EUR 850.00 For Business Accounts Only

Morningstar | Communication Solutions Weakness Weighs on Guidance; Med Waste Results in Line; Shares Undervalued

Narrow-moat medical waste specialist Stericycle posted a 1% organic revenue decline in third quarter, slightly below our expectations due mostly to incremental weakness in the communication and recall services unit, or C&RS, which is variable by nature. C&RS’ product recall business is seeing decent growth in the number of events, but they are much smaller this year with significantly lower revenue per event. Organic revenue in the flagship medical waste and compliance segment fell roughly 3% year over year (3% year to date), but was largely in line with our expected run rate. Because of ongoing small-quantity, or SQ, customer pricing concessions, the med-waste segment has been a key focal point for investors. Along those lines, thus far in 2018, SQ-account repricing has shown scant signs of incremental deterioration beyond our previous expectations. In fact, management noted on the call that SQ-account related discounting came in better (lower) than their internal third-quarter forecast by around $1 million; they’ve been expecting pricing headwinds of $40-$45 million for 2018.

Consolidated adjusted profitability came in slightly shy of our expectations, though similar to last quarter, that’s probably because of lost leverage from lower C&RS revenue. On the other hand, we were pleased to see that the firm’s “transformation” related expenditures remain within budget and annualized EBITDA savings targets for 2018 remain on track--an important factor to watch in the year ahead.

We tempered our revenue forecasts for 2018 and 2019 on the back of sluggish C&RS trends, and we also modestly lowered our operating margin assumptions due to related lost leverage. The impact of these adjustments were only partly offset by the time value of money, thus we expect to reduce our $86 fair value estimate slightly, by about 2%. That said, at $50.78 as of market close on Nov. 1, the shares remain solidly undervalued, trading at a healthy discount to our DCF-derived fair value.

Management revised its 2018 EBITDA guidance to a range of $736 million to $756 million (from $750 million-$775 million), a decline of $17 million at the midpoint--weakness in the C&RS division was the biggest contributor. As a result of the guidance adjustment, we think the stock may see incremental selling pressure on Nov. 2. While we consider it a positive that the revision didn’t stem from core med-waste division results or faltering execution in terms of the multiyear ERP implementation, the market has not historically reacted favorably to Stericycle’s guidance shortfalls/reductions at any level. We attribute that to numerous disappointments over the past few years that have hit management's credibility. Overall, Stericycle is very much a “show me” story.

On the other hand, our thesis remains intact. Stericycle has seen several headwinds arise over the past several years, but in our view, market sentiment remains overly negative, and the current valuation offers an attractive entry point for patient value investors willing to stomach near-term volatility. We don't expect the company to reclaim its glory days of high-single-digit organic top-line expansion with 30% EBITDA margins. However, in our view, midcycle consolidated (and med-waste segment) organic revenue growth in the ballpark of 3.5%-4.0% and material margin improvement are achievable against a stable pricing backdrop, with incremental help from up-selling ancillary services and efficiency optimization. We note execution risk adds uncertainty to the equation, especially given the firm’s multiyear ERP-system rollout, but the firm’s med-waste segment pricing headwinds of the current magnitude should abate beyond 2019 as the firm cycles through SQ-customer contract renewals.