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Stericycle's Positive Prognosis

By Mark Basham Amid increasing volumes of medical waste, and stricter government regulation of its disposal, Standard & Poor's Equity Research Services has a positive view of growth prospects for medical-waste services outfit Stericycle (SRCL

; recent price, $48). We also think the company will benefit from the industry's substantial barriers to entry to potential competitors.These factors will enable the company to earn superior returns and apply free cash flow to grow through acquisitions and to augment total return to shareholders via stock and debt repurchases, in our opinion.

Our positive outlook on Stericycle reflects our view of the low volatility of the shares relative to the U.S. equity market, a high level of earnings predictability and consistency, and better-than-average growth prospects compared to expected U.S. economic growth. We have a 5 STARS (strong buy) recommendation on the shares.

Stericycle is the largest provider of regulated medical waste services in North America. It operates a fully integrated medical waste management network in North America, consisting of 42 treatment and collection centers and 101 additional transfer and collection sites. The company operates a similar network in Britain, with 10 treatment/collection centers and two additional transfer/collection sites. In addition, Stericycle licenses its technology, sells equipment, or has joint venture interests in a number of other countries.

TRASH AND BURN. Services include collection and transportation, treatment and disposal, and related services required by regulations, such as documentation and compliance. As of spring 2005, the company had approximately 325,000 customers, including 317,000 small accounts and 8,000 large accounts.

The company uses its proprietary electro-thermal-deactivation (ETD) treatment technology, as well as autoclaving (steam at high pressure and temperature) and incineration. While incineration in certain areas is mandated, the company believes its ETD technology offers a safer and more environmentally-sound method for treatment of medical waste.

The company is the conglomeration of 78 acquisitions of regional and local medical-waste providers from 1993 to 2005, of which the most notable was the 1999 purchase of the medical-waste business of Browning Ferris Industries. The industry remains fragmented, however, with a large number of such regional and local operators.

GLOBAL SPREAD. During 2004, the company entered, through an acquisition, the British medical waste management market. The company also has various licensing, joint venture, and other types of agreements to provide equipment or technology for other foreign medical waste management markets, including Mexico and Japan.

In North America, Stericycle seeks to expand the scope of the services it provides to its customers. These additional offerings primarily concern Occupational Health & Safety Administration compliance services through the company's Steri-Safe program, and the Bio Systems sharps (e.g., hypodermic needles) management program.

Stericycle estimates that the U.S. regulated medical waste services market generates about $3 billion in revenues annually, with the global market being in excess of $10 billion. The amount of medical waste is driven by increases in population and the intensity of usage of medical services by the population. As the U.S. population continues to grow older on average, medical waste per capita is expected to increase.

PREDICTABLE RESULTS. In addition to large health-care facilities, medical-waste generators include doctor's offices, clinics, and other non-traditional medical care facilities. As environmental and safety regulations have tightened, generators may also include manufacturing facilities, schools, restaurants, casinos, and hotels, as well as any business where contact with blood-borne pathogens is possible. Medical waste generated by home health care providers is currently unregulated.

Environmental regulation of how medical waste is treated and disposed of has also increased. We believe the increasing regulatory complexity and cost of medical waste management is driving many waste producers to employ outsourced service providers, such as Stericycle.

Cost savings and other operating efficiencies achieved by customers of Stericycle are strong inducements, in our opinion, to maintain their relationships with the company. As such, we think its operating results have a high degree of predictability. Furthermore, we believe that demand for medical waste management services is by and large not driven by economic cyclicality as much as population change and the extensive level of regulation to which the industry is subject.

HEALTHY FLOW. We think economies of scale derived from growth in the company's customer base, as well as the expansion of service offerings, will result in margin improvement in 2005 and 2006. As such, we expect organic (i.e., from existing businesses) revenue and profit growth to exceed growth in nominal U.S. gross domestic product in both years. We expect Stericycle to use cash from operations in excess of required capital expenditures for acquisitions, stock and debt buybacks, and at some point, we think, the initiation of cash dividends.

Stericycle has followed accounting rule APB 25 in accounting for stock options, under which such expense in recent years has been between 5% and 10% of reported income. Beginning in 2006, it will apply fair value recognition of stock-based compensation under FAS 123. Our $2.28 operating EPS estimate for 2006 includes an estimated 10 cents for stock-option expense.

We project that Stericycle, for the foreseeable future, will generate substantial free cash flow. Our multi-year cash-flow analysis assumes a declining rate of cash-flow growth in phases or steps from 8% in 2006-09, gradually falling to a sustainable 3% rate.

Although the stock's movement in the past has been negatively correlated with overall market volatility, we have assumed a beta of 0.65, which we think reflects its non-cyclical nature but also allows for calculation of a realistic present value. The present value of future free cash flows under our assumptions is $51, from which we derive a 12-month forward value of $56. Based on our 2006 estimate, our 12-month target price of $56 results in a p-e multiple of 25 times.

MORE DISCLOSURE, PLEASE. While this is a significant premium to the market p-e, we think Stericycle's earnings consistency and the projected availability of free cash flow support the premium valuation implied by our target price. Our target price is also 27 times our 2005 EPS estimate of $2.09 and 26 times our forecast free cash flow per share of $2.17, which we think is warranted by our investment thesis.

We think that Stericycle's corporate-governance practices are generally as good as, or somewhat superior to, peers of equal size or those in the environment/commercial services industry.

However, we think it could improve its corporate-governance disclosure policies -- particularly in regard to the board duties of its independent directors -- as well as formally state its policies regarding executive-compensation practices. For example, while option grants in recent years have been less than 3% of shares outstanding, stock-based incentive plans have been adopted without shareholder approval.

MORE PLAYERS? We believe there are several risks to our recommendation and target price. The expiration of noncompete agreements with former insiders of companies that Stericycle has purchased, as well as the above-average return on investment the company currently garners, may attract future competitors.

Potential changes in technology and regulations could negatively affect the company's business, and international expansion often carries more risk than domestic operations. Analyst Basham follows stocks of emerging growth companies for Standard & Poor's Equity Research Services

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