Stericycle

Why I bought SRCL

Published on:
February 10, 2019
Reading time: 3 Minutes.
Last Update:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Since 2010, Ganel works for Silvergate as Vice President in Capital Markets and provides advisory services to family offices,  private companies, and financial advisors on their capital allocation decisions.

After less than two days of research [1], 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.

Buying a few Stericycle shares

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.

The income statement includes non-operating expenses which results in the understatement of earnings.

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.

Stericycle's valuation

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.

Stericycle's runaway

Three factors are forming the runaway [2]. 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.

The amount of medical waste, a reduction in payroll expenses, and regulation will grow, a boon to Stericycle investors.

Stericycle's return on equity test and debt coverage test were reasonable

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 [3].

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.


FOOTNOTES: [1] I usually need weeks of research, at minimum, before I buy a stock. [2] From Mohnish Pabrai, I learned to look for 'the runaway of a stock.' What he means is to ask whether the industry in which the company operates will grow. [3] It is hard to predict the profits of a mutual fund such as Diamond. This is because 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.