Five year summary of PDCO stock price. From 2012 to 2018

Written by:

Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.

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Stericycle

Why I bought the stock

February 10, 2019

After less than two hours of research, I decided to buy shares of Stericycle, a medical waste management company. At $44 per share, Stericycle (the stock trades under the symbol SRCL) is offered at a much lower price today compared to the past three years. In 2018, SRCL traded between $75 and $45. In 2017, it traded between $88 and $61. And in 2016, the stock traded in the triple digits, between $152 and $111 per share.

The loss in popularity was due to an abnormally high SG&A expense. The company's gross earnings were $1,486.9 million in 2016 and $2,462.5 in 2017. But while the 2016 selling, general and administrative expenses (SG&A) were $1,053.1 million, they had mushroomed to $1,470.1 million in 2017. This resulted in recorded 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 difference of $417 million in the SG&A expenses: because of a class action lawsuit, the company paid $295 million and charged a $65 million goodwill impairment charge. These expenses were unrelated to on-going business, in my opinion, and without these expenses, the company would have reported earnings of $168 million, or $1.96 per share, in 2017.

How does Stericycle earn money? Imagine the following scenario: a representative of the company walks to the administration office at your local hospital. "Do you know the amount of risk you take by disposing of trash yourself?" the representative rhetorically asks. "Stericycle offers waste services, compliance training in OSHA and HIPAA, and we also have a proprietary secure information destruction service."    

Over the past decade the company reported earnings each year. And during this period, investors valued the stock at earnings multiple as low as 21 times and as high as 62 times. The average earnings multiple was between 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 below the 10-year average.

Waste management's runaway

From Mohnish Pabrai I learned to look at "the runaway of a stock." What this term means is whether the industry in which the company operates is expected to grow. An example of a stock without any runaway is Kodak. I think Pabrai will agree that Stericycle is an example of a stock with plenty of runaway.

Three drivers are forming the runaway. First, the amount of medical waste produced by hospitals is increasing. As the U.S. population is aging, more medical procedures are being performed and that increases the number of tests, which translates to an increase in medical waste.

Second, the current trend in hospitals is to cut payroll expenses by outsourcing functions to third parties. Paying someone else to take care of waste management not only reduces overhead expenses but reduces the liability associated with waste disposal.

The third driver is regulation. Every area of our lives, I believe, has become 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.

The return on equity test and debt coverage test were not bad

Return on equity: 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%.

Leverage: For every dollar of asset, Stericycle had about 60 cents of debt - a 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 5 times. While I expect gross earnings to be $250 to $300 million in 2019, it is still at a reasonable debt service coverage of about 3 times.

Epilogue

A friend of mine recently asked how I find stock ideas. My two main sources are the list of stocks that are trading at a 52-week low. The second resource is simply reading newsletters written by investment managers that I find interesting.

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 10 times the earnings per share, but I decided against buying the common stock.

It is hard to predict the earnings of a mutual fund such as Diamond. Their earnings are dependent on the amount of assets under management. And those in return are dependent on the performance of the mutual fund itself.

In short, I investigated buying shares in Diamond, decided against it and ended up buying 300 shares that cost $13,200, in a company Diamond had bought for their own portfolio. And all this happened in less than two hours.