Value Play: US Ecology (Nasdaq: ECOL)

“It’s hard to think of a more perfect industry than waste management. If there’s anything that disturbs people more than animal casings, grease and dirty oil, it’s sewage and toxic waste dumps.”

— Peter Lynch, legendary Fidelity fund manager

My June pick for the Roadrunner Value Portfolio – chemical company Stepan (NYSE: SCL) – fit perfectly into Peter Lynch’s mold of a “boring” company and my August pick combines boring with disgusting to qualify as the perfect industry for value investors: toxic waste management.

Toxic waste management is not only disgusting, but also heavily regulated due to public safety concerns. Only a select few companies are licensed to perform the task. US Ecology is:

• One of only three full-service Class A, B, and C LLRW disposal facilities in the U.S.
• One of only two full-service Class A, B, and C low-level radioactive waste disposal facilities in the U.S.
• The first company in the nation to obtain a Toxic Substances Control Act (TSCA) processing and disposal permit to handle polychlorinated biphenyls (“PCBs”).

Being part of oligopoly (29% market share of hazardous waste disposal) means that US Ecology faces little price competition and can generate high profit margins. Peter Lynch loves companies in industries where barriers to entry are significant. In his book One Up on Wall Street, he offers the example of a local rock quarry:

I’d much rather own a local rock pit than own Twentieth Century-Fox, because a movie company competes with other movie companies, and the rock pit has a niche. What makes a rock pit valuable is that nobody else can compete with it. You don’t have to pay a dozen lawyers to protect it. The nearest rival owner from two towns over isn’t going to haul his rocks into your territory because the trucking bills would eat up all his profit. There’s no way to overstate the value of exclusive franchises to a company or its shareholders.

In the waste business since 1952, US Ecology currently owns six fixed disposal facilities located in the states of Idaho (corporate headquarters location), Michigan, Nevada, Texas (refinery waste), Washington (radioactive waste), and Quebec, Canada. In addition, US Ecology is vertically integrated through its ownership of a dedicated fleet of 234 gondola railcars that transport waste to its disposal facilities. Not only does its transportation segment add significantly to revenues when leased out to competitors, but it reduces U.S. Ecology’s own transportation expenses by eliminating reliance on costly rentals and offers customers a bundled transportation/disposal offering that wins business during times of railcar scarcity. Lastly, controlling transportation of the hazardous materials reduces liability risk for customers because the government holds the waste customers responsible for any contamination accidents during transport.

Headquartered in Idaho, US Ecology was originally a regional operator in the West, but it has recently made two transformative acquisitions that have turned it into a national player.

• October 31, 2010: Stablex Canada, a provider of hazardous waste services that operates a permitted hazardous waste processing in Quebec.
  
  
• May 31, 2012: Dynecol, a chemical and industrial byproducts treatment and reuse facility in Detroit, Michigan.

U.S. Ecology’s business is somewhat lumpy because 37% of its revenues are derived from one-time “event” cleanups that occur at varying rates from year to year. Breakdown of revenues are as follows:

 Source: 10Q Filing (page 18)

A management shakeup occurred in October 2012, when former CEO James Baumgardner was ousted in favor of CFO Jeff Feeler, a six-year veteran. The ouster does not appear to have been based on poor business performance but rather on ideological differences. Chairman of the Board Stephen Romano, who was US Ecology CEO from 2002-09, remained in place, so the ouster did not disrupt institutional knowledge in the executive suite. The stock jumped on the news; investors apparently think the company is better off without Baumgardner.

Second-quarter financials were strong, with double-digit increases in both operating income and EBITDA that reached record-high levels. Earnings beat analyst estimates and a couple of research outfits (Wunderlich and Zacks) boosted price targets and upgraded the stock on the results. Profitability metrics continue to impress and are improving:

• Return on invested capital = 15.6%
• Return on total assets = 12.3%
• Return on equity = 24.2%

CEO Jeff Feeler was very upbeat in his July 29^th remarks:

Solid waste volumes, a favorable mix of higher margin niche business and continued operational excellence combined to produce another record quarter and strong first half 2013 results. Our Event Business growth was driven by strong commercial activity, more than offsetting expected softness in government business.

Our pipeline for Event Business remains healthy, with a number of projects currently shipping and a series of new opportunities slated for the second half of 2013. This, combined with solid growth in our Base Business and demand for our thermal recycling services, puts the Company on track for a strong finish to 2013 and financial results towards the upper end our previous guidance range.

The company should achieve substantial economies of scale and scope from its Stablex and Dynecol acquisitions, which open up the entire East Coast of the U.S. as new markets. Consequently, US Ecology’s annual earnings growth rate – which averaged 22.1% per year over the past three years — should accelerate in the years to come.  Debt to capital is low at 20% and the company has generated positive free cash flow in each of the past 10 years – including during the global financial crisis of 2008-09.

Despite the company’s high profitability, strong growth, and reasonable debt levels, US Ecology remains inexpensive with an EV-to-EBITDA ratio of only 9.4 and a price-to-earnings ratio 19, which is below its five-year average earnings multiple.

US Ecology is a buy up to $32; I’m also adding the stock to my Value Portfolio.

Momentum Play: Hill-Rom Holdings (NYSE: HRC)

A little over a year ago, I wrote an article entitled Medicaid Nation: Winning and Losing Healthcare Stocks under Obamacare, in which I predicted that acute-care hospitals would be one of the winning healthcare sectors because increased availability of health insurance would reduce the amount of uncompensated emergency-room care they provide. Since the July 13, 2012 publication date, my prediction has proven true as hospital stocks have outperformed the S&P 500 by a whopping 44.8 percentage points:

Source: Bloomberg

This healthcare advantage may not be a one-time fluke, but could be the start of a long-term trend of outperformance. Indeed, 2013 is shaping up to be the first year that healthcare stocks have outperformed the S&P 500 index since 1998!

No wonder that super-smart private equity investors have invested so heavily in for-profit hospitals! I also predicted that hospital suppliers would do well because hospitals would be in a stronger financial position to make purchases. So far, hospitals have focused more of their spending on information-technology (IT) and less on capital equipment, and have proven to be shrewd price negotiators concerning the supplies they have purchased, but even so suppliers have managed to outperform the S&P 500 by four percentage points over the same July 2012-August 2013 period of time. This 4% constitutes only a tenth as much outperformance as the hospitals themselves, but I continue to believe that hospital supplier stocks will eventually catch up to the hospital stocks and fully benefit from a trickle-down of Obamacare largesse toward hospitals. Two reasons: (1) healthcare IT spending has exhausted itself with over 90% of hospitals having already taken advantage of Medicare/Medicaid IT incentive payments enacted in the federal government’s 2009 stimulus package; and (2) the imminent implementation of Obamacare removes regulatory uncertainty and provides hospital managements with the confidence that insurance reimbursement money will be there to justify increased capital expenditures.

If I’m right about hospital suppliers, then one of the best ways to play the sector is Hill-Rom Holdings, formerly known as Hillenbrand Industries before it spun-off its funeral division in 2008. Hill-Rom is a leading supplier of “patient support systems,” which primarily means high-tech hospital beds (53 percent of total revenues). The company has a 70% installed-base market share in the U.S.  Hospital beds are not commodities, but include a lot of proprietary technology:

• Prevention of bed sores (constant airflow and changes in mattress air pressure)
• emergency alerts if a patient tries to get out of bed unattended
• lifting and turning capability to help move patients in and out of bed or from stomach to back within the bed
• location monitoring within the hospital
• adjustable mattress angle by electronically moving both the head and the foot of the bed
• patient weight monitoring
• power outlets to accommodate oxygen feeds, lighting, and IV drips.

The more capabilities of the bed itself, the more money a hospital can save through reduced nurse staffing. Furthermore, high-tech beds are making it possible to discharge patients from high-cost hospitals sooner and transport them to lower-cost rehabilitation clinics, long-term acute care facilities and home-care settings.

The company is diversifying both geographically and product-wise thanks to two acquisitions in 2012:

February 14, 2012: Germany-based Volker, which specializes in acute-care hospital  beds for the European marketplace

July 25, 2012: Aspen Surgical Products, which produces basic medical supplies for the operating room, including scalpels, needles, fluid collection, and wound dressings.

The third-quarter financial report was uninspiring, with year-over-year adjusted earnings and revenues both down slightly, and full-year 2013 guidance reduced modestly. CEO John Greisch called the current healthcare environment “challenging,” but in the conference call he offered some glimmers of hope for improvement. For example, orders for capital equipment in North America were up 7% in the third quarter, which marks:

the strongest quarterly year-over-year growth we have seen for two years. We expect to see continued momentum in our North American capital business in the fourth quarter, traditionally our strongest quarter of the year.

Greisch is a straight shooter, which I like, and he doesn’t believe that the roll-out of Obamacare is going to have a large effect on hospital-bed demand. His forecast for the bed business is annual growth in the single digits:

Do I think healthcare reform was going to grow the population of licensed beds, and therefore have positive impact on capital as a result of that? I firmly believe the answer to that is no as much as I’d like to convince myself otherwise. It’s going to be a tough low growth business. I really don’t see the bed population growing for the reasons that we talked about, shorter length of stays, more care being pushed out of the acute care hospitals, et cetera. So I feel good about the momentum we’ve got going here into the fourth quarter and into 2014. But in terms of significant changes in our outlook, I think the low-single digit growth for this business over the long term is where we continue to believe this business is headed.

A low-growth business can still be very profitable if you’re the market leader like Hill-Rom. And Greisch confirmed that Hill-Rom is maintaining its leading market share, thanks to a North American growth rate higher than its competitors are able to achieve. Still, Greisch’s long-term goal is to reduce the company’s reliance on lumpy, big-ticket capital equipment sales from the current 62.5% weighting to something under 50%, with stable and recurring revenues from monthly rental services and “disposable” medical supplies like needles, bandages, etc. making up the majority of the company’s business.

Hill-Rom is transforming itself from a one-trick pony hospital bed manufacturer with unstable earnings to a diversified medical supplies company and that is a good thing. I like to invest in companies that are improving their business model. The integrity of management is also very important and the honest candor of CEO Greisch is refreshing. Also refreshing is management shareholder-friendly actions that return cash flow to shareholders. Continued acquisitions are a priority to jumpstart growth, but the company is determined not to overpay and is happy to return cash to shareholders while waiting for a good deal. In the past year the company has expanded its share repurchase plan by 3.5 million shares and raised its dividend by a hefty 10%. Quoting Greisch from the conference call:

We remain committed to returning cash to shareholders. Year-to-date, an excess of 50% of our operating cash flow has been deployed toward dividends and share repurchases. During the quarter, we repurchased 700,000 shares of common stock for approximately $26 million, bringing our total for the year to $70 million. This share repurchase activity is consistent with our capital allocation strategy of returning a significant portion of our operating cash flow to shareholders as one of our key levers for creating value. We also announced a 10% increase in our quarterly dividend, bringing our annual rate to $0.55 per share.

Regarding M&A activity, we’re going to remain disciplined around what we go after. So despite the revenue challenges, I don’t want to panic into an acquisition mode just for the sake of going after opportunities if they don’t meet either our strategic objectives or financial objectives, and we’re going to remain disciplined around both of those.

Hill-Rom’s valuation is cheap, with an EV-to-EBITDA ratio of only 8.3. Debt is reasonable at only 22% of total capital. Cash flow per share is greater than earnings per share, which signifies sustainable earnings quality.

The company took a bit earnings hit in fiscal 2009 during the global financial crisis and the uncertainty surrounding Obamacare, and that one bad year continues to skew 3,5, and 10-year annualized earnings and revenue growth statistics. But the future is what counts and its diversification efforts are looking very bright and promise to pay off big. Combined with honest management and a commitment to returning cash to shareholders, Hill-Rom is a small-cap company that should outperform the market over the next 3-5 years.

Hill-Rom Holdings is a buy up to $38; I’m also adding the stock to my Momentum Portfolio.