Stericycle Is on a Path for Strong Margin Expansion

Sector Director

Brian Bernard

Since its founding in 1989, Stericycle had been extremely acquisitive, having purchased more than 500 companies. This strategy led to a lengthy period of impressive growth, and the firm built unmatched scale. However, acquisitions began to stray from Stericycle's core competencies, and poor integration efforts caused inefficiencies to build. After decades of strong growth and profitability, Stericycle's financial performance began to deteriorate in 2017.

However, with a refreshed management team led by CEO Cindy Miller, we now believe Stericycle has turned the corner. With Miller at the helm, Stericycle has divested low-margin, noncore businesses, most notably environmental solutions. The enterprise resource planning implementation project continues, and we expect it will be completed within the next couple of years. We expect a common ERP system will streamline Stericycle's operations and improve financial planning and analysis. Finally, Miller has implemented much-needed oversight and standardization; for example, customer contracts are now reviewed by a deal review committee.

Management's turnaround efforts are taking hold. The company has realized solid organic growth since 2021, and consolidated gross profit margin has substantially improved compared with 2019. Stericycle's self-help measures and significant exposure to the growing U.S. medical waste market should result in solid top-line growth and margin expansion over the next five years. We forecast Stericycle's revenue to grow at about a 4% five-year compound annual rate and adjusted EBITDA margin to expand to around 23.5% by 2027-28 from 17%, on average, during 2019-23. Most importantly, we expect return on new invested capital will rebound to the low double digits by 2027.

Business Strategy & Outlook

We believe Stericycle's regulated waste and compliance segment enjoys a narrow economic moat. We see a scale-driven cost advantage as the segment's primary moat source with intangible assets (licenses and permits) and switching costs as secondary moat sources that create additional barriers to entry and support high customer retention rates (about 90%). Customer retention rates were relatively unaffected by the class-action lawsuit as customers have few alternatives.

Stericycle has long dominated the North American medical waste space. The next-largest national competitor is Sharps Compliance, which generates less than 3% of Stericycle's global regulated waste and compliance revenue and is barely profitable (Aurora Capital Partners acquired Sharps in August 2022). Aside from Sharps, there are a couple of hundred small private local and regional medical waste operations. The three largest traditional solid waste management companies have either failed to enter the space or decided to not even try. 

We believe Stericycle's regulated waste and compliance segment possesses a scale-driven cost advantage, underpinned by superior route density and fixed-cost leverage compared with its much smaller competitors. Stericycle's dominant market share often translates into dense collection routes, which allows the firm to collect more medical waste per mile driven and direct more volume through its transfer sites and processing facilities (that is, better asset utilization) compared with smaller competitors that operate sparser routes. Furthermore, the firm's scale allows it to spread its selling, general, and administrative costs over a greater revenue base relative to its competition.

We see Stericycle's cost advantage as a strong deterrent to new entrants, which has helped defend the firm's high market share. Given its superior unit economics, the firm can price lower than competitors that must also grapple with high startup costs (for example, collection vehicles and processing facilities). Even municipal solid waste giant Waste Management struggled to profitably enter the medical waste market and decided to move on rather than press on and incur losses.

In our view, Stericycle's strong share in the medical waste market is also supported by two other moat sources, intangible assets and switching costs, which can prove to be challenging barriers for new entrants and existing competitors to overcome.

The medical waste industry is heavily regulated, and operators must acquire myriad licenses, permits, and other authorizations. Permits for hospital, medical, and infectious waste incinerators are the most challenging to obtain. We consider the difficulty in obtaining new incinerator permits akin to, or perhaps even more challenging than, obtaining permits for new solid waste landfills. Stringent Environmental Protection Agency regulations caused the number of incinerators to plummet from several thousand in the late 1990s to less than 60 by 2010. Sharps recently disclosed that there are only 10 permitted commercial incinerators for medical waste and unused pharmaceuticals in the U.S., and we believe Stericycle owns most of these (Sharps owns one).

Stringent environmental regulations and alternative disposal methods (mainly autoclaves, which use high pressure and steam to sterilize medical waste) have greatly reduced the role incinerators play in medical waste disposal today. According to the EPA, over 90% of potential infectious medical waste was incinerated before 1997, but that figure has shrunk to less than 10% today. Still, incinerators are used to dispose of trace chemotherapy, pathological, and other hazardous waste. Given that incinerators still play a crucial role in disposing of high-risk medical waste streams and we believe it is unlikely new incinerators will be constructed, Stericycle's control of this scarce asset helps the firm retain customers that need access to incinerators. 

Medical waste operators must obtain permits to transport medical waste and construct and operate transfer stations and processing facilities. Many of these permits are granted by local jurisdictions, but some come from other entities. Many of the permits needed to transport and process medical waste can be obtained by competitors, but it can be a lengthy process. Furthermore, new processing facility proposals can face community opposition that can delay or scuttle the projects. 

Medical waste generators must comply with myriad state and federal regulations that can be strict and onerous, and violations can result in significant monetary and reputational damage. For example, state regulations can place cradle-to-grave liability on waste generators, meaning the ultimate liability for mishandled medical waste can fall on the generator even if the collection and disposal process is managed by a third party. We believe the substantial risks involved with medical waste disposal dissuades generators from switching to less reputable providers and makes managing some of the disposal process in-house a less attractive proposition. We think this assertion is especially true given that waste disposal represents a small cost for generators. We estimate that medical waste disposal accounts for well below 1% of hospital costs and perhaps costs a few grand annually for a small-quantity generator. 

Stericycle's secure information destruction services segment consists of its Shred-It business, acquired in October 2015 for $2.5 billion (10.8 times EBITDA with synergies and 14 times EBITDA without synergies). Like Stericycle's medical waste business, Shred-It is a route-based business serving regulated markets with leading share. Unlike the medical waste business, Shred-It has a much more formidable, albeit still smaller, competitor in Iron Mountain's $400 million information destruction business (about half the size of Shred-It), and the market is more fragmented with thousands of private regional and local competitors compared with hundreds of these firms in the medical waste market. 

We assign Stericycle's secure information destruction segment a no-moat rating. However, because we estimate the segment accounts for less than 50% of Stericycle's earnings, it doesn't prevent us from assigning the consolidated firm a narrow moat rating. We believe the segment has a scale advantage (better route density and overhead cost leverage) compared with smaller regional and local competitors; however, we don't think it benefits from intangible assets or switching costs. While there are regulations for data destruction, we think many businesses are less concerned about the risk of shredding documents in-house, as evidenced by the large portion of the market that Stericycle believes is unvended (50%-60%). Furthermore, our analysis of Shred-It's historical financial performance supports our no-moat rating, in our view. The business Stericycle acquired in 2015 was created a year earlier through the combination of privately held Shred-It and Cintas' paper shredding business. Based on our estimates, Cintas' paper shredding business struggled to earn the consolidated company's cost of capital between 2006 and 2014. While Cintas was bullish on its paper shredding business early on, it proved to be its most volatile business due to changes in paper prices that are difficult to forecast and can have an outsize effect on profit margins. Cintas also found it more challenging than expected to cross-sell its paper shredding services to customers using its other services. As a result, Cintas' management decided to move on from the business. 

We're unsold on the strategic merits of the Shred-It acquisition. We think the prior management team overpaid for the business, given its long-term prospects. Still, despite the specter of a shrinking market, Shred-It has posted organic revenue growth (aside from pandemic-stricken 2020) since its acquisition. We believe the current management team, with its narrowed focus on optimizing core assets, can better realize Shred-It's scale-driven cost advantage and perhaps achieve modest excess returns.

Narrow

Economic Moat

Stericycle

Stericycle, Inc. engages in the provision of waste management services. It operates through the following segments: North America and International. The North America and International segments offer the following services: Regulated Waste and Compliance Services (RWCS), Secure Information Destruction Services (SID), Communication and Related Services (CRS). The RWCS provides collection and processing of regulated and specialized waste, including medical (including reusable sharps disposal management services), pharmaceutical and hazardous waste, for disposal and compliance programs. The SID provides a collection of personal and confidential information for secure destruction and recycling of shredded paper. The CRS includes communication services such as appointment reminders, secure messaging, event registration and other communications for hospitals and IDN’s. The company was founded by James W. Sharp in March 1989 and is headquartered in Lake Forest, IL.

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Stericycle reports robust Q1 performance, anticipates challenges, eyes acquisitions

Stericycle's Q1 2023 earnings call highlighted strong performance, with a focus on organic revenue growth and margin expansion. The company is navigating challenges related to pricing strategies and inflation impact while capitalizing on opportunities for acquisitions and ERP deployment. Overall, the company remains cautiously optimistic about its outlook for the year.

Stericycle achieves lowest debt leverage ratio since 2015, focuses on growth opportunities

Stericycle's Q2 2023 performance reflects progress in debt reduction, organic revenue growth, and infrastructure modernization. While challenges exist in certain segments, the company remains confident in achieving full-year guidance and is focused on future margin improvement and portfolio optimization.

Stericycle reports mixed Q3 results, focuses on ERP benefits

Stericycle's Q3 performance reflects mixed results, with growth in regulated waste services but a decline in Secure Information Destruction revenue. The successful ERP deployment and focus on customer experience highlight operational strengths, while challenges include potential glitches and the impact of lower commodity index revenues. Opportunities lie in the transition to a subscription-based service revenue model and the anticipated benefits of the ERP system and operational improvements.

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