications of a challenging competitive market and a bad business model built on rolling up other companies and paying a premium to do so. Over the long term, the accounting gimmicks will be washed out by real economic impact and shareholders will be disappointed. The balance sheet is no longer management's tool to fix up the income statement, and when the income statement can’t get by on adjustments there will be a correction for the stock price. My target price is $40 in the base case and $34 in the bear case, assuming larger than expected cash requirements in the near term. In the bull scenario, SRCL revenue growth takes off out of nowhere, and all operating expense adjustments vanish in FY17, rendering a price target of $101. My Bear, Base, and Bull Case Scenarios have upside/downside of -61%, -53%, and +18%, respectively.

(Editors' Note: This is a republication of an entry in the Sohn Investment Idea Contest. All figures are current as of the entry's submission - the contest deadline was April 26, 2017).

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. I have no business relationship with any company whose stock is mentioned in this article.

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