Stericycle Sell-Off Overdone

We already expected that a hurricane-soaked quarter would weigh on wide-moat

Stericycle finally announced its intention to move ahead with a comprehensive turnaround plan that will include restructuring and the implementation of an enterprise resource planning system. While it won’t reveal full details until early 2018, we’ve proactively tempered our expectations for near-term earnings to reflect the additional costs that such large-scale efforts typically require.

This knocked our fair value estimate down to $105 per share from $110, but our longer-term thesis for the company is intact, and we believe the shares offer value investors a significant margin of safety.

Revenue declined 0.8% year over year to $882.8 million in the third quarter as three hurricanes affected operations in the U.S. Gulf Coast and Puerto Rico, exacerbating weakness in the industrial hazardous waste business. This, combined with ongoing challenges in Stericycle’s Latin American region, made up much of the revenue shortfall.

All other parts of Stericycle’s portfolio increased sales at or above expectations. Shred-it, retail and healthcare hazardous waste, and large-quantity medical waste all reported strong sales performance. Also, pricing headwinds in small-quantity medical waste did not accelerate, a positive sign that highlights Stericycle’s ability to manage through a difficult contract-reset cycle.

In addition, Stericycle’s gross margins held up fairly well in the third quarter, expanding from 41.6% in the second quarter to 41.7% as growth in higher-margin businesses offset declines in low-margin industrial waste and international businesses. Year-to-date reported free cash flow was a healthy 11.2% of sales, highlighting the company’s resilience despite revenue headwinds.

When excluding the negative impacts of small-quantity pricing headwinds and the exit of an underperforming patient transport contract in the quarter, domestic medical waste revenue expanded 4.1% on an organic basis. In our opinion, this cadence of revenue growth is much more indicative of what Stericycle can sustain across its portfolio once it rightsizes the international and industrial hazardous waste businesses and progresses through the bulk of its small-quantity contract resets.

Furthermore, while restructuring and ERP implementation are likely to weigh on near-term profitability, we expect two major benefits to emerge from the process. First, implementation planning will further ferret out underperforming business units, possibly earmarking these for divestiture. Second, consolidating Stericycle’s disparate systems under one common platform is likely to generate significant future selling, general, and administrative savings, which supports our longer-term margin expansion thesis.

Investors need to be comfortable with the near-term volatility that may persist in Stericycle’s shares as the company progresses through a significant turnaround effort; however, we believe these changes are long overdue and will result in a stronger company capable of generating reliable recurring revenue streams at attractive margins over the long run.