Stericycle

Research Notes
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Broyhill Asset Management, LLC CDK Research Notes | Page 1

SRCL Investment Thesis
Date: 2/6/2017
Source: Loeb

Stericycle is a diversified business waste collection and disposal company with focuses
in medical waste, pharmaceutical waste, hazardous material waste, sharps management
(think syringes), recall management, compliance management, and secure information
destruction.

The vast majority of the business is relatively simple. Drivers pick up various waste
products and return the waste products to a local Stericycle-owned facility where the
product is either incinerated or autoclaved (high-temperature steam). It is basically a
logistics business with an additional layer of regulatory complexity. Stericycles heritage
is in serving the medical space, from private practices all the way up to hospitals. As you
might imagine, the smaller customers are more profitable than higher volume large
customers such as hospitals. Like FedEx, UPS, and Waste Management, the value in
Stericycles business lies in its network density. The denser the network, the more
profitable a truck can be, or conversely, the lower the price Stericycle could bid and still
break even on each truck in its fleet.

Additional note: Like UPS and FedEx, and Waste Management and Republic Services,
both of these route density-based businesses evolved to be essentially duopolies.
Stericycle has roughly 33% share of its $6BN core U.S. waste collection market
(excludes Shred-it business), and is by far the largest player. In short, there is likely
continued consolidation opportunity in Stericycles most mature market.

Anyways, the business earns over 40% gross margins, 20% operating margins, and over
30% FCF returns on tangible capital.

Historically, the company has grown through hundreds of small acquisitions at 3-6x
EBITDA and grown from primarily a medical waste company into the other adjacencies
mentioned in the first paragraph. Generally, these acquisitions have made a lot of
strategic sense as the company pursues greater economies of scale. However, the Shred-
it acquisition, though still recent, represents a more significant departure from their
core business (as does their client communications business). Obviously, paper is not as
popular as it once was, and some would say its use is in secular decline, especially in the
predominantly medical end markets in which Stericycle dominates. While there is some
customer overlap, I question the idea of buying this business at a full price (9.3x giving
full effect to $50MM synergies and expected $150MM tax benefit. Excluding these
benefits, by my estimates, the purchase price was 12.7x EBITDA).

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 The Shred-it acquisition represents the biggest risk to the company: namely, losing
focus and diworsifying. The companys pre-Shred-it revenue growth model is shown
below:

1. Volume growth 2-3%

2. Pricing 2-3%
3. Acquisitions 2-3%

As a result of this growth and leveraging fixed costs, the bottom line was capable of
growing at a double-digit rate. Fundamentally, I dont think that thesis is broken for the
medical waste businesses, but Im more skeptical about long-term growth existing in the
information destruction segment.

Lastly, the international segment provides a large opportunity for Stericycle. As the only
focused scale competitor that I am aware of, they have a long runway of growth around
the world. Healthcare is still much less common outside North America and Europe,
and regulations are even scarcer. Stericycle is a business that will benefit from
increasing regulation and the global population aging. While it is a less profitable
business than North America right now due to some international customers being
entire countries, the opportunity is vast to penetrate global markets with a more
fragmented healthcare system.

In short, I still believe that Stericycles business offers one the opportunity to invest in a
recession-resistant business with good secular growth prospects. The question is what is
a fair price to pay. Chuck Akre has said that paying 15x cash flows is a good place to start
for businesses that can compound capital, which Stericycle is certainly capable of.

Management estimates free cash flow will be $400-420MM in 2016 and $450-470MM
in 2017. At the midpoint, FCF per share will $4.78 in 2016 and $5.37. At a current price
of $78, SRCL is trading at 16x 2016 FCF and 14.5x 2017 FCF.

I believe a mid-teen return is possible in Stericycle. When you buy a business that can
grow at 8% annually before M&A spending at a nearly 7% cash flow yield, your one-year
return should approximate 15% and longer term fade towards 8% growth. If I pay $100
for an asset that pays me $7, and that $7 grows 8% to $7.56, at a constant valuation, the
business is now worth $108. So youve received $7 that can be reinvested in the business
through M&A or returned to shareholders through dividends/repurchases and your
original investments terminal value is now up 8% ($8).

Note: I dont assume any valuation reversion to historical norms for Stericycle, although
if interest rates were to stay at todays low levels, certainly a 7% free cash flow yield for a
growing business would not make sense. So, there is a little bit of extra upside there, but
I prefer to consider this from a business owners perspective.

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SRCL Thoughts on Competitive Position/Price
Concessions
Date: 2/6/2017
Source: Loeb

SRCL has sold off hard in the last year or so, and I think its an attractive business, and the valuation is on
the verge of being very attractive, probably 10-20% below current prices.

Your question to me when I first showed you the idea was why are they giving price concessions? The
company announced this during 2016 and added to the amount of price concessions they would give
customers. I believe sell-side analysts said at the time that the space has become more competitive. Ive
read notes from managers who bailed on the stock who said they believed the competitive environment
had changed and they no longer held conviction in the company.

I stumbled on a few articles last week talking about people suing the company for price gouging very
recently (with some settlements in the recent past). You have a company giving price concessions and
being sued for overcharging its customers. I dont believe the logical conclusion from this set of facts is
that the business is getting more competitive. Instead, it seems just as likely if not more likely that they
were in fact gouging their customers to juice their organic growth numbers.

While I would never condone this business practice, I believe the fact that they have done this for so long
indicates that the business does have a competitive advantage, and likely has pricing power. They were
abusing that power, but in the event real inflation occurs, I think they should be able to pass along costs
more easily than other players. I dont have all the answers on this, but I think its worth investigating
more.

Additionally, SRCL, while part of the healthcare supply chain, is not part of third-party payor dynamic in
the industry. As I understand it, SRCL is not reimbursed by the government and is not at direct risk of cuts
to reimbursement. Of course, their customers (i.e. private practices, hospitals, urgent care centers, etc.)
are impacted by these dynamics, but they are not directly subject to the whims of the governments
health care policy. This is also a positive factor for the company, because I dont think there is anything
currently preventing them from raising prices (appropriately) when their own costs rise.

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