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Morningstar | Stericycle's 4Q Results Mostly in Line, but Margin Outlook Disappoints; Shares Remain Undervalued

Narrow-moat medical waste specialist Stericycle’s fourth-quarter top line fell 1% organically but wasn’t far off our expectations. Relative to a year ago, lower revenue stemmed from core medical waste and compliance services division pricing headwinds and the onset of weakness in the communication and recall services segment, which is variable by nature. C&RS’ product recall business has been grappling with smaller events that carry significantly lower revenue per event. These factors more than offset robust underlying document-destruction (Shred-it) growth. Organic sales in the med-waste unit fell 1.5%, but that was largely in line with what we’ve been anticipating as small-quantity customer pricing concessions amortize in. Along those lines, small-quantity account repricing hasn’t shown many signs of incremental deterioration beyond our previous expectations. Also, management hinted that its previous guidance for $130 million of cumulative pricing concessions (from 2016 through 2019) remains valid. Stericycle’s adjusted profitability didn’t deviate much from our forecast.

On the other hand, management’s adjusted 2019 EBITDA margin guidance (19.4%-20.1%) came in well short of what we were anticipating, and below consensus. It isn’t clear what’s behind the weak guidance since med-waste pricing pressure doesn't appear to be worsening and "transformation" costs were said to be on track. We suspect it’s partly related to lost leverage from sluggish C&RS trends, and we sense productivity and efficiency aren't where they should be.

Because of the disappointing profitability outlook, we expect to reduce our 2019 and 2020 EBITDA forecasts. We also expect to temper our midcycle EBITDA margin assumptions (previously near 26%) by at least 100 basis points, given the high uncertainty surrounding execution at the moment. We expect to lower our $83 fair value estimate by 8%-10%. Even after that, though, the shares appear attractively undervalued.

Along with fourth-quarter earnings results, Stericycle disclosed several changes to its senior leadership team. Most notably, Charlie Alutto (CEO since 2013) intends to retire in early May; the board selected current chief operating officer Cindy Miller to take the reins. Miller only joined Stericycle as president and COO last October, but she appears to have a solid leadership resume--her background includes time as president of integrator UPS’ global forwarding division (she spent 30 years at UPS). CFO Dan Ginnetti will transition to the role of executive vice president of the international division once the firm finds a replacement. In addition, former CEO Mark Miller (along with another board member, Thomas Brown) will be retiring from the board. The firm announced a few other leadership changes, including the hire of a chief commercial officer (a newly created role). Overall, this was a surprise to us, and we don’t have the whole story yet, but at first glance we think this management shift will prove to be a net positive for Stericycle as it may bring a much-needed fresh perspective for a firm that’s been grappling with executional shortfalls.

Even with our revised midcycle profitability assumptions, we still see opportunity in the shares. Stericycle has clearly 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 3.5%-4.0% 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. Execution risk adds uncertainty to the equation, especially given the firm’s multiyear ERP system rollout. However, med-waste segment pricing headwinds should abate next year as the firm cycles through its small-quantity contract renegotiations, and we suspect new management team members--including new CEO Miller--will bring a fresh perspective.