Description

Recommendation

Long Clean Harbors, ticker: CLH; an attractive SOTP investment with limited downside.

Clean Harbors is North America’s largest provider of commercial hazardous waste collection and disposal. Its incineration assets are particularly valuable with nearly 70% share, high barriers to entry, attractive margins and consistent pricing.

The thesis here is relatively simple: CLH owns a collection of “good” and “bad” assets. The good assets (core waste collection and disposal) are worth more than the current enterprise value and will continue to grow in value. The bad, cyclical assets (oil & gas, Canadian lodging, and motor oil re-refining) have performed poorly over the past several quarters but represent only 20% of EBITDA. At the current price, investors are getting these businesses for “free” with the upside case that they see a cyclical rebound or are divested to unlock the discount.

Background

Norwell, MA-based CLH was founded in 1980 by Alan McKim. He started the business at age 25 as a four-person tank cleaning operation, growing CLH into a leading commercial waste business and taking sales from $50m to $3.5b. McKim remains Chairman and CEO and is also the third largest shareholder with >$200m in stock.

Be warned: CLH is fairly complex. It operates 55 lines of business across 6 segments (as described below). This scares some investors off but is also what likely creates the opportunity. This is especially true as CLH takes steps to simplify the business going forward. The crown jewel is the “technical services” segment, which is undoubtedly a good business. These moat-like assets have seen consistent growth and would be highly valued on a stand-alone basis.

The knock on CLH is that it has been a classic case of “diworsification.” The company has moved away from its high quality legacy business (waste disposal) and into more commoditized, cyclical areas that have subsequently performed poorly. This started about 5 years ago when CLH entered the oil & gas business through the acquisition of Eveready and later Peak Energy. The diworsification was further accelerated by the acquisition of Safety-Kleen for $1.25b in October 2012, introducing yet another unfamiliar and cyclical business: motor oil re-refining.

There was a brief glimmer of hope this past April when Relational announced that they had accumulated a 9% stake and CLH welcomed their input. This has since morphed into an overhang as Relational is now reported to be liquidating. Another recent overhang has been the sharp decline in oil prices. While only 15-20% of sales are related to oil & gas (including lodging and oil sands work), investors appear to have thrown CLH out with all of the oil services stocks. You can see this quite clearly by graphing CLH vs. OIH (the oil services ETF).

As a result, shorts in the name have had success: the stock has done absolutely nothing since 2011 and is down 24% YTD.

Though, to steal a line from Buffett/Gretzky: “skate to where the puck is going to be, not to where it has been.” The key today is that the good assets cover the entire EV and will continue to grow in value. The technical overhang from Relational has surely hurt the stock but is by definition temporary. More important is that CLH has continued its strategic review undeterred and has a buyback authorization in place to take advantage of the weakness. Finally, management will likely take steps to divest the cyclical segments (the “bad” assets). While these businesses have been a doozy of a black eye, they still have significant asset value and such an action could serve as a catalyst to reverse the SOTP discount.

Good assets (78% of sales / 80% of EBITDA)

The good assets consist of the core waste disposal and collection assets plus the industrial business.

Technical services (37% of sales / 50% of EBITDA)

Technical is a very attractive business. This is the core waste disposal segment. Commercial customers (think chemical and general manufacturing co’s) accumulate waste in drums and CLH collects, transports, treats and ultimately disposes of this hazardous material. It does so at a number of different facilities, the largest of which are in Nebraska, Arkansas and Texas. CLH is the dominant player in this niche business with nearly 70% share in incineration (9 of 13 facilities in North America), 24% in landfills (7 of 20) and 35% in TSDFs (Treatment, Storage and Disposal Facilities). This is a very good business for several striking reasons. First, this is close to an annuity revenue stream with increasing demand (commercial hazardous waste) and fixed supply (disposal assets). Second, there are large barriers to entry (a new incinerator hasn’t been built or permitted in 16 years, and a new landfill hasn’t been permitted in 18 years). CLH’s permits are nearly impossible to duplicate. Third, switching costs are highly prohibitive (a result of the lengthy government documentation required). Fourth, CLH has demonstrated pricing power, having taken 4-8% annual price hikes on the incinerator side (equating to ~$20m in EBITDA per year). And, fifth, it’s a very profitable business with EBITDA margins in the mid-to-high 20s. As a result, technical has seen consistent growth and margin expansion. EBITDA has grown at a 14.5% CAGR since 2005 with only 1 down year (-5% in 2009). With utilization in the mid 90s, CLH should be able to continue to take pricing and expand margins going forward. The general drivers are: overall GDP growth/continued industrial output, increased regulation and enhanced cross-selling. In addition, new capacity is set to come on in late FY16 (at CLH’s El Dorado facility). This will provide room for continued growth. I value technical at 8-10x EBITDA and think these assets should trade at a premium to the Waste Managements and Republics of the world given the barriers to entry, superior pricing power and irreplaceable assets.

S-K Environmental Services (23% of sales / 18% of EBITDA)

S-K ES is also a good business – it is a lower growth, lower margin segment (vs. technical) but it has #1 market position across all three of its main businesses (small quantity containerized waste, parts washers and vacuum services). This is a business that came from the Saftey-Kleen acquisition and deals with waste collection and services for a large number of small commercial customers (the main segment being automotive). It operates through >150 local branches. CLH has an opportunity here to recapture share that S-K lost due to years of mismanagement (CEO turnover, PE ownership, bankruptcy and underinvestment). The company also has a much stronger pitch now as a “one stop shop” for waste. The closest competitor, HCCI, is twice as profitable and there should be an opportunity for CLH to increase EBITDA margins over time. This year, EBITDA will likely be flat as it was hard hit by weather in Q1’14 (absent that it would be +10-12%). Going forward, this segment should see HSD growth. I value environmental services at 7-9x EBITDA. The closet comp, HCCI, has historically traded at 7-9x forward EBITDA and that includes its lower multiple used oil business. CLH has a superior small generator waste business that should trade at a premium, not a discount to HCCI.

Industrial and Field Services (19% of sales / 12% of EBITDA)

In the past, investors have looked favorably upon this segment (industrial cleaning, refinery turnarounds, and emergency response work) given the multi-year contracts and strong DD growth. However, today the jury is out given the segment’s exposure to the Canadian oil sands. EBITDA in this segment will likely be down 10% this year due to the lower oil sands activity in conjunction with a weaker CAD and the lapping of a customer loss from Q3’13. Going forward though, it’s important to consider that the majority of the business here is non-oil sands. The segment should do $620m in sales this year and only 30% or $180m is from Canada. The US business is humming along and should see strong growth next year as many US refiners have pushed out turnaround work to the limit (because they’ve been making such good yields). As such, 2015 is setting up for very strong growth in the North America turnaround group. I value industrial and field at 7-9x EBITDA, similar to environmental.

The takeaway here: the “good” assets are worth more than the current EV by my estimation, have a long history of growth and should continue to expand in value.

Bad assets (22% of sales / 20% of EBITDA)

The “bad” assets consist of three segments that are largely unrelated to CLH’s core waste disposal and collection business: lodging (8% of EBITDA); oil & gas (4% of EBITDA); and, re-refining (8% of EBITDA). I could spend a lot of time here but I’ll try to keep it short (and answer questions in the thread) given that these businesses represent a small portion of the value. I’ll start with the bad and end with the ugly.

Lodging Services (4% of sales / 8% of EBITDA)

CLH owns 9 fixed lodges in western Canada that provides accommodation for workers in the oil sands, including its own workers. This business does ~$200m in sales with nearly 40% margins. In addition, >60% of the sales are LT in nature via “take or pay” contracts (a 2-3 year contract where a company guarantees to take x% of the rooms or they pay the whole amount). The problem here is the obvious near-term concern about the oil related slowdown in Western Canada. See charts for CVEO, HNL CN or BDI CN. CLH’s lodging business is higher quality but it still isn’t immune to the risk of lower occupancy.

Oil Re-refining & Recycling (10% of sales / 8% of EBITDA)

Re-refining is a legacy S-K business that operates large plants that turn used motor oil into base oil. CLH is the largest player with more capacity than any other company in the US. Historically, this has been an okay business and S-K used to make a spread between what they bought motor oil at (the price of crude) and what they sold the recycled end product at (the price of base oil). This equation has been turned upside down over the past two years as base oil prices have collapsed (down 38% from June 2012) as the result of additional capacity coming online (new Chevron plant). CLH has the opportunity to fix this by going out to its customers and reducing its PFO (“pay for oil”) price. This will happen but it’s a slow process (the drop in crude could help). Re-refining will likely earn $60m in EBITDA this year vs. what would be something like $120m in a normalized scenario.

Oil and Gas Field Services (7% of sales / 4% of EBITDA)

Finally, there’s Oil & Gas services , which consists of seismic, surface rentals, fluid handling, etc. This is a very competitive business with low barriers and little relation to CLH’s waste operations. It’s been a disaster and the outlook is bleak with crude plummeting. To put this into perspective, I think O&G will do ~$25m in EBITDA next year vs. $77m in 2012.

The takeaway here: The bad, cyclical assets have performed poorly over the past several quarters. This has garnered most of the sell side headlines and is well reflected in estimates at this point. These segments, however, represent only 20% of EBITDA and an even smaller percentage of value given that they are inherently lower multiple businesses. While they may not be at rock bottom, the operating results are getting close… I think the “bad” assets have more upside than downside going forward. At the current valuation, investors are getting these segments “for free” with the potential (like any cyclical business) that they might turn around. In addition, I would not be surprised if management acted to divest one or more of these businesses in the near future. All three of these segments have significant asset value, which could be valuable to a strategic buyer.

In summary, the hair created by CLH’s bad assets has created an opportunity to own the good waste disposal assets at a reasonable price with “free” upside should the cyclical business turn around or get sold. I also like the fact that CLH is run by an owner operator. While he has had his missteps in recent years, McKim has a long history of creating value for shareholders and remains heavily invested.

Capital Expenditures

One of the consequences of CLH’s push into more cyclical segments is that the overall business has become increasingly capital intensive. Prior to the Eveready acquisition (from 1992-2008), CapEx as a % of sales averaged just 3.7%. Since then capital expenditures have ballooned, totaling 7-9% of sales over the past 3 years (see below). This has had the further consequence of dragging down ROIC. However, what you can also see below is total CapEx has far exceeded what management classifies as “maintenance” capital. If you’re skeptical, I understand. I too generally find such classifications as bogus / “fun with numbers.” Though, in this case, you can point to clear projects that are non-recurring, namely: Ruth Lake (a lodge that CLH completed in 2013) and El Dorado (an incinerator expansion that will be completed in 2016). I expect that CLH will spend CapEx of $260m next year and $200-$220m in FY16. That includes El Dorado spend of $60m next year and $10-20m in FY16. As such, if you back out El Dorado, total CapEx would be close to $200m for each of the next two years (5.5%-6% of sales). Management claims that MCX is $140m. I use $170m below in my valuation.

The point is this: the capital intensity of the business is currently elevated and should decline going forward. You have a spurt of growth projects rolling-off, in addition to CLH managers being newly incentivized to reduce unnecessary CapEx. Finally, should CLH’s ongoing strategic review result in a sale of its oil & gas or lodging segment (which I think is likely), CapEx would take another step down as these are much more capital intensive segments despite comprising only a small piece of overall value.

Valuation

I estimate that CLH will earn $550m in EBITDA in FY15. That presumes continued weakness across all of its more cyclical segments. After beating up my estimates, I think this is a realistic target (a far cry from the 3-5 year target of $1b in EBITDA that management laid out at their September 2013 Analyst Day). As such, at the current price of $45.57, CLH trades at the following multiples on FY15:

EV/ EBITDA: 7.3x

EV/EBITDA-MCX: 10.6x

P/FCF (using MCX): 11.0x

It’s worth noting that P/E can be a bit deceiving for CLH because D&A exceeds CapEx, distorting the “economic” EPS. As mentioned above, part of this is due to elevated levels of growth CapEx and part of this is due to amortization from Safety-Kleen.

On a SOTP basis, I value CLH at $64 today and $43 in a downside scenario. You can see my assumptions below and I’m happy to answer questions in the thread about comp multiples, CapEx, etc. In short, this presumes that the consolidated business trades at 7.2x - 9.2x EBITDA. Over the past four years, CLH has traded between 6.5x - 9.5x forward EBITDA and this seems within reason. Most importantly, you get the vast majority of the value from the “good” assets, which I’m happy to own given their strong market share, defensible position and continued growth. These good assets should put a floor on the price and limit the downside.

In 1 year from now, I would expect the fair value to be ~10% higher as the waste assets continue to grow (i.e, I’m basing my PT below on FY15 estimates, not FY16). That gets me to a PT in 1 year of $70 with downside of $47.

Catalyst

Sale of oil & gas or lodging segment

New activist involvement

Continued cost cutting that could drive upside to estimates

Continued growth in technical