Headwinds for Stericycle but Shares Undervalued

Matthew Young: Medical waste management industry leader Stericycle has encountered several headwinds over the past few years that have weighed heavily on operating performance and investor sentiment.

For one, the firm is navigating a painful customer-pricing reset phase. In short, consolidation of independent healthcare practices into larger hospital groups with greater bargaining power is driving material pricing concessions. Additionally, the firm has grappled with distractions from a customer class action lawsuit that settled last year, two uncharacteristically large, complicated acquisitions, and to top it off, it's in the midst of a multiyear turnaround program that will cloud near-term margins.

However, Stericycle is trading at a healthy 32% discount to our fair value estimate at $86. We think the shares are undervalued, offering attractive upside potential to value investors that can stomach near-term volatility. In our view, the current valuation assumes Stericycle has lost much of its growth potential, but we think it can rekindle 4% midcycle revenue growth and high teens operating margins. Importantly, the bulk of pricing concession should amortize in by 2019, and the firm has a plentiful opportunities to upsell ancillary services (such as OSHA compliance) to a massive installed base; contracts have built-in pricing escalators, as well.

Overall, our growth assumption is well below the historical high-single-digit average, but it reflects our belief that the firm's growth potential hasn't evaporated. We also think the firm enjoys a narrow economic moat rooted in unrivaled route density that yields sustainable cost advantages. Despite a shift in bargaining power in favor of small quantity healthcare accounts, we don't think the firm has lost its footing relative to regional peers, as evidenced by its high retention rates and stable market share.