Changing Healthcare Landscape Benefits Stericycle

In recent years, we’ve seen Stericycle accelerate its evolution from a pure-play medical waste company toward a comprehensive provider of ancillary services. Following the $2.3 billion purchase of Shred-it in 2015 and the $275 million PSC Environmental deal in 2014, we estimate that close to 40% of Stericycle’s consolidated sales now come from document destruction and nonmedical hazardous waste management. Adding these compliance-driven services expanded Stericycle’s addressable market far beyond healthcare into the industrial, retail, legal, and financial landscapes; however, we believe the better potential resides in generating incremental revenue streams from Stericycle’s healthcare customers through bundled service adoption. It remains to be seen how Stericycle navigates the competitive landscape in its newest verticals.

Stericycle’s international sales have grown to represent about one third of sales as the company attempts to replicate its domestic strategy. However, economic weakness in Latin America and unprofitable U.K. patient transport contracts have negatively affected margins recently. We expect international expansion efforts to be tempered as the company works through these issues.

Unmatched Scale Digs Wide Moat As an integrated specialty waste hauler operating in a highly regulated industry, Stericycle's wide moat springs from unmatched scale in medical waste collection, treatment, and disposal assets, which combine to create a cost advantage and customer switching costs supported by intangible assets (regulatory permits). There used to be 2,000-plus medical waste incinerators in the United States, mainly consisting of captive facilities housed on hospital campuses. However, after regulatory scrutiny prompted a wave of incinerator closures due to the costs of retrofitting these facilities to higher health and safety standards, little more than 50 remain. Of these, 15 are commercial (noncaptive) incinerators with large capacities that accept waste from generators, and Stericycle controls 10.

Industry estimates suggest that only 15% of a generator’s waste stream ends up in the medical waste incinerator; however, we argue that this particular waste stream can be the most problematic for generators, as improper handling of it can result in steep financial penalties. State regulations have evolved to allow greater portions of the medical waste stream, such as certain materials that come into contact with bodily fluids, to be treated in autoclaves rather than incinerators. These include sharps, gloves, gowns, dressings, and other materials. Autoclaves steam-sterilize materials at lower temperatures than the extremely high temperatures needed for combustion in an incinerator. This achieved the objective of lessening the amount of environmentally adverse emissions from incinerators while allowing the healthcare industry to lower the total cost of safe infectious waste disposal. Stericycle’s participation in the promotion of autoclaving as waste treatment resulted in a large network of 114 autoclave processing facilities in the U.S. As with incinerators, states require permits for infectious waste autoclaves, which govern capacity, minimum temperature, and minimum processing time. These factors must be scientifically validated at regular intervals to assure that all pathological material is rendered harmless. In addition, Stericycle innovated a proprietary method of treatment called electro-thermal deactivation, which subjects certain waste to low-frequency electromagnetic waves that achieve more uniform temperature control. After steam sterilization or ETD, the remaining material is shredded and taken to a landfill. Because autoclaves must uphold capacity limits, Stericycle’s 200-plus permitted domestic transfer stations provide the ability to store or to move around loads of waste in wait for processing.

State medical waste regulations place liability on generators, which must ensure safe collection, storage, transfer, treatment, and disposal of medical waste from cradle to grave; we believe this level of regulation increases customer switching costs more so than for customers of municipal solid waste companies. Fines for improper handling of medical waste can be severe, prompting both large- and small-quantity customers to choose reputable providers of medical waste management. Small generators--doctors, dentists, tattoo shops, funeral homes, and the like--produce much lower quantities of waste, with the majority fit for the autoclave; however, liability avoidance is arguably of greater concern to a small business due to hefty financial penalties, and Stericycle’s ability to manage the entire process has attracted a dense network of customers (more than 500,000) with an annual retention rate over 90%.

As such, we believe that Stericycle’s ability to provide a closed-loop solution from pickup, sortation, proper storage, and treatment to ultimate disposal is a clear advantage. Moreover, we believe that a dense network of treatment, transfer, and disposal facilities, all supported by regulatory permits (intangible assets), provides a cost advantage against smaller players that do not have incinerators and/or have fewer autoclave facilities in a locality. Since autoclaves have strict capacity limits, Stericycle’s ability to store waste at transfer stations and move it around a network secures route-optimization benefits that fragmented players cannot easily replicate.

In addition to medical waste management, Stericycle offers both large-quantity and small-quantity customers other outsourced services, often bundled together in one contract. With healthcare providers increasingly seeking to simplify operations and lower costs by outsourcing noncore services, Stericycle benefited from its ability to be a one-stop shop, a trend that continues to be an important driver of the company’s historically attractive year-over-year organic revenue growth. The Steri-Safe service provides regular training, essentially teaching healthcare workers and lab personnel how to properly segregate waste at the source. Other services include sharps management solutions (reusable sharps boxes), patient communications (automated appointment reminders), hazardous waste pickup and treatment (nonmedical), and paper shredding. In our view, every additional service that Stericycle adds to a contract becomes an incremental source of revenue and margin for the company, as many of these services are less capital-intense than pickup and disposal of medical waste. Furthermore, as additional services are layered onto a bundled solutions contract, the large-quantity or small-quantity customer becomes more reliant on Stericycle, lessening the ease of breaking the contract and finding replacements for multiple vendors. In our view, growth of ancillary services has strengthened Stericycle’s switching cost advantage.

The addition of Shred-it in late 2015 was an admittedly big bet. Securing this asset brings Stericycle a relatively established network of pickup routes and shredding equipment. Although paper use on the whole is in decline, regulated industries such as healthcare, finance, and legal still incorporate documentation with sensitive information into daily practice. While we believe that paper shredding as a stand-alone business lacks any real barriers to entry, route density increases overall efficiency and protects against competition from fragmented players, much as we see in wide-moat Cintas’ uniform services model. Stericycle has the advantage of introducing Shred-it to a vast network of healthcare customers, increasing penetration in regulatory-driven networks, and enhancing route density of this service line.

Acquisitions Add Some Risk Our fair value uncertainty rating for Stericycle is medium. The necessity of Stericycle's medical waste services supports a reliable stream of recurring revenue, which mitigates the overall risk of cyclicality in this business. Continued global economic uncertainty has the potential to slow Stericycle's international expansion plans; however, as its base of business continues to achieve density in these new markets, the international business should exhibit organic growth characteristics that mirror the domestic market, lending greater stability to international cash flows.

While we like Stericycle’s plans to enhance its product portfolio with higher-margin services, there is no guarantee that these investments will add value over time. For example, Stericycle’s recent acquisition of NotifyMD--a patient communications system--strays considerably from its core competency of route-based medical waste management platforms. Furthermore, the addition of PSC Environmental to Stericycle’s portfolio depressed gross margins considerably. Thus, Stericycle’s acquisitive strategy can make it difficult to accurately forecast sales growth, margin progression, or even future value creation.

As is typical with any highly acquisitive firm, integration risk can be significant; while Stericycle has a long history of quickly and efficiently integrating tuck-in acquisitions, recent deals have been larger and more complex. Furthermore, Stericycle needed an extension to file its 2015 10-K, citing difficulties in assessing the effectiveness of internal controls at PSC Environmental in a timely manner while at the same time onboarding Shred-it. This snafu illustrates the bottlenecks that can occur behind the scenes at highly acquisitive firms that could ultimately affect value if not addressed and corrected.

The company has proved itself to be adept at extracting value from acquisitions, which has led to an impressive record of shareholder returns. As such, acquisitions receive capital-allocation priority, with remaining excess capital typically returned to shareholders via stock buybacks. However, this heavy reliance on acquisition growth prevents cash from building up on the balance sheet, which lessens the likelihood that Stericycle will pay a dividend anytime soon.