Description

Stericycle (SRCL) is a business that continues to face a number of headwinds, has poor earnings quality and potential leverage issues. Despite much worse than expected earnings guidance for its current fiscal year, the stock has run up 56% YTD on hopes that the worst is now over and that a new CEO will bring much needed change. I think the consensus view that “all is clear” will prove too optimistic and I expect downside of $35-$45 over the next year (down 20-40% from current levels).

For those unfamiliar with SRCL, I would point you to Napoleon’s write-up from February. This gives a good background and covers the long case.

I will skip most of the basics but suffice to say that SRCL has faced tough sledding over the past several years. As the story goes, SRCL grew rapidly in regulated medical waste through hundreds of tuck-in acquisitions. It began broadening the business into other adjacent areas - the most significant of which was the acquisition of Shred-It in mid 2015. This was a classic example of diworsification and marked the top in the stock at around $150 in October of the same year.

The real problems for SRCL began shortly after when it was accused of price gouging (in its mainstay small quantity or SQ business), which led to a class action lawsuit that was settled in late 2017 for $295m. As a result, SRCL has faced pricing headwinds since early 2017 as it reset pricing for these highly profitable, small quantity medical waste customers.

The bull thesis is that we’re finally at the tail-end of this pricing reset. The new CEO, Cindy Miller (a former UPS exec), has set guidance that can’t be missed and is leading a business transformation/ERP effort that will result in meaningful cost savings down the road. SRCL was once a great business with dependable growth and high margins, and bulls believe it will be a “compounder” once again when the noise is cleared. I think there a number of issues with this argument.

Let’s start with the numbers. SRCL’s disclosure is terrible and the company has hidden behind the fact that it’s resetting SQ pricing to explain the decline in EBITDA from FY17-FY19. You can see the Adj EBITDA numbers below as well as the Street expectations for go forward (note that these are heavily “adjusted” numbers).

To understand where we’ve come from, it’s worth noting that SRCL reported $720m in Adj EBITDA in FY14 (the year prior to the Shred-It acquisition). Shred-It was meant to contribute another $230m in EBITDA and $50m in synergies. Gains from rising paper prices have added another $50m. Total that up and it suggests that EBITDA dollars have eroded $350m or a decline of over 50% from the peak. As such, it’s understandable why there’s optimism for a turnaround. Indeed, the Street has SRCL gaining back close to half of these dollar losses by the end of FY21.

The problem is that SRCL’s business is in decline even after adding back the losses from SQ pricing (which bulls argue is the main headwind and soon-to-end). Based on what we know, we can make some simple adjustments to show that underlying growth (excld SQ headwinds) is negative and getting worse:

1. First, we know from company disclosure that SQ pricing reductions were expected to be ~$130m from FY16-FY19 and SRCL has confirmed that’s been tracking in-line (as shown below).

2. Second, we know that rising sorted office paper (“SoP”) prices have contributed ~$40m over the past two years. Through its Shred-It business, SRCL sells ~1m tons of shredded SoP every year and the average SoP price has risen from $120 at the start of 2016 to $200 in late 2018 (+67%).

3. Finally, SRCL proclaimed a $64m EBITDA benefit in FY18 from its “business transformation” program (think cost cutting and better sourcing).

All of this is excluded below (in addition to the partial year of acquired EBITDA from Shred-It in FY16) to arrive at my estimate of underlying EBITDA growth. Oddly enough, most Street analysts don’t attempt to go through this exercise.

What you’ll see is that underlying EBITDA growth has been negative in each of the past 3 years and got significantly worse in FY18. Again, this is after adding back SQ pricing headwinds, suggesting something else is at play. My belief is that SQ headwinds may be more severe than appreciated and mix shift to large quantity (“LQ”) accounts is diminishing profitability. Meanwhile, the Street is expecting strong growth in FY20 and FY21 despite underlying results that suggest the business is in decline.

The broader issue here is that despite repeated reductions, SRCL’s SQ pricing is still 15-40% above local competitors (and this is according to a recent note from a sell-side bull). The new CEO, frustrated by the continued attention on SQ, has said she “wants to talk about the other 70% of (lower margin) revenues.” In my experience, that tends to be a red flag.

Even FY19 guidance doesn’t look as low as most investors might expect and which Street views as “can’t miss.” Importantly, SoP prices have declined for each of the past 6 months and are down ~20% YTD. This represents a roughly $25m headwind to FY19 EBITDA. We know that SQ pricing is expected to be another $25m headwind, though management dodged questions about this on the Q4’18 call and it was the first time since Q4’16 that we didn’t get a real confirmation of how this was tracking. The other factors at play are an expected decline in the recalls business (negative) and a roll-forward of the business transformation benefits from FY18 (positive). Assuming a 5% underlying decline before these items (a big improvement from last year), I get to Adj EBITDA of roughly $670m, which is below Street and closer to the low-end of the management guidance range.

Looking forward, this calls into question how SRCL is going to add over $150m in EBITDA over the next three years as the Street expects - especially given that the benefits from its ongoing ERP are back-end loaded (2022 and beyond) and the risks are of course front-end loaded (2019 and 2020).

My hunch is that new management is likely to revisit the assumptions around SQ pricing headwinds and I wouldn’t be surprised if the Q2’19 finish line is pushed out further. In addition, the ERP will result in the regulated medical waste and Shred-It businesses becoming more closely integrated and tougher to pull apart. I think this calls into question the validity of a SOTP analysis that almost all bulls use to justify a higher stock price. Believe it or not, the sale of shredded paper now accounts for close to 25% of SRCL’s EBITDA! If Shred-It were still a stand-alone business, you can easily imagine the short pitch given the secular trends away from paper and over-earning due to record SoP prices in recent years.

I could stop there but the other big issue with SRCL is earnings quality and leverage. The company uses a very heavily adjusted EBITDA calculation, which really started around 2015. There a number of different buckets, including fuzzy categories like “business improvement” and “operational optimization.” I give SRCL full credit for adding back amort and don’t ding them for large non-cash charges like the $295m settlement in FY17 and $385m impairment in FY18. What’s left though is a string of increasing (and seemingly recurring) add-backs that are largely cash items. As you can see below, such add backs represented a whopping 43% of adjusted EBITA in the most recent fiscal year. At the same time, CapEx has increased from ~3% of revs to close to 6% expected in FY19.  

The Street has increasingly focused on FCF as SRCL’s adjusted numbers remain in flux. The idea is that if you exclude the $295m settlement payment, SRCL did $330m in FY18 FCF or $3.64/share. That puts the stock at 16x FCF. The company, however, stopped providing FCF guidance last quarter and I would expect that number to decline significantly in FY19 as cash charges remain high, core EBITDA declines and CapEx increases. I have SRCL producing FCF of just under $2 in FY19, putting the stock closer to 30x and (maybe more importantly) resulting in limited debt reduction absent diversitures.

Leverage has the potential to become a problem as SRCL’s covenants require it be under 3.75x after FY19. Its credit agreement permits $200m in add-backs through this current year, $90m in Q1’20 and nothing thereafter. At the end of FY18, reported credit agreement leverage was 3.64x, which doesn’t necessarily seem troubling until you appreciate the significance of the add-backs that will no longer be permitted in five quarters hence. SRCL ended FY18 with $2.8b in debt and GAAP EBITDA was $453m (adding back the $385m non-cash impairment). That implies a leverage ratio of 6.1x - well above the required limit and problematic if GAAP and adjusted numbers don’t quickly converge over the next year.

When you add this all up, I would argue that SRCL is an industrial business with negative underlying growth, significant earnings quality issues and potential covenant problems on the horizon. The stock has run-up YTD on a new CEO and expectations that the worst is now over. Street estimates beyond the current fiscal year are far too rosy in my opinion and I would argue that SRCL should trade at 9-10x EBITDA. Using the “adjusted” number of ~$680m in FY19 EBITDA, I get to a stock price of $35-$45.    

This report (the “Report”) with respect to Stericycle Inc. (the “Issuer”) has been prepared by the author (the “Author”) for informational purposes only. The Report contains certain forward-looking statements and opinions which are based on the Author’s analysis of publicly available information believed to be accurate and reliable. While the Author believes that such forward-looking statements and opinions are reasonable, they are subject to unknown risks, uncertainties and other factors that could cause actual results to differ materially from those projected. The Author has no obligation to inform readers of changes in such forward-looking statements and opinions and no warranty is made with respect to the accuracy or completeness of any of the information set forth herein.

As of the date the Report is published, the Author and/or certain entities (the “Entities”) affiliated with the Author hold a short position in the securities of the Issuer and therefore have a financial interest based on changes in the price of the Issuer’s securities. The Entities may increase, decrease or otherwise change their position in the securities of the Issuer based on changes in market conditions or other analysis. Neither the Author nor the Entities undertake any responsibility to inform readers of changes in such position.

Nothing in this Report constitutes investment advice. Readers should conduct their own due diligence and research and make their own investment decisions.

Catalyst

• Disappointing earnings results
• Continued SQ headwinds beyond 1H'19
• Leverage issues in 1H'20