Stericycle (SRCL) is a current selection of GuruFocus’ Undervalued Predictable Companies screen. Using SRCL’s 10-year average EPS growth rate, GuruFocus’ DCF tool has SRCL shares trading at a ~28% premium to fair value.
EPS growth has been decelerating in recent years, however. In this article we will take a look at the business model and the primary factors that will influence whether SRCL can drive EPS growth higher towards historic rates.
The business:
Stericycle provides regulated and compliance solutions to healthcare and commercial businesses. This includes the collection and processing of specialized waste for disposal, and a variety of training and compliance services.
Over 95% of revenues are under long-term contracts and generally include pass through price increase provisions. Because the business is highly regulated and mostly mandated, SRCL has experienced relative stability compared to the rest of the market.
The company operates 166 processing facilities, 155 transfer sites and 70 other service facilities globally. SRCL believes they specialize in complex and highly regulated jobs.
Why has EPS growth slowed?
SRCL serves 566,000 customers worldwide, of which ~20,000 are high-volume customers such as hospitals, blood banks and pharmaceutical manufacturers. The remaining customers are lower-volume clients such as outpatient clinics, medical and dental offices, veterinary offices and retail pharmacies. The shift towards smaller customers has been a primary driver of higher gross margins as smaller accounts are more likely to outsource and are easier to up-sell.
As the company has reached a higher penetration of smaller customers, however, gross margin expansion has slowed.
Recent years of margin compression along with slowing revenue growth have been the major forces behind EPS growth rates below their 10- and five-year averages.
International growth the key to future success:
Stericycle has stressed acquiring smaller companies and assets internationally to sustain its revenue and EPS growth rates. Through the first three quarters of 2014 they have acquired 35 different companies in ten different countries. The vast majority of the M&A activity has largely developed in the last two quarters, accounting for 30 of the 35. In Q3, they acquired their first assets in Romania (selected assets of one regulated waste business) and Japan (100% of two regulated waste businesses). They also have interests in Canada, Chile, South Korea, Spain, and the United Kingdom from acquisitions in 2014.
International markets are much more fragmented than SRCL’s domestic business and there is significant room for future acquisitions.
International business isn’t as attractive:
Despite the positives, there is some reason to believe SRCL will not experience as positive operating dynamics in foreign markets as they did in the U.S. Here are a few of the industry’s major growth drivers and how they compare with domestic markets:
1. Aging of Population: The average age of the population in the countries SRCL operates in is rising. As people age, they typically require more medical attention and a wider variety of tests, procedures and medications, leading to an increase in the quantity of regulated waste generated. Positively, this driver also appears to be a factor in outside markets.
2. Pressure to Reduce Healthcare Costs: The healthcare industry is under pressure to reduce costs. SRCL believes its services can help healthcare providers reduce their handling and compliance costs and reduce their potential liability for employee exposure. While healthcare costs have been a focus globally, the imperative of reducing costs is less dramatic outside the U.S.
3. Environmental and Safety Regulation: Many businesses that are not currently using third party regulated waste management services are unaware either of the need for proper training of employees or of the requirements of OSHA and other regulations regarding the handling of regulated waste. While the U.S. has heavily outlined regulations from numerous agencies including the EPA, DEA, FDA, OSHA, DOT, etc., foreign markets can be less strict outside the most developed countries, reducing a key driver of demand for SRCL’s services (compliance).
The company is also at an initial disadvantage in terms of competitive strengths. The company lists its three major advantages as follows:
- Broad Range of Services: Offers customers a broad range of services and works with businesses across a number of industries.
- Established Network of Processing and Transportation Locations in Each Country: SRCL believes that “our network of locations results in a very efficient operation.”
- Diverse Customer Base and Revenue and Cost Stability: They have a diverse customer base and contractual relationships in all of their major markets.
These strengths are inherently weaker in markets where they have a smaller presence. This forces the company to buy the larger players in the region, most likely acquiring larger customers (lower gross margin) at a higher price than captive, smaller sellers.
The company’s CEO outlines their strategy as follows:
“When we enter a new market, we try to buy a larger player because we want to buy some of that infrastructure. And you've seen that in the recent acquisitions in Japan, in Brazil, in South Korea, the most recent. And then from there, look at strategic acquisitions that can leverage off that infrastructure from a tuck-in strategy. It varies by country. We try to test first before we double down. But certainly, when it comes to buying scale, we've done it before in Communication Solutions, and we've done it in our international strategy for our regulated waste business.” –Â 4Q 2014 Conference Call
Valuation:
Even with an arguably more difficult environment going forward (at least in terms of execution difficulties), investors are still pricing the company to grow at a rate that outpaces one-, five- and 10-year growth rates. Using GuruFocus’ Reverse DCF tool, we can estimate that investors are currently pricing in ~23% annual EPS growth for the company over the next ten years.
While the company has been a successful serial acquirer to build up their business domestically (completing >350 acquisitions since 1993), the path internationally may be more difficult. Additionally, because it will take time to build out the competitive strengths they enjoy in the U.S., specifically a strong existing network, the margin degradation that has weighed on EPS growth in recent years may not reverse any time soon.
Please see GuruFocus’ Undervalued Predictable Companies screen for more potential investment ideas like this one.
