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Pricing Reset Needles Stericycle's Growth, but Shares Undervalued

Small-quantity rollbacks won't weigh on the stock indefinitely.

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Narrow-moat medical waste industry leader  Stericycle (SRCL) has grappled with negative investor sentiment, some of it warranted, for several years. This was driven in large part by the emergence of painful contract concessions in its premium-priced small-quantity, or SQ, waste-generating account base, coupled with guidance shortfalls and lackluster performance in the noncore industrial hazardous waste unit. Importantly, SQ pricing rollbacks are the fruit of a decade of consolidation of small physician practices into large hospital groups with stronger buying power, as well as pushback from existing small independent healthcare customers looking to slash costs against an inflationary backdrop. However, we believe Stericycle's market price is baking in overly pessimistic midcycle revenue and profitability assumptions. Execution risk adds uncertainty to the equation, but pricing headwinds of the current magnitude are probably not permanent, and we expect the flagship regulated med-waste division to gradually rekindle low- to mid-single-digit organic revenue growth. The shares trade more than 40% below our $83 fair value estimate, which we think is a compelling buying opportunity for patient, long-term-minded value investors capable of stomaching heightened volatility in the year ahead.

Stericycle's shares reached a peak near $150 in October 2015 before heading into a multiyear decline, with several big steps down along the way. Selling pressure was initially driven by earnings misses in late 2015 and early 2016 that were in part linked to two large, expensive acquisitions that added complexity to the organization and stretched its resources. Not long after Stericycle bought it in 2014, PSC Environmental (industrial hazardous waste; now the manufacturing and industrial services, or M&I, segment) ran into a pullback in U.S. industrial activity and headwinds among energy end-market customers, and the deal arguably took the company into a less core, more competitive marketplace. Also, although the document destruction services of Shred-it (acquired in 2016) are now enjoying healthy organic growth, the integration faced a rocky start. More important was the emergence of a painful contract repricing phase among the company's premium priced small-quantity waste generator accounts. By mid-2016, management began acknowledging the issue as formerly robust organic growth in the flagship regulated medical waste and compliance services division began to deteriorate. Further guidance shortfalls and concerns about the duration of SQ pricing concessions have continued to weigh on sentiment.

Why Did SQ Contract Concessions Emerge in 2016?
In 2016, Stericycle's core regulated medical waste and compliance division saw the emergence of significant pricing pushback in its most profitable customer base--domestic small-quantity waste generators--and we expect the impact to persist into 2019. Other issues have contributed to the company's notable revenue and margin headwinds over the past two-plus years, including cyclical weakness in the manufacturing and industrial services segment, the need to exit unprofitable patient transfer contracts in the United Kingdom, and most recently, a pullback in major recall projects in the communication solutions division. But SQ contract concessions have been at the forefront and remain one of the most prominent investor concerns, in our view. SQ pricing headwinds aren't new to the story, but they're often misunderstood, and limited disclosure on the customer segmentation front makes it more difficult to discern the impact. This pricing reset has pulled Stericycle's domestic SQ business off its previously robust organic growth trajectory of nearly 8% on average between 2007 and 2015.

Recently acquired hospital-owned SQ customers (blended accounts) are a key pressure point. The U.S. healthcare end-market landscape has shifted over the past decade, with large hospital groups actively acquiring small healthcare practices, especially physicians' offices like general practitioners and cardiologists. In many cases, individual hospitals have rolled up hundreds of these providers into an integrated network of satellite locations. In the past, Stericycle has referred to these recently acquired SQ customers as "blended accounts"--in most cases, they are still SQ waste generators processing the same waste levels as before, with Stericycle stopping at the same location, but with one major caveat: They're no longer independent. They operate under the umbrella of a large hospital group or purchasing organization that enjoys much greater bargaining power than a doctor's office representing itself as a small-business owner. With a large amount of consolidation having already occurred, hospital groups have been moving beyond their initial integration phases in recent years, shifting focus to smaller cost synergies/savings opportunities--including medical waste removal--that were previously a lower priority. As these contracts renew, Stericycle is seeing heavy discounting of about 35% on average. The company doesn't consistently break out specific customer segmentation, but on the basis of past disclosures we've pulled together, we estimate blended SQ accounts make up somewhere around 20% of total SQ revenue.

True SQ customers are also pushing back. In addition to pricing pressure among hospital-owned SQ accounts, Stericycle is grappling with pushback among independent SQ customers, or true SQ accounts, to which it has been conceding discounts near 15% on average as contracts renew. We estimate true SQ accounts (unaffiliated doctors, dentists, veterinary offices, and so on) make up roughly 55% of total domestic SQ revenue; in our view, the onset of rate concessions stems from a few factors. First, independent physician offices have been faced with rapidly rising operating costs and declining reimbursements in recent years (driven in large part by intensifying regulation, including the Affordable Care Act), and small bills like medical waste removal (often under $1,000 annually) that previously fell under the radar are now under scrutiny as providers leave no stone unturned for cost savings. Second, the SQ class-action lawsuit, which settled in 2017 with a $295 million payout funded in July 2018, brought significant attention to Stericycle's pricing practices, prompting true SQ customers to inquire about their bills and push for price cuts--the company has long been the premium-priced provider for SQ customers. The original complaint filed in 2013 alleged the company "imposed unauthorized or excessive price increases and other charges." Management denies wrongdoing, and there was no admission of fault in the settlement. On the positive side, the issue is now in the rearview mirror and any negative publicity should begin to subside in the year ahead.

Putting it all together, we estimate 75% of Stericycle's SQ business (true SQ and blended accounts) is facing a pricing rollback that's proving painful for the flagship regulated medical waste segment. Management reclassified reporting segments in 2016, which makes it tough to make an apples-to-apples comparison of med-waste division organic growth with that of previous years. This is because the segment's quarterly results for 2014 and 2015 reflect domestic-only med-waste operations and industrial hazardous waste business (M&I), while subsequent periods include domestic and international med-waste operations while excluding M&I. Nonetheless, we can see that SQ pricing concessions are the primary driver of the marked organic slowdown by the first quarter of 2016. In short, declines over the past few years compare with a previous run rate in the high single digits. We note that the pullback in 2015 had less to do with SQ pricing concessions and more to do with lower fuel surcharge revenue and slowing industrial hazardous waste activity for the M&I unit due in part to cyclical factors.

The SQ pricing reset is a major headache for Stericycle, but not all med-waste customers are affected. We estimate true SQ and blended SQ accounts together make up a ballpark 26% of total medical waste and compliance division revenue, which in turn constituted 57% of consolidated revenue in 2017. We don't believe Stericycle has been conceding price with customers making up most of the other 74% of med-waste segment revenue, which includes domestic large-quantity, or LQ, waste-generating customers (hospitals), retail/healthcare hazardous waste, and international med-waste. LQ customers already enjoy strong bargaining power that's long yielded more favorable terms than SQ accounts could negotiate. On top of that, waste removal expenses for large hospitals (including high-cost must-incinerate waste) are a much larger and more visible outlay to begin with, often exceeding $35,000 annually. Thus, Stericycle's invoice doesn't fly under the radar screen for LQ accounts as it often does for a small doctor or dentist office that pays less than $1,000 per year. The international med-waste operations have seen intermittent bouts of pricing pressure, particularly with government-owned contracts in Latin America, but do not appear to be facing a broad multiyear repricing problem, and the retail hazardous waste business is growing nicely on the back of strong demand for pharmaceutical disposal services (medication disposal kiosks). Lastly, in the domestic SQ customer segment, national SQ accounts (national chains of individual kidney dialysis clinics, for example) aren't commanding concessions because, like LQ accounts, centralized buying scale already affords bulk discounts.

Broad-Based SQ Repricing Won't Last Forever
We expect the bulk of Stericycle's SQ pricing concessions to abate by the end of 2019. Contracts have an average duration of three to five years, and given Stericycle's immense customer base, this implies that around 25% renew annually and it should take roughly four years to cycle through all contract renegotiations. Thus, having begun in 2016, the impact of pricing concessions of the current magnitude should begin to diminish in 2019. Management has provided guidance in terms of its expected impact, but to get our own sense of how pricing concessions should be playing out (as a check), we ran a revenue analysis that assumes one fourth of true SQ and blended SQ customers renew at a discount each year between 2016 and 2019, using the company's run rate of SQ revenue in 2015 of $750 million, which management disclosed in 2016. We applied renewal price discounting of 15% for true SQ and 35% for blended SQ customers while keeping national SQ pricing stable. National chains of local dialysis clinics, for example, already enjoy bulk discounts. On the basis of management's commentary during the first half of this year, we believe the 15% and 35% discounting levels are still valid.

Our initial revenue analysis, which assumes contracts renew evenly each year, suggests pricing concessions should be reducing Stericycle's organic SQ revenue base by at least 4.0% annually on average between 2016 and 2019, all else equal (ignoring pricing escalators, customer additions, and increased ancillary penetration). That translates into an approximate $115 million cumulative pricing-related loss on the original run rate of existing SQ business in 2015. In fact, our estimate came in below the company's internal forecast provided in 2016, which hasn't materially changed, and since guidance proved more conservative, we've chosen to factor those numbers into our base-case med-waste segment model assumptions. When all is said and done, the company expects $130 million in total SQ pricing concessions through 2019, which implies a 4.5% average annual decline. Management has drilled that down a bit further, estimating SQ pricing-related losses of about $15 million in 2016, $44 million in 2017, $45 million in 2018, and $25 million in 2019. Applying that annual cadence yields SQ revenue declines by year of 2.0%, 6.0%, 6.5%, and 4%, respectively. When baking in the favorable impact of price escalators (which we expect will at minimum approximate inflation, or 1.5%-2.0%), we estimate SQ revenue should be posting organic declines in the ballpark of 1.0%, 5.0%, 5.5%, and 2.5%, respectively, between 2016 and 2019. That's an average of 3.5% annually, ignoring contributions from customer additions or increased penetration of ancillary services, which we don't bake in until 2020 anyway. We already incorporate it, but an annual pricing-related loss of $130 million has roughly a $4 per share negative impact on our fair value estimate, ignoring other losses associated with management distraction or changes in sales strategy.

How does this cadence of expected SQ revenue declines compare with actual results? So far, so good. Our discussions with management lead us to believe pricing concessions have not worsened beyond the company's original expectations, and the numbers appear to back this up. Stericycle doesn't disclose domestic SQ revenue, save for a few one-time disclosures in the past. Thus, to gauge the trajectory of pricing concessions, we are left with having to assess total organic med-waste segment performance, which reflects more than just SQ business, including LQ (hospitals), retail/healthcare hazardous waste, and international med-waste. Along those lines, we calculated what Stericycle's med-waste division organic revenue trends should have looked like between 2016 and the first half of 2018 by weighting what we know to be roughly true about the growth contribution from non-SQ business (derived from management commentary) and layering in our aforementioned approximations for SQ revenue declines thus far (which are not disclosed). We then compared that outcome with actual med-waste segment performance, and it wasn't far off. Overall, the cadence of pricing concessions appears to be roughly tracking our expectations, and that's good news.

Market Price Reflects Overly Pessimistic Midcycle Growth Assumptions
Stericycle’s current price offers upside potential with an attractive uncertainty-adjusted margin of safety. Because of numerous earnings shortfalls over the past few years, Stericycle has morphed into a show-me story in terms of an upside catalyst. Even so, negative investor sentiment looks excessive when we back into the current market price with our discounted cash flow model by adjusting key assumptions. Our analysis suggests the market price is implying only flattish midcycle organic revenue growth with negligible operating margin improvement. Execution risk remains, Stericycle's top line won't return to its former high-single-digit organic growth trajectory, and margins will shake out below the historical run rate (partly because of blended SQ pricing rollbacks), but we think organic top-line growth near 3.5% and EBITDA margins near 26% are achievable against a stable pricing backdrop, with incremental help from upselling ancillary services and efficiency optimization. Ignoring divestitures, we currently forecast 40-50 basis points of average annual growth from acquisitions on top of that.

Switching gears to Stericycle's profitability, it looks to us as if the current market price is baking in scant margin improvement over the long run. We agree that if Stericycle faced a wholesale mix shift of high-margin true SQ accounts to hospital-owned blended SQ accounts, it would see long-term declines in SQ contract pricing and overall med-waste segment sales, which would frustrate margin improvement. In fact, we expect total adjusted EBITDA margin to fall 130 basis points in 2018 (to 21.4%) on the back of lost leverage from current pricing rollbacks. However, we are betting incremental SQ customer mix shifts will be relatively modest in the years ahead. We expect the impact of pricing concessions to dissipate in 2019 and look for med-waste division revenue to return to modest organic growth in 2020, thus driving incremental leverage over fixed network costs.

We are also giving the company some credit for longer-term internal productivity gains stemming from its recently implemented "transformation" initiatives. The company appears to be seeing initial benefits from various optimization efforts (standardizing route logistics, upgrading field IT), and portfolio rationalization (it recently divested hazardous waste services in the U.K.) has the potential to be of help by simplifying the portfolio. But the company expects the bulk of savings to come from its multiyear enterprise resource planning system rollout. We think Stericycle has been successful integrating tuck-in med-waste acquisitions over the years in terms of revenue synergies, but its disparate back-office IT systems, which lack standardization, are long overdue for a makeover. Thus, provided the company doesn't overspend, an ERP upgrade makes sense and should boost visibility (more surgically optimize pricing decisions, for example).

Applying management's cost savings targets to clean 2017 results implies an adjusted EBITDA margin in the ballpark of 28%-29% (stripping out nonrecurring items and transformation costs). Our fair value bakes in a midcycle operating margin near 26% (our 2022 forecast), which compares with 22.7% in 2017 and our ballpark 21% forecast for 2018. Before the onset of SQ pricing declines, between 2011 and 2015, Stericycle's adjusted EBITDA approached 29% on average.

A notable risk to our midcycle profitability assumptions is management execution, especially in terms of overspending or distraction with respect to the broad ERP project. Our discussions with management give us some degree of comfort that the team is cognizant of the common pitfalls associated with ERP implementations and is striving to avoid them (for example, the company has added compliance and auditing head count, including dedicated project teams, to improve internal controls and oversee best practices in the ERP process). Nonetheless, the project's success is by no means a foregone conclusion, which is one reason for our high fair value uncertainty rating.

Matthew Young does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.