Harsco Shifting From Turnaround To Transformation

About: Harsco Corporation (HSC), Includes: CODI, GTLS
by: Stephen Simpson, CFA

Harsco's first quarter earnings were solid, particularly given challenging end-market conditions in the steel end-market.

Acquiring Clean Earth and selling the heat exchanger business makes sense, with Clean Earth offering a less-cyclical growth opportunity with good margins.

Harsco shares still look undervalued below the high-$20's to low-$30's.

Harsco (HSC) is a case-in-point as to why I say that successful turnarounds can exceed your expectations at the start of the turnaround, as management has done a great job of improving its core Metals & Minerals business and it seems as though some of the changes made to the Rail business are about to start paying off. On top of that, Harsco benefited from lucky timing (always a good thing in a turnaround) with the global recovery in steel production and in markets like oil/gas (for its heat exchangers).

Now management is underway with a transformation process that is seeing the company become less of a multi-industrial hodgepodge and more of a focused player in industrial-environmental markets like waste reclamation and treatment. Although the bigger move into waste treatment carries some operational risk, I believe management has earned the benefit of the doubt with respect to its ability to execute.

As for the shares, even with this recent sell-off, the shares are up about 10% from the time of my last article. I saw high $20’s to low $30’s value then, and I still see that now, and a return to the low $20’s in a broader market sell-off would be an opportunity to consider.

A Very Busy Quarter … With Good Earnings

Harsco’s earnings were arguably the lesser news of the company’s report, but they were still broadly good.

Revenue came in about 2% better than expected, with 10% reported growth and closer to 14% growth on a constant currency basis. Gross margin was a little better than expected (up 50bp), and operating income rose 14% - exceeding both management and sell-side expectations by more than 5%.

There was some lumpiness in the segments, though. M&M revenue was down slightly, hurt by currency, but also by lower nickel prices (down 13%) and lower steel production. Using management’s disclosures about its geography exposures and global steel production figures for the first quarter of 2019, Harsco’s underlying markets saw a 0.5% decline in steel production on a year-over-year basis in the first quarter. All things considered, then, I’d say the business did pretty well, although the adjusted operating income decline of 19% and nearly two points of margin compression wasn’t so good.

The Rail business saw a 15% improvement in revenue and a significant improvement in margins, with segment profit improving from around 3% last year to nearly 12% this quarter and almost in line with last quarter’s 12.1%. The Industrial segment continues to benefit from strong upstream/midstream demand for heat exchangers, with total segment revenue up 40% and segment profit up 37%.

With these solid results, management lifted its full-year adjusted operating income guidance by about 2% at the midpoint, and more than the amount by which the company beat expectations this quarter.

A Major Change In The Portfolio And The Strategy

Noting that the market is no longer so favorably inclined toward multi-industrials without clear operating synergies among the components, Harsco has chosen to focus more on industrial-environmental market opportunities. With that, the company announced the sale of its Air-X-Changers heat exchanger business, the acquisition of Clean Earth, and the intention to dispose of its industrial grating (the IKG business) and boiler/heater (Patterson-Kelley) businesses. Although not said explicitly, management’s consistent messaging on its commitment to environmental-related operations suggests to me that Rail could be sold if and when the right opportunity arises.

As it happens, Harsco’s transactions all involve companies I follow, so I know the respective businesses pretty well. Starting off with Air-X-Changers, it makes a lot of sense to me that Harsco is selling this business to Chart Industries (GTLS). Chart has a very solid existing business in heat exchangers and Air-X fills out the product offerings, particularly in upstream/midstream gathering, compression, and processing. A purchase multiple of 10x ($592 million overall) looks reasonable, particularly as Harsco could be selling into a near-term peak (or at least plateau) in the U.S. onshore market, while its complementary to Chart’s long-stream plans to cover the value stream in the U.S. LNG market.

Harsco also announced the acquisition of Clean Earth from Compass Diversified (CODI) for $625 million. CODI acquired this business for $251 million back in 2014 and subsequently tacked on seven other deals for $108 million. While Harsco management talked of a 9.6x multiple to 2019 EBITDA, based on my own model for CODI and sell-side models, that looks a little ambitious, but there should be some expense synergies in the deal.

Strategically and operationally this deal looks somewhat risky, but I understand the logic. Clean Earth is a specialty waste processing company that takes in contaminated materials and hazardous waste streams from a variety of end-market sources (including metals/mining, chemicals, biopharma, and healthcare) and then applies a range of services and processes (including recycling/recovery) before sending them on. Addressing a market worth over $4 billion, the business is somewhat complementary to the M&M business, but the recovery of valuable waste streams is less of a driver.

The Outlook

Clean Earth’s EBITDA margins are healthy relative to Harsco’s, and I like the non-cyclical growth opportunities in the business. What’s more, given the permitting requirements, it’s not an easy business to get into, and that helps support margins and returns. I do see some execution risks in the business, but as I said, I believe management has earned a benefit of the doubt here.

I’m still valuing Harsco on the assumption of mid-single-digit long-term revenue growth and mid-teens FCF growth, with FCF margins improving towards the high single-digits. If anything, Clean Earth could modestly improve the long-term growth rate and certainly the year-to-year variability, with some potential uplift in long-term FCF margins as well.

Harsco’s EV/EBTIDA evaluation continues to be a little convoluted; it’s not valued as it would be were it a “normal” industrial, but it’s also valued more richly than if it were just a straight commodity company. That dichotomy makes sense (the M&M business is certainly cyclical), and I continue to believe that a high single-digit forward multiple is fair, though the inclusion of Clean Earth should help nudge that higher over time.

The Bottom Line

A chance to buy Harsco in the low $20’s would be great, but I still see upside as is into the high $20’s to low $30’s. While there are some operational risks to adding Clean Earth, and maybe inflated expectations for 2019 EBITDA, I like the long-term implications for revenue, revenue stability, and margins. So much the better if Harsco can also find a buyer for Rail at some point. All in all, then, I still think there are good arguments to hold Harsco and it’s pretty close to a “buy” level as is.

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.