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Morningstar | FX, Winter Weather, and Cost Variability Pressure Stericycle's 1Q, but Shares Still Attractive

Narrow-moat medical waste specialist Stericycle’s first-quarter top line fell 4% organically, below our expectations because of weather disruption for the communication and recall services unit (temporary closure of its largest outbound sales center). Additionally, retail hazardous waste business within the core med-waste unit faced a tough project-work comparison we overlooked, and the industrial hazardous waste unit (M&I) is facing competitive pricing. Relative to first-quarter 2018, the organic revenue decline largely reflects ongoing medical waste segment pricing concessions and continued weakness at C&RS. C&RS’ product recall business is grappling with smaller events that carry lower revenue per event, and it lost sales on weather disruption. These factors more than offset document-destruction (Shred-it) growth.

Organic sales in the core med-waste division fell 2%, but that didn’t deviate drastically from our forecast, which incorporates small-quantity customer pricing concessions. SQ-account repricing hasn’t shown signs of deterioration beyond our previous expectations. Management noted that discounting remains in line with “previously communicated plans,” which implies guidance for $130 million of cumulative pricing concessions (from 2016 through 2019) remains valid.

Total adjusted EBITDA margin fell to 16.5%, from 21.2%. The decline isn’t surprising, especially given med-waste pricing pressure. However, the margin missed our expected run rate because of a handful of costs the firm was adamant won’t recur, including elevated third-party transportation costs linked to temporary plant closures and the need to true up certain cost accruals. We tempered our 2019 top-line and profitability forecasts and modestly reduced our midcycle EBITDA margin assumption to roughly 24.5%% (previously near 25%), given high uncertainty surrounding execution. Overall, we expect to lower our $77 fair value estimate by about 5%, but shares still look attractively undervalued.

Interestingly, despite elevated cost headwinds in the quarter, management reiterated guidance, which includes an expected adjusted 2019 EBITDA margin of 19.4%-20.1% in 2019. We do expect profitability improvement as the year progresses (and especially in the years ahead), but given the firm’s myriad optimization projects, recent variability in C&RS and M&I revenue, and a brand new senior leadership team our 2019 forecast will likely come in slightly below the low-end of management’s guidance range. We suspect investors will have a similar sentiment, and as a result the stock may see some near-term selling pressure. Of note, management hinted that its multiyear ERP rebuild program remains on budget, which is good news.

Despite our expected fair value adjustment, we still see plentiful opportunity in the shares. Stericycle has seen numerous headwinds arise over the past several years, but we think investor sentiment remains overly negative, and the current valuation offers an attractive entry point for patient value investors willing to stomach near-term volatility. The company won’t 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%-3.5% and material margin improvement are achievable against a more stable med-waste pricing backdrop beyond 2019, with incremental help from upselling ancillary services and efficiency optimization stemming from a more unified IT infrastructure. Execution risk adds uncertainty to the equation, especially given the firm’s multiyear ERP system rollout. However, the bulk of med-waste segment pricing headwinds should be in their final year, and we suspect new management team members--including new CEO Cindy Miller--will bring a fresh perspective.