After less than two days of research , I bought a few shares ofStericycle, a medical waste management company. At about $44 per share, Stericycle (SRCL on Nasdaq) is selling today at a much lower price compared to the past three years.
In 2018, SRCL traded between $75 and $45. In 2017, it changed hands between $88 and $61. And in 2016, the stock traded in the triple digits, between $152 and $111 per share.
The loss in popularity is because of an abnormally high selling, general, and administrative costs (SG&A). You can see that by looking at the company's gross earnings of $1,486.9 million in 2016 and $2,462.5 in 2017. While the 2016 SG&A were $1,053.1 million, they had mushroomed to $1,470.1 million in 2017. So, Stericycle reported earnings of $433.8 million in 2016 and a reported loss of $7.6 million in 2017.
Page 43 of the 10-k report provides more details about the $417 million difference in the SG&A expenses: because of a class-action lawsuit, the company paid $295 million and charged a $65 million goodwill impairment charge.
But these expenses were unrelated to on-going business. And without these non-operating expenses, the company would have reported earnings of $168 million, or $1.96 per share, in 2017.
Over the past decade, the company reported earnings each year. And during these ten years, investors valued the stock at earnings multiple as low as 21 times and as high as 62 times. The average earnings multiple range was 40 to 28 times the earnings.
I estimate the normalized earnings of the company to be $174 million or $2 per share, so the implied current valuation is 22 times. While still high, it is much less than the 10-year average.
Three factors are forming the runaway . First, the amount of medical waste produced by hospitals is increasing. As the U.S. population ages, there are more operations. And that increases the number of tests, which increases the amount of medical waste.
Second, hospitals are slashing payroll expenses by outsourcing functions to third parties. Paying someone else to take care of waste management not only reduces overhead costs but reduces the liability associated with waste disposal.
The third factor is the regulation of medical waste. Most aspects of our lives, I believe, are becoming regulated and will become even more regulated. From how we marry to how we get a loan, there are more and more rules by which we must abide. And the more regulated the environment in which we live, the more attractive the service offered by companies such as Stericycle.
To quickly calculate the return on equity, I used the following definitions. In the numerator: to the reported earnings, I added back depreciation and amortization and removed capital expenditures.
In the denominator: to estimate capital deployed, I removed from the reported assets the long-term debt.
The average 3-year cash flow was $382 million, and the average 3-year capital was $4.1 billion, a reasonable return on equity of 9%.
For every dollar of asset, Stericycle had about 60 cents of debt - reasonable leverage, especially for a company that signs a multi-year contract with its customers.
The 5-year average gross earnings were $499 million, and the interest expense was $100 million, an adequate debt service coverage of about five times. While I expect Stericycle to report gross earnings to be $250 to $300 million in 2019, it is still at a reasonable debt service coverage of about three times.
A reader asked how I find stock ideas. Two sources are the Value Line Investment Survey and newsletters written by investment managers.
I learned about Stericycle from the Industry Perspective section of Diamond Hill Capital Management. I visited their website because I initially looked into buying shares of Diamond (DHIL on Nasdaq), a publicly-traded asset manager that reported tremendous growth in earnings over the past decade.
Diamond earned $1.36 per share in 2008, $5.44 in 2012, and $14.48 in 2017. The stock is trading hands at about ten times the earnings per share, but I decided against buying the common stock .
In short, I investigated buying shares in Diamond, decided against it, and ended up buying 300 shares in a company Diamond had bought for their portfolio. And all this happened in less than two days.