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Stericycle

Why I bought SRCL

Published on:
February 10, 2019
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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.

My return to the waste management business

Published on:
February 2, 2019
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One way to find stock ideas is to look at yourself. From the restaurants that you eat at to the clothing stores that you visit, these companies are often publicly traded. While writing to you, I am drinking coffee from Starbucks (SBUX on Nasdaq), checking (too often) my iPhone (AAPL on Nasdaq) and looking at a Dell computer screen (DELL on the New York Stock Exchange).

It is an endless list: I lease a Subaru (FUJHY on the over the counter market). Later on today I’ll pick up a package from Amazon (AMZN on Nasdaq). This evening I'll probably watch an episode of Jerry Seinfeld’s Comedian in Cars Getting Coffee on Netflix (NFLX on Nasdaq) while heating up leftovers using a General Electric Company (GE on the New York Stock Exchange) microwave. Even my electric toothbrush was manufactured by a publicly traded firm - Procter & Gamble (PG on the New York Stock Exchange).

Because many investors follow this principle of investing in products they use, the stock price of these companies is steep. Apple is trading at over 15 times the trailing earnings multiple, with a price to book value of 6 times. It is a somewhat high valuation, but it is minuscule compared to Netflix - its price to earnings multiple was over 100 times, with a price to book value of 27 times. Amazon is trading at 84 times the 2018 earnings and at 23 times the book value. These dear valuations would leave Benjamin Graham aghast.  

My work as a recycler

Frustrated by the lack of new stock investment ideas, I took out the trash. While sorting and dividing into recyclables and nonrecycles, I suddenly thought of the time I worked in Santa Ana, California, at a computer recycling company. It was about ten years ago and - for a minimum wage of $7.25 per hour - I stood on my feet for ten hours and tore apart old computers.

It was a lousy gig. By inhaling dust and gases, I reduced my life expectancy. Try to remove platinum chip from the CPU and you will see what I mean. I also had never before stood on my feet for such an extended amount of time, and to this day I empathize with cashiers at supermarkets. 

Thinking about that yearlong period of work as a recycler, I now realize how busy we were. The phone would constantly ring with local businesses inquiring about whether or not we could recycle their computer hardware (in California, the donation of old computers is a tax-deductible event). And there was no limit how much recycled parts we could sell in the market place.

I decided to call the owners of the business, two brothers who worked together. I asked them how their business was doing. “You wouldn’t recognize the place,” said Jacob, the older brother. “We now have over 200 employees; we increased our warehouse space by ten-fold, and we still cannot keep up with demand. We are even considering going public in 2019.” And that’s when I realized I needed to be back in the waste management business.

The lure of the waste management business

Three things are attractive about the waste management business. First, it is a growing industry with a growing need for companies to responsibly handle waste while meeting regulatory requirements. Second, in an economic down cycle, which we are likely to see in the coming years, the demand for recyclables will still be high in my opinion. Consider companies in medical waste, for example. The amount of waste they collect is unrelated to the business cycle.

Third, it is not a sexy business. I don’t imagine recent Ivy-league school graduates submitting their resumes to HR departments for middle management positions in waste management firms. I also don’t see young, famed-starved entrepreneurs pitching to angel investors how passionate they are about trash and its disposal. It is this lack of appeal that leads me to believe that no company will disrupt the waste management business any time soon.

So I researched a few publicly traded companies and quickly learned that I was not the only one in search of cheap waste management stocks. Appearantly they are in high demand and are trading at high valuations. Clean Harbors, that provides companies hazardous waste disposal, traded between $72 and $45 over the past year. It now trades at $60. Covanta Energy traded, during this time, between $18 and $13. It now trades for $16. Republic Services, which focuses in waste management for the energy sector, traded between $78 and $60. It now trades at $76. In short, all the waste management companies  were trading at the upper bound of the one-year valuation.

Stericycle

I did buy a few shares in Stericycle, a waste management company with $4 billion in market capitalization. While I was looking for waste management stocks, I accidentally found Diamond Hill Capital Management’s discussion about Stericycle and thought it was an appropriate buy. I will write more about  Stericycle in next week’s post.

Returning to my desk the morning after buying shares in Stericycle, I thought about the difference between principles and specific details. Principles stand the test time of time and guide us in the present. But they are often too general and universal so, specific details are the ones that really guide us.

In the Tanakh there are specific instructions as to how the principal of “love thy neighbor” is to be performed. “If you see your enemy’s ass sagging under its burden, you shall not pass by. You shall surely release it with him.” [Exodus 23:5]. It is a specific requirement following the general principle. Returning to stock investing, the principle I followed was to “invest in companies in which you are familiar with their product.” The specific detail was, “Look everywhere. Even in your trash.”